Article: Defined Contribution Plan Overview

Email this information to a friend/associate Print this information Contact this Author View this advisors's profile

Frank Armstrong, is President and founder of Investor Solutions, Inc. He is a pioneer in integrating academically driven portfolio management techniques with institutional best practices for individual investors around the world. Frank has over 30 years experience in the securities and financial services industry. He holds a B.A. in Economics from the University of Virginia and is a CERTIFIED FINANCIAL PLANNER® practitioner.

Defined Contributions Pension Plans

Like it or not, Defined Contribution (DC) plans are the wave of the future. Understanding how they work, and how to make them work to meet your needs will be a critical part of your retirement strategy.

DC pension plans come in several flavors each with their own particular quirks. They all share common traits: a formula determines how much is contributed for each participant, each participant has his/her own separate account or readily identified share of a pooled account. The ultimate benefit depends on the investment results of the account.

This design concept has important implications for both plan sponsors and participants.

For plan sponsors

• Most importantly, because there is no fixed retirement benefit guarantee, the problem of under funding that was so vexing in the defined benefit pension plan is not an issue. Once the plan contribution is made the sponsor need not be concerned about potential future pension liabilities. There is no possibility that a down securities market can destroy earnings or decimate the balance sheet.
• The sponsor can plan annual costs with a great deal of certainty.
• Plan administration, compliance, and associated costs can be substantially reduced. There is no annual actuarial reporting, and no PGGC insurance requirement.
• Plan administration, and investment costs can be shifted entirely to the participants if the sponsor so elects.
• In plans that allow self direction and comply with certain “safe harbor” provisions, fiduciary liability for investment choices can be substantially eliminated.
• A portion or all of the funding costs may be shifted to the participants through required contributions, matching requirements and/or pre-tax contributions.

For Participants

• Accurate forecasting of benefits is not possible.
• The plans tend to be more “portable” when changing jobs.
• Younger participants will have proportionally more benefit per dollar spent on the plan at retirement than older participants.
• Especially for younger participants, with decent investment results there is a possibility for higher benefits than a defined benefit might offer.
• If plans feature self direction, the entire responsibility for investment outcome shifts to employees. Investment choices available under the plan may be inadequate to properly control risk and reward characteristics of the account.
• Where administrative and investment costs are passed on to the employee, they may be so burdensome that they substantially reduce future benefits.
• Where contributions are required, employees must determine if the benefits provided by the plan are superior to their other alternatives.

The Basic Defined Contribution Plan

The “vanilla” DC Plan is also called a Money Purchase Pension Plan (MPPP).  The plan sponsor simply contributes to an account according to a formula, usually based on compensation. The account grows until the employee either terminates or retires. Then the vested balance is turned over to the employee, often as a lump sum, or alternatively and less frequently as an annuity. This type design clearly benefits younger employees that have a long time for the account to grow before it is needed.

Defined Contribution Plans offer a powerful combination of benefits to both sponsor and participant:

• The contribution is fully deductible for the sponsor, and not taxable to the employee. The employee even escapes the Social Security and Medicare Tax on the contribution.
• Contributions grow free of tax burden until distributed. While the funds are inside the plan, there is no tax drag for dividends, capital gains, or interest.
• Participants may be in a lower bracket when funds are distributed than during their working career. Deductions at a high marginal rate coupled with distributions at a lower rate are a powerful leverage of the tax system.
• Assuming the sponsor makes the contributions in a timely manner, the fund can never be under funded.
• The funds are in a separate trust for the benefit of the employee/participants. Even if the sponsor company vaporizes, the trust is protected against creditors.
• Savings are automatic. Because the funds never reach the employee and go directly to a retirement investment program,

In 2004, the maximum contribution per individual is $41,000 or 25% of compensation, whichever is less.

Here’s an example of how this simplest of Defined Contribution plans might work: The company contributes 10% of compensation to a pension fund each year. Two employees each make $50,000 a year. The company contributes $5000 for each. One employee enters the plan at age 25, one is 45. Assuming they both work until age 65 and that the plan has a compound return of 8% per year, the younger employee can look forward to a benefit of $1,295,282, while the older receives only $228,809. The difference in benefit ($1,066,472) has little to do with what the company contributed (in this case an additional $100,000) and a lot to do with the additional time the money had to grow.

Another big factor that impacts the final benefit is the plan’s investment return. If the plan’s net return in our previous example increased to 9%, the final lumps sums rise to $1,689,412 and $255,800 respectively. These are non-trivial differences, at least in my neighborhood.

In a defined benefit plan, the plan sponsor must make up any deficiency if investment returns fall below target. No so in a defined contribution plan. There is no target, and poor returns will simply result in low benefits. However, as fiduciaries, they must insure that the plan assets are invested prudently.

Plan sponsors are not supposed to invest in just any old junk. ERISA dictates very stringent fiduciary obligations which have been further expanded by a Uniform State Prudent Investor Act, a mountain of case law, and volumes of regulations. Together they set a very high standard for anyone that has responsibility over investment decisions for qualified plans. Additionally, ERISA and subsequent regulations impose personal liability for breaches of fiduciary duties. We will have lots more to say about fiduciary standards and procedures later.

Plan sponsors can and should delegate to a “prudent expert” some of their responsibilities. However, they must carefully select and continuously monitor the advisor, and they can never completely escape their obligations or liability.

Investment Control and Safe Harbor Provisions

If the plan sponsor retains investment control by offering no investment options, it also retains fiduciary liability for the investment results. Participants may later claim that the plan was too risky, causing them loss, or that the plan was so conservative that they didn’t obtain market returns.

As you can imagine, many plan fiduciaries do not enthusiastically embrace any form of liability that they might be able to unload. As it turns out they can shed a great deal of it – but not nearly as much as many of them might think. ERISA contains “safe harbor” provisions that if met, transfer much of the investment risk to the plan participant. By offering participants a choice of investment options in a form that complies with the ERISA regulations, liability for the investment results is transferred to the participant. The so called Section 404(c) provisions are almost universally misunderstood, and far too often misapplied with unfortunate results for the participants.

While often displayed by glib salesmen on a single slide with 4 bullet points, the actual subsection is 12 single spaced pages in the code and requires far more than most plans offer. Failure to fully comply with the provisions extinguishes the safe harbor hopes of the plan sponsors. Worse yet, it limits the ability of participants to control their investment results, optimize returns and limit risk.

We will have more about Section 404(c) in subsequent articles.

Funding Options

In defined benefit plans the sponsor contributes both investment funding plus plan administration costs. In defined contribution plans, the sponsor can either pay the administrations separately as a necessary and proper business expense, or have them deducted from the participant accounts. The second option shifts the cost to the participant, and reduces the ultimate benefit proportionately. More about that later, too.

Portability

DC Plans are usually much more portable than Defined Benefit Plans. Participants are encouraged to take their pension balances with them when they change employers. This opens up opportunities for the knowledgeable or pitfalls for the unwary.  A subsequent chapter will explore the options for employees changing jobs.

Coming up:

Our next article will examine some additional common varieties of defined contribution plans: the profit sharing plan, the 401(k) plan, and their close cousin for not for profit ventures, the 403(b) Plans.

> Return to Planning for Retirement