Defined Contribution Plans

While defined-contribution plans are often referred to as pension plans, they don't work in the same way as defined-benefit plans, which are what most of us think of when we think of pensions. Those who are covered under defined-benefit plans are paid a fixed benefit upon retirement, regardless of how much they contribute to the plan while they're working. Those covered under defined-contribution plans contribute a fixed amount but do not receive a fixed benefit. In other words, the amount of the benefit at retirement will depend on how much the employee and employer have contributed, along with how well the investments do over the years. The most common defined-contribution plan is the 401(k).

If you participate in a defined-contribution plan, it can often feel overwhelming to think about the fact that the investment decisions you make today directly affect the amount of money you'll have to live on during retirement. The total value of the account will depend on how much you contribute, how aggressively or conservatively you invest, and how market cycles affect growth. To make the most of your defined-contribution plan you'll need to contribute the right percentage of your salary, make informed investment decisions, and put time on your side.

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Types of Defined-Contribution Plans

The most well-known defined-contribution plan is the 401(k). Other types of plans include 403(b), ESOP (employee stock ownership plan), and profit-sharing plans. Self-employed individuals also have the option of establishing a SEP IRA, into which they make pre-tax contributions for themselves and their employees.

With 401(k) and 403(b) plans, the maximum contribution allowed is $16,500 for those under age 50 and $22,000 for those between the ages of 50 and 70. Most employers that offer either a 401(k) or 403(b) plan also provide a matching contribution. While the amount is up to the employer, a typical match is a percentage of an employee's salary. For example, an employer who offers a 6% match would contribute $4,500 to the account of an employee earning $75,000.

If your employer offers a defined-contribution plan with a matching contribution, take advantage of it. First, the money you contribute consists of pre-tax dollars that are taken right off the top of your annual income. Second, the employer's match is free money. In the above example, the employer is literally giving the employee an additional $4,500 for the year. If your salary isn't that high or if you have other financial obligations that prevent you from contributing the maximum amount allowed, contribute at least the amount of the employer's match. If your employer provides a 6% match, you should contribute at least 6% of your salary.

How to Choose Investments in a Defined-Contribution Plan

Most defined-contribution plans offer a number of investment options. In general, larger companies will offer more choices than smaller ones, but the following mutual fund categories should be represented: ttock, bond, balanced, and asset allocation funds.

Stock funds will include large cap funds that invest in large, stable, "blue chip" companies, mid cap, and small cap funds that invest in smaller companies, international funds that invest in companies of other countries, and sector funds that invest in specific market sectors like technology, energy, and financials.

Bond funds invest in debt securities of various terms, yields, and quality. Types of bond funds include those that hold United States Treasuries, municipal bonds, and corporate bonds. Funds that invest solely in US Treasuries will provide a higher level of safety but will also return less. Corporate bond funds offer the potential for higher returns but also present more risk of loss.

Balanced funds invest in stocks, bonds, cash, and cash equivalents such as certificates of deposit. Asset allocation funds invest in all of the above in certain percentages. Stocks, bonds, cash, and cash equivalents are divided into percentages based on the goal of the fund. The fund can be weighted toward aggressive growth, growth, growth and income, or income only.

When to Rebalance Contributions to a Defined-Contribution Plan

Choosing the right balance between stocks and bonds and growth and income isn't always easy. Asset allocation should be based on your age and level of risk tolerance. The trick is to make sure that you've selected investments that will grow at a rate that will allow you to retire comfortably without taking on too much risk. While the most appropriate level of asset allocation is unique to you and based on your personal choices, there are some guidelines to follow. In general, those between 25 and 45 should have up to 90% of their defined-contribution accounts in stocks and 10% in bonds. Even with serious declines in the stock market during certain turbulent economic periods, equities have returned an average of 10% per year over the past 70 years. Granted, your average return will be based on the actual years you'll be investing and not the past 70 years, but stocks outperform all other asset classes.

Investors between the ages of 45 and 60 should assess the value of their defined-contribution accounts and rebalance based on what they have and where they need to be. While it's certainly acceptable to keep a large portion of the account in equities, the allocation should shift to between 70% and 80% in stocks funds and 20% to 30% in bond funds. If you'd prefer not to have such a high percentage of your account in bonds, you should at least invest in less aggressive stock funds in order to protect your assets.

In your 60s, it's usually best not to hold more than 60% to 65% in stock funds. Stocks are much more volatile than bonds, and you need to make sure that the gains that have been earned over the several decades aren't lost.

What are the Advantages of Defined-Contribution Plans?

There are three main advantages of defined-contribution plans: contributions are made with pre-tax dollars; an employer may offer a match that is the equivalent of getting free money; and taxes on earnings are deferred until distributions begin.

What are the Downsides of Defined-Contribution Plans?

While defined-contribution plans offer many more advantages than disadvantages for most people, there are a few things to consider when enrolling in an employer-sponsored plan.

First, investment choices rest solely with the employee. For this reason, participants are always advised to seek the help of a qualified financial advisor to ensure that they select the most appropriate funds. Second, contributions cannot be made after an employee reaches age 70 ½, even if he or she is still working. Third, distributions will be made based on the age at which they begin and the value of the account. Because distributions are taxed at ordinary income rates, it's always possible that a retiree's tax bracket could be the same or even higher at retirement. Finally, while an employee can take a loan against the account value if the plan allows for it, early distributions that do not meet strict federal guidelines will be subject to a 10% penalty.

While we've covered the basics of pensions here, there is much more to developing a solid retirement plan. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.

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