Nearly 30 years ago, the Internal Revenue Service approved the use of defined benefit programs to help future Baby Boomers (and following generations) better plan for their retirements. This came at a time when longevity at one company in order to earn a pension plan was quickly becoming a thing of the past.
While the entire employee benefits market has been transformed by more recent mandates set forth by the Affordable Care Act, ERISA and other benefit laws, there is still a strong link between defined contributions and retirement plans that can influence compensation.
What are Defined Contributions?
If you are somewhat unfamiliar with defined contributions, or just need a refresher – let’s define what this is and how it differs from a defined benefit plan.
As mentioned above, pension plans are a form of defined benefits. How they work is that the employer will give an employee a certain amount of money at retirement. The defined benefit is based on several factors, including length of service and the overall salary earned while employed. The company chooses how much they want to put into the defined benefit. At retirement, generally age 65, the employee then receives a monthly distribution from this account until the funds are gone.
A defined contribution is different. In this type of plan, there is a specific amount of money that goes into the retirement plan from day one of eligibility. The retirement plan, generally a 401(k), is funded by both the employer and the employee. The defined contribution is based on a percentage of the employee’s salary, or it can be a flat rate added to the fund periodically. The funds are generally invested in mutual funds that remain in the retirement plan account. Therefore, the amount that is available for distribution upon the employee’s retirement is based on how much the employee saved, how much the employer contributed, and how well the funds performed in the investments.
Why Defined Contributions Work Well
Over the last couple of decades, the defined contribution has emerged as the leading way in which employers help employees plan for the financial responsibilities of retirement. The reasons for this include:
- Historical problems with the management of pension plans, including company bankruptcies which eliminate defined benefits
- Long term obligations and high costs associated with running defined benefit plans from the employer perspective
- More tax credits for employers and tax shelters for employees who choose defined contributions vs. pension plans
- Opportunity to leverage defined contribution plans as part of a total compensation package
How Defined Contributions Improve Retirement Savings Plans
There are several ways that employers can use defined contribution plans to boost employee participation in retirement savings plans.
- First, start with a strong compensation strategy that highlights how much the company contributes to the 401(k) plans offered. Encourage all employees to at least contribute the minimum percentage of their pay. Use examples of how employees are planning well in advance for their retirements, with success stories.
- Second, offer defined contributions that are above the IRS minimums to make the most of tax breaks. Move away from retirement options that do not offer the maximum in tax credits for the business.
- Lastly, use defined contributions as a way to start having conversations around compensation with your entire team. Use reports like PayScale’s Total Compensation Statement to increase awareness of important trends in your industry where it relates to compensation methods. Get buy in from your management team to offer something more to your best workers to increase productivity when they don’t have to worry as much about their future incomes.
When you clearly see the link between defined contributions and retirement planning, your organization will be better able to retain your most valuable workers until they are ready for the next chapter of their lives.