Defined Contribution Plans

[Rip Verkerke <ripv@virginia.edu>]

A student asked:

I have kind of a basic question about pension plans.  If
the plan is defined contribution, who controls it?  It
seemed like you were alluding to some kind of employee
control in that they can decide how to weigh risks and
potential returns.  How much control does the employee
have? It seems like many employees would be ill-equipped to
fully manage their pension portfolios, but also (ever the
liberal) I like the idea of them having options.

I replied:

Employees choose how to allocate their defined contributions among
investment funds selected by the employer.  The employer contracts with one
or more investment firms (say Fidelity, Vanguard, or TIAA-CREF) to provide
employees with a menu of investment options.  The firm typically offers a
range of mutual funds from the very safe (with low returns) to the riskier
"aggressive" funds (with comparatively high returns).  Employees can get
advice from the investment firm about what to choose, but the final decision
is their own.

As a participant in such a plan, I can testify that the informational
demands on participants are not all that great.  Basically, you should
choose an "aggressive" strategy when you are young and then slowly shift
into safer investments as you approach retirement age.  Of course, the nice
thing about mutual funds is that you don't really have to "manage" a complex
portfolio at all.

I hope that is helpful and would welcome further comment or discussion of
these issues.

Warm regards,

Rip