The basic premise of the defined contribution method is that the onus of retirement planning is on the individual. This means that they take the necessary amount of risk in the entire venture. The starting point is the contribution and there is a defined amount or a specified amount that is contributed to start off the process.
The nature of the investment in terms of whether this will be made by the employee or by the employer or by both and the different proportion in which this is made will differ according to the scheme. However, the sum is invested as per the requirements and then the required figure paid out from the earnings of this investment.
In simple words, the earning of the investment determines the amount that the individual will get from the scheme. If the earnings are less they will get a lesser amount while if it is more then a higher amount is available. But the key part is that the risk is on the shoulders of the individual. No one else will share the blame and even more important is the fact that there is no amount that is guaranteed anywhere.
A very good example of the defined contribution plan is the provident fund of an employee. The employer contributes a percentage of the salary to the fund and on the other side the employee also contributes a certain percentage of the salary to the fund. This is done regularly and on a monthly basis.
Once this amount is deposited into the account the sum is then invested in various assets that are permissible under the investment rules of the fund. From the earnings that come the interest as a percentage is decided and then paid to the subscribers of the fund. Thus, the final figure depends upon the earnings and there is no surety that a certain sum will be earned or not and the extent to which the earnings will be present.
The risk is squarely on the shoulder of the employee because if the earnings fall due to several unfavorable conditions in the market then it is the investor who bears the impact, as they will get a lower earning from the investment. This means a lower amount to be received when they retire and collect their provident fund. The employer has no responsibility or even a mandate to contribute amounts to provide a certain high rate of return to the employee.
