What is an Employee Contribution Plan
An employee contribution plan is an employer-sponsored savings plan where employees elect to save a portion of each paycheck in an investment account. Employee contribution plans are subject to annual contribution limits imposed by the federal government, but often have tax benefits such as deferred taxes on investment gains and the ability to contribute pre-tax income. Employees always own 100% of the contributions they make. Some companies match employee contributions up to a specified limit, but the employee may not own the entire matching contribution until it fully vests after several years of continued employment.
Breaking Down Employee Contribution Plan
Employee contribution plans in the United States include defined contribution plans such as the 401(k), the 403(b), employee stock ownership plans (ESOP), and profit-sharing plans. Types of 401(k) plans include: traditional 401(k) (the most popular); safe harbor 401(k); SIMPLE 401(k) and automatic enrollment 401(k).
Unlike a defined benefit plan, where the employer pays the employee a predetermined amount of benefits during retirement, a defined contribution plan's payout is based on how much money the employee contributes, whether the employer matches a percentage of those contributions, how the employee chooses to invest the money in that plan and how those investments perform over time. Employee contribution plans shift investment risk from the employer to the employee. As such, the value of an employee contribution plan may rise or fall based on the performance of the investments in it.
Employee contribution plans are set up by employers (plan sponsors) with the help of third-party plan administrators who manage recordkeeping, provide a platform with investment options, help educate plan participants, oversee disclosures, and handle proxy voting, regulatory compliance, among other services.
Employee Contribution Plan Investing
Employees are fully responsible for choosing what to invest in in their employee contribution plan. Most plans have a wide variety of debt and equity mutual fund investment options covering the full spectrum of diversification, cost, style, geographic focus and capitalization. Most plans will offer a full range of domestic and international equity mutual funds, target-date funds, fixed income funds, and cash investments. Most selections tend to be relatively conservative, though some plans may feature a self-directed brokerage option or a company stock option, which tend to be riskier.
Roughly two-thirds of American employees who have access to an employee contribution plan fail to contribute to it. And those who do are not contributing enough to receive their full company match. Studies also show that automatic enrollment — a strategy some plan administrators use to help employees start saving — has only limited success in encouraging plan use and engagement. Employees are usually enrolled at a lower-than-optimal rate and many fail to amend their default investment selection, which tends to be the safest option the plan offers.
In the U.S., employee contribution plans are subject to the rules and oversight of the Department of Labor and the Employee Retirement Income Security Act of 1974 (ERISA).