What Is an Employee Contribution Plan?

An employee contribution plan is a type of employer-sponsored savings plan. By choosing to participate in the plan, employees contribute a percentage of their paycheck into the plan, which is then invested on their behalf by a third-party plan administrator. Employers, meanwhile, will typically match a portion of the employee's contributions.

Unlike a defined benefit plan, the employee does not know what the value of their savings plan will be in the future. Instead, that future value depends on a number of factors, including the size of contributions made by the employee, the extent to which their employer-matched those contributions, and the investment performance of the savings plan itself.

Key Takeaways

  • An employee contribution plan is a type of savings plan sponsored by employers on behalf of their employees.
  • They require the employee to contribute funds out of their paychecks, which are then invested by a third-party plan administrator.
  • Many employee contribution plans also include a matching component from the employer, making 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 intended to help employees save for their future. In the United States, common examples of employee contribution plans include defined contribution pension plans such as the 401(k), employee stock ownership plans (ESOPs), and corporate profit-sharing plans.

Employee contribution plans have become more popular in recent decades, gaining ground relative to defined benefit plans. Under defined benefit plans, the employee is guaranteed a particular benefit paid to them in retirement. They can thus plan ahead for their retirement knowing that a certain level of income will be provided by their employer.

By contrast, employee contribution plans offer no guarantee that any particular lump sum or income will be delivered in the future. Instead, the benefit received in the future will depend on the performance of the plan's invested assets; the employee may obtain less or more than they expected, depending on how the market behaves before they retire. In this manner, employee contribution plans effectively shift the investment risk from the employer to the employee.

Design of an Employee Contribution Plan

The employers who create employee contribution plans are known as the "sponsors" of those plans, whereas the companies who actually invest and oversee the plan assets are known as its plan administrators.

These third-party companies are responsible for tasks such as record-keeping, regulatory compliance, and educating employees about their investment options. The employees, meanwhile, are fully responsible for choosing among the available investment options.

Types of 401(k) Accounts

Although the term "401(k)" is commonly used in the media, there are in fact many different types of 401(k) plans. These include safe harbor plans, automatic enrollment plans, and the Savings Incentive Match Plan for Employees of Small Employers (SIMPLE).

Typically, employee contribution plans will offer a range of debt and equity investment options to choose from, including domestic and international mutual funds, fixed-income funds, and money market investments.

Although these selections tend to be relatively conservative, some plans also offer self-directed brokerage services through which the employee can select individual stock investments. In some cases, the employer sponsoring the plan will also offer their own company stock, sometimes on a discounted basis.

Many employee contribution plans provide tax benefits. The portion of an employee's salary that is invested is pre-tax, which means that their taxable income is less, resulting in fewer taxes paid on their income. Taxes on the funds in the plan are incurred when they are withdrawn, which is usually during an individual's retirement when they are in a lower income-tax bracket.

Popularity of Employee Contribution Plans

Employee contribution plans have been a very successful product and have been growing in popularity over time. Initially, the participation rate of contribution plans was low, but as they became more widely available and measures were taken to increase participation, such as automatic enrollment, they have seen a significant increase.

Vanguard, one of the largest investment companies in the world, reports that participation in Vanguard's 401(k) plans has increased from 76% in 2010 to 83% in 2019. It also reports that the plan participation rate between 90% and 100% has increased from 21% to 49% in the same period, while a participation rate of less than 50% has decreased from 10% to 6%.