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of time, the amount of the benefit offered with a two-life guarantee should be expected to
be lower than for a benefit guaranteed for only one life.Defined Contribution Plans
Unlike defined benefit plans, defined contribution (DC) plans do not provide a fixed,
guaranteed income in retirement. Instead, the employer contributes money to a retirement
account for each employee on the basis of some set formula. The money is then invested
and (hopefully) grows in value during the employee’s working years. In retirement, the
employee has the assets in this account to live on.
Sometimes the contributions to the plan are made entirely by the employer. In most
plans of this type, though, the employee is either permitted or required to contribute money
as well. It is not uncommon for the contribution formula to base the amount the employer
contributes on the amount the employee does. The following examples represent typical
defined contribution formulas.Example 7.1.4 The company Jesse works for contributes 8% of each employee’s
annual earnings to a defi ned contribution plan, provided that the employee contributes
at least 3%. Jesse makes $32,500 per year. How much will go into his account this year
if he contributes (a) nothing, (b) 3%, and (c) 10% of his income?(a) If Jesse does not contribute anything himself, neither does his employer. Nothing goes
into his account.(b) If Jesse contributes 3%, his employer will contribute 8%. So Jesse contributes (3%)
($32,500) $975, and the company contributes (8%)($32,500) $2,600, for a total of
$975 $2,600 $3,575.(c) If Jesse contributes 10%, that amounts to (10%)($32,500) $3,250. The company
still contributes 8%, or $2,600. The total going into his account will be $3,250 $2,600
$5,850.With another type of common formula, the employer contribution is a percent of the
employee’s. This sort of formula is often referred to as matching.Example 7.1.5 Daxxilon Digital Devices has a defi ned contribution plan. The
company matches 75% of each employee’s contributions up to a maximum of 10%.
Hamid earns $60,000 at this company. How much will be deposited to his account this
year if he contributes (a) nothing, (b) 5%, (c) 15% of his earnings?(a) If Hamid does not contribute anything himself, neither does the company. Nothing will
be deposited.(b) If Hamid contributes 5%, this means he will deposit (5%)($60,000) $3,000. The com-
pany matches 75% of this, or (75%)($3,000) $2,250. The total deposited will be $3,000
$2,250 $5,250.(c) If he contributes 15%, he will deposit (15%)($60,000) $9,000. The company will
match only up to 10%, though, so it will deposit (75%)(10%)($60,000) $4,500. The total
going into his account will be $9,000 $4,500 $13,500.Vesting
What happens if you leave your job, for whatever reason, before you reach retirement
age? Or, what if your employer decides to change or even discontinue its retirement plan
before you reach retirement age? What happens to your retirement benefits? After you have
accumulated a certain number of years of service, you become vested in the plan, meaning
that any benefits earned will not be lost, regardless of whether or not you continue working
or even if the plan is discontinued.
How quickly someone attains this vesting is determined by a vesting schedule, which
is determined when the plan is put into place. Vesting may be an all-or-nothing deal, or the7.1 Basic Principles of Retirement Planning 309