Understanding Defined Contribution Plans for Business Owners

As a business owner, you're likely familiar with the concept of retirement plans, but have you ever stopped to think about the specifics of defined contribution plans? A defined contribution plan is a type of retirement plan where your business contributes a fixed amount to your employees' retirement accounts on a regular basis.

This is in contrast to a defined benefit plan, which promises a certain benefit amount to employees based on their salary and years of service. With a defined contribution plan, the benefit amount is not predetermined and can vary depending on the contributions made.

One of the key benefits of defined contribution plans is that they are often more cost-effective for businesses, as they don't require a large upfront investment. In fact, according to our article, "a defined contribution plan can be more affordable for businesses with a smaller workforce."

A defined contribution plan is a type of retirement plan where contributions are paid into an individual account by employers and employees, and the returns on investment are credited to the individual's account.

Contributions can come from employee salary deferral or employer contributions, making it a flexible arrangement for both parties.

In a defined contribution plan, investment risk and investment rewards are assumed by each individual, not by the sponsor or employer.

The portability of defined contribution plans is generally the same as defined benefit plans, but due to lower administrative costs, defined contribution plans have become more portable in practice.

The cost of a defined contribution plan is easily calculated, but the benefit depends on the account balance at the time of retirement, making it unpredictable.

Defined contribution plans have become widespread globally, with many countries adopting them as the dominant form of plan in the private sector.

In some countries, such as France, Italy, and Spain, there's a significant risk of not having enough savings to replace income in retirement, with a 10% probability of a real replacement ratio of 0.25, 0.20, and 0.17 respectively.

The plan sponsor retains a significant degree of fiduciary responsibility over investment of plan assets, including the selection of investment options and administrative providers.

Designing a defined contribution plan is crucial to its success. Employers should take into account a variety of factors in designing their plans, including a guide to common qualified plan requirements.

An effective design of a defined contribution plan's vesting schedule can encourage retention. Cliff vesting requires an employee to remain employed for at most three years before becoming vested in any portion of their employer contributions. Different vesting schedules may be established for union and nonunion employee groups if the union vesting schedule is negotiated.

Employer contributions must be 100 percent vested immediately if the employer's nonelective or matching contributions are used to satisfy a safe harbor. This trade-off needs to be evaluated by an employer considering taking advantage of a safe harbor.

You can voluntarily contribute up to 100% of your annual compensation on a pre-tax basis, but typically no more than $23,500 for 2025.

Contributions can be made with catch-up provisions if you're over age 50, allowing you to contribute more. Participants aged 60, 61, 62, and 63 can contribute an additional amount on top of the normal contribution limit.

Some employers may offer a matching contribution to your account, which can differ in amount and not every employer offers it. Employer contributions are usually a fixed-dollar or percentage amount, matching your own contributions.

If your employer offers a 6% match, they'll match your contribution to your account dollar for dollar up to 6% of your salary. You always fully own your contributions and associated earnings.

A defined contribution (DC) plan, like a 403(b) plan, takes pre-tax dollars and allows them to grow capital market investments tax-deferred. This means income tax will ultimately be paid on withdrawals, but not until retirement age.

DC plans accounted for $10.6 trillion of the $38.4 trillion in total retirement plan assets held in the United States as of Dec. 31, 2023.

Employer contributions play a significant role in defined contribution plans. Employers can choose to make no contribution, nonelective contributions, or matching contributions. A plan document may specify the amount of employer contributions to be made each plan year or the formula to determine the amount.

Employers have the discretion to decide whether to make nonelective or matching contributions, or both, for each plan year. This flexibility allows employers to adjust their contributions based on their financial situation. Decreasing the employer contribution requirements in the plan document generally requires amending the plan document before the time when the employer contributions must be allocated to participants' accounts.

Employer contributions are subject to vesting, which means they become nonforfeitable after a certain period of time. The structure of a plan's vesting schedule is limited by the Internal Revenue Code. Alternatives to offering immediate vesting in the plan are cliff or graded vesting schedules.

Here are some key points about vesting schedules:

Employer contributions can be a valuable benefit for employees, especially if they are matched by the employer. The most common employer matching contribution is $0.50 per $1 contributed up to a specified percentage. Some companies match contributions dollar for dollar up to a percentage of an employee's salary, generally 4% to 6%. It's best to contribute at least the maximum amount they'll match if your employer offers matching on your contributions because this is essentially free money that will grow over time and will benefit you in retirement.

Automatic enrollment can be a game-changer for retirement savings. Employers can automatically enroll eligible employees in the plan unless they opt out, which can significantly increase participation in the 401(k) plan.

According to a 2019 Deloitte survey, 69 percent of plan sponsors include an automatic enrollment feature, with three or six percent being the most common default deferral percentages.

