Final answer:
Defined contribution plans like 401(k)s and 403(b)s are private pensions based on the amount contributed by the employee and employer, usually invested and growing tax-deferred over time. These plans contrast with defined benefit plans with fixed payouts and offer the advantage of portability and potential growth to offset inflation.
Step-by-step explanation:
Defined contribution plans are private pension schemes where the size of the retirement benefit is contingent on the contributions made by the individual or their employer. The most common types of these plans are 401(k)s and 403(b)s. In contrast to defined benefit plans, which promise a fixed income upon retirement, defined contribution plans allow the employee to invest their contributions along with employer match funds in various investment vehicles.
The accumulation in these accounts is typically tax-deferred until withdrawal. An added advantage of defined contribution plans is portability; workers can carry over their 401(k) to a new employer if they change jobs. This flexibility, accompanied by the potential for investment growth, helps to mitigate the impact of inflation over time, unlike traditional pension plans that may have fixed payouts not indexed to inflation.
Inflation is a significant concern for retirees relying on a fixed income. The decrease in purchasing power over time can erode the value of fixed incomes from traditional pensions. Defined contribution plans are set to alleviate these issues by allowing the retirement savings to potentially grow with the market, offering a hedge against inflation and providing more control over personal retirement funds.