What is an employee contribution plan?
An employee contribution plan is a type of employer savings plan. By choosing to participate in the plan, employees contribute a percentage of their salary to the plan, which is then invested on their behalf by a third-party plan administrator. Employers, on the other hand, will generally match a portion of employee contributions.
Unlike a defined benefit plan, the employee does not know the future value of his savings plan. Instead, this future value depends on a number of factors, including the amount of contributions made by the employee, the extent to which their employer has matched those contributions, and the return on the savings plan’s investments. -same.
Key points to remember
- An employee contribution plan is a type of savings plan sponsored by employers on behalf of their employees.
- They require the employee to put funds into their paychecks, which are then invested by a third-party plan administrator.
- Many employee contribution plans also include an employer matching component, which makes them more attractive investments.
- Unlike defined benefit plans, which provide the employee with a guaranteed future sum, the value of employee contribution plans fluctuates based on the market and other factors.
- Most employee contribution plans are tax-deferred investment products.
Understanding an employee contribution plan
Employee contribution plans are designed to help employees save for their future. In the United States, common examples of employee contribution plans include defined contribution pension plans such as 401 (k), employee share purchase plans (ESOPs), and corporate profit sharing plans.
Employee contribution plans have become more popular in recent decades, gaining ground over defined benefit plans. Under defined benefit plans, the employee is guaranteed a specific benefit which is paid to him upon retirement. They can thus anticipate their retirement knowing that a certain level of income will be guaranteed by their employer.
In contrast, employee contribution plans do not offer any guarantee that a lump sum or a particular income will be paid in the future. Instead, the benefit received in the future will depend on the performance of the plan’s invested assets; the employee may get less or more than expected, depending on market behavior before retiring. In this way, employee contribution plans effectively transfer the investment risk from the employer to the employee.
Design of an employee contribution plan
Employers who create employee contribution plans are called the “sponsors” of those plans, while companies that actually invest and oversee plan assets are called plan administrators.
These third-party companies are responsible for tasks such as record keeping, regulatory compliance, and training employees on their investment options. Employees, on the other hand, are fully responsible for choosing from the available investment options.
Typically, employee contribution plans offer a range of debt and equity investment options, including domestic and international mutual funds, fixed income funds, and money market investments.
While these selections tend to be relatively conservative, some plans also offer self-directed brokerage services through which the employee can select individual equity investments. In some cases, the employer sponsoring the plan will also offer their own company stock, sometimes at a reduced price.
Many employee contribution plans offer tax benefits. The portion of an employee’s salary that is invested is pre-tax, meaning their taxable income is lower, resulting in less tax paid on their income. Taxes on plan funds are incurred when withdrawn, that is, usually during a person’s retirement when they are in a lower tax bracket.
Popularity of employee contribution plans
Employee contribution plans have been a very successful product and have grown in popularity over time. Initially, the participation rate in contribution plans was low, but as they became more widely available and steps were taken to increase participation, such as automatic enrollment, they saw a significant increase.
Vanguard, one of the largest investment firms in the world, reports that participation in Vanguard’s 401 (k) plans increased from 76% in 2010 to 83% in 2019. It also reports that the participation rate in plans between 90% and 100% a fell from 21% to 49% over the same period, while a participation rate of less than 50% fell from 10% to 6%.