Employers have the option of implementing an automatic increase in employee contributions, with an increase of 1 percent per year being the most common.

New 401(k) plans established after Dec. 31, 2024, must include automatic enrollments for all eligible participants at no less than 3 percent and no more than 10 percent of qualifying earnings, with automatic 1 percent increases annually up to a maximum limit set between 10 percent and 15 percent.

Participants may opt out and may recoup contributions within 90 days of the start of automatic enrollment without penalty.

There are two basic approaches to allocating responsibility for investment of the plan's assets: participant directed and administrator directed.

Participant directed is the most common approach, where each participant has the authority and responsibility to direct the investment of their own plan account.

This approach allows participants to make investment decisions that reflect their own risk tolerance, expected investment horizon, and other retirement assets outside of the plan.

To reduce exposure to ERISA fiduciary liability, the plan administrator may comply with specific requirements under §404(c) of ERISA.

These requirements include the frequency with which participants can change investment elections, the range of investment options offered, and the information provided to participants on the investment options.

A variation on participant directed is to provide access to a qualified investment advisor, whom participants may elect to give control over the investment of their accounts.

If the plan administrator selects the investment advisor, they are subject to ERISA fiduciary duty requirements with respect to the selection and retention of that advisor.

In a 403(b) plan, participants control how their account is invested, choosing from a wide range of options, including stable-value investments, bond and stock funds, and target-date or target-risk funds.

It's essential to evaluate each 403(b) plan carefully, as plan designs can vary significantly, especially related to fees and expenses.

Over time, plans with higher fees will diminish retirement assets, and fixed-rate investments may not offer the same level of potential growth as mutual funds and other variable-rate investments.

Plan design and management are crucial aspects of a defined contribution plan. Employers should take into account various factors in designing their plans, including the type of vesting schedule to use.

A cliff vesting schedule requires an employee to remain employed for up to three years before becoming vested in any portion of their employer contributions. This can encourage employees to remain employed for a longer period of time.

Employer contributions to a defined contribution plan become vested when the participant has a nonforfeitable right to some or all of the employer contributions if the participant terminates their employment. The structure of a plan's vesting schedule is limited by the Internal Revenue Code.

A graded vesting schedule provides for partial vesting, delaying full vesting for up to six years of service. The participant's vested percentage in the employer contributions starts at less than 100 percent and increases with each year of service.

Here are the key differences between cliff and graded vesting schedules:

The choice of vesting schedule depends on the employer's goals and the employees' needs. Employers should carefully design a defined contribution plan to provide affordable retirement benefits to employees.

Defined contribution plans come in various types, each with its own unique features. Profit sharing plans, for example, allow employers to contribute a percentage of profits to employees' accounts.

Money purchase plans, on the other hand, require employers to make fixed contributions to employees' accounts each year. Employee stock ownership plans (ESOPs) are another type of defined contribution plan, where employees own shares of the company's stock.

The most common type of defined contribution plan is the 401(k) plan, which is offered by 94% of employers, according to SHRM's 2022 Benefits Survey.

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Let's break down the different types of defined contribution plans. A 401(k) plan is a type of defined contribution plan that's available to employees of publicly-owned companies, and 94% of employers offer one according to SHRM's 2022 Benefits Survey.

Profit sharing plans, money purchase plans, and employee stock ownership plans are also examples of defined contribution plans. These plans are similar to 401(k) plans in that the benefit payable at retirement is determined by the amount of contributions made.

The 403(b) plan is a type of defined contribution plan that's typically open to employees of nonprofit corporations, such as schools. This plan is similar to a 401(k) plan but has some key differences.

457 plans are available to employees of certain types of nonprofit businesses as well as state and municipal employees. The Thrift Savings Plan (TSP) is used for federal government employees, providing a similar benefit to a 401(k) plan.

In a combined approach, participants are permitted to direct the investment of a portion of their plan accounts, while the plan administrator retains investment authority and responsibility for the remainder of the plan assets.

This approach allows participants to have some control over their investments, while also giving the plan administrator some protection from ERISA fiduciary liability.

The plan administrator remains responsible for selecting the investment options made available to plan participants and for monitoring those options to ensure they remain appropriate.

The plan administrator will also be required to specify a default investment option into which a participant's account will be invested if the participant does not provide any investment directions.

This default investment option is also a fiduciary act under ERISA, and the plan administrator will be exposed to ERISA fiduciary liability if it does not exercise this responsibility in compliance with ERISA fiduciary duties.

Employers that sponsor defined contribution plans often opt for a combined approach, as it balances participant control with plan administrator responsibility.

In a combined approach, the plan administrator will never fully escape all potential liability for breach of its ERISA fiduciary duties, but it can obtain some protection by complying with the requirements of §404(c) of ERISA.