A Defined Contribution Plan is a type of retirement plan where the employee contributes a specified percentage of their salary to the plan. In many cases, employers also contribute by matching a portion of the employee's contributions. The money in the plan is then invested, and the growth of the investments determines the amount available to the employee upon retirement. Examples of Defined Contribution Plans include 401(k) plans in the United States or similar pension systems available worldwide.
These plans are popular because they allow individuals to take control of their retirement savings. For instance, an employee might decide to contribute 5% of their paycheck to their 401(k) plan, and their employer might match this contribution up to a certain percentage. The combined contributions are then invested in funds chosen by the employee, typically offering a range of stock, bond, and money market investment options. Over time, the investments may grow depending on market conditions, giving the employee a larger sum to withdraw during retirement.
The primary difference between Defined Contribution Plans and other types of retirement plans, like Defined Benefit Plans, is that the latter guarantee a fixed payment upon retirement, while Defined Contribution Plans do not. Instead, the payouts from a Defined Contribution Plan are entirely dependent on the investment's performance. Hence, financial planning and investment strategy are critical for individuals using Defined Contribution Plans.