Defined Benefit vs. Defined Contribution Plans

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Defined Benefit vs. Defined Contribution Plans

Introduction

In comparison, the number of defined contribution plans has grown in the past few years as opposed to the traditionally defined benefit plans. Additionally, many defined benefits plans have been converted to hybrid plans that incorporate aspects of both the defined contribution and defined benefit (Gale et al, 1999; Campbell, 1996). his transformation of the private pension system has led to the rise of a new ensemble of risks and opportunities as well as a vigorous debate regarding the benefits or shortcomings of either one of the systems.

This paper seeks to explain the differences between the defined benefit and the defined contribution plans. Additionally, it will attempt to trace the evolution of the private pension sector and speculate on the possible future directions that the sector may take.

Defined Benefit Plans

This is a more traditional form of pension plan than the defined contribution and the hybrid plans. In this plan, the employer promises to pay a certain amount of money at retirement as an annual pension; this amount is determined by a formula that factors in the number of years served in the firm and the average size of the salary during the closing years of the retirees employment (Kruse, 1995). Consequently, the amount of money the person gets is not determined by the return to investment on any contribution to a kitty funding the pension; on the contrary, the retirees benefits tend to get back-loaded significantly (Gale et al, 1999).

In the united states, the regulations that govern the defined benefit plans are the 26 U.S.C. § 414(j); this defines a defined benefit plan as a plan that is not a defined contribution plan; where the latter means a plan where each retiree has an individual account.

Historically, these plans have been used by institutions that are designated specifically for the function, by big firms, for civil servants, or by the government agencies (as a benefit for the citizens) (Kruse, 1995). Primarily, the defined benefit plans assumed a final salary plan structure where workers were paid pension calculated as per the number of years in the workplace, multiplied by compensation size at retirement, times accrual rate (specially formulated). The final figure attained was awarded to the retiree either as a single payment or as a monthly allotment.

Today, the formulae used have to take into account the salary, the years of service, the age at retirement among other factors that may differ from plan to plan. Among the most common defined benefit plans in the US is the Final Average Pay (FAP) plan; this applies the average sum of money remunerated in the final year of service in the formula to establish how much benefits the retiree will get.

In the United Kingdom, the law demands that all registered schemes to index their benefits for inflation; this is called the Retail Prices Index (RPI). This is aimed at countering the effects of inevitable inflation that tends to lower the purchasing power of retirees who get a fixed pension every year (that is not as dynamic as inflation). Therefore, the amount of pension is increased every year at the rate of inflation (but limited to 5% inflation in any given year) thus cushioning a pensioner from a devaluation of their pension.

If an employee opts to take early retirement, then this means if he or she were to be paid at the same rate as the one taking the retirement after attaining the age, s/he would receive a larger amount of money in the long run; to prevent this, the payments made to such a retiree are reduced at the rate that will ensure that they get an equal amount in the long run. Generally, the salary of an employee tends to increase with the period of service (due to experience, increased range of responsibilities or expertise) and younger employees tend to be paid less than their older counterparts in the same job situation. In view of this, many firms opt to hire younger staff at lower costs rather than retain older staff; consequently, many defined benefit plans have an early retirement provision to encourage the older spectrum of employees to leave the employment. Some of the incentives offered by the companies for taking an early retirement involve additional or temporary benefits that mature when the pensioner attains a certain age that is usually before the retirement age (about 65 years).

Arguably, the pensioner is less at risk of losing out on pension since the amount given is predetermined and not pegged on the number of contributions made to such a fund; it transfers all the risk of investing retirement funds to the body holding (them) and paying the pensioner. On the other hand, the pensioner cannot reap the maximum benefits of investment of such funds since any surplus is owned by the investing body.

Funding of Defined benefit plans

The money to pay such pensioners has to come from somewhere; defined benefit plans can therefore be categorized as either being funded or unfunded.

Unfunded defined benefit plans

The employer or other pension payee has no asset that is generating money to pay the pensioner; as such, this body pays when they receive the money themselves. In most countries that have one form or the other of a state-sponsored pension scheme, the unfunded model is prevalent; with such agencies paying the pensioner from contributions of the current workforce (for example in form of social security contributions) and directly from public coffers. This model of financing is commonly referred to as Pay-as-you-go (PAYGO). A good example of this model is the social security system in the United States. In some European countries such as Sweden, some private entities also utilize the PAYGO system for their pension schemes.

Funded defined benefit plans

In this case, a fund built from contributions from the employer or sponsoring body (and sometimes even the members of the plan) is invested with the aim of generating income to finance the pension payments to the members. In this case, there is no guarantee that an investment will result in an outcome that will be sufficient to pay the pensions of the member at the required time. Consequently, the contributions which such sponsors are to pay are reviewed regularly after the valuation of the assets and liabilities of the investment and the determination of their ability to meet future payment obligations; as such, if the assets cannot meet the obligations, then the sponsor is forced to increase the number of contributions to cover this deficit (Gale et al. 1999).

It is clear therefore that all the risk emanating from the investment is borne by the sponsor and that the pensioner will receive his/her pension regardless of whether the investment paid off or not. In the same breath, any reward emanating from such investment can only be enjoyed by the sponsor.

Government policies regarding defined benefit pension schemes tend to favor funded systems through giving tax incentives with the aim of ensuring uninterrupted payment of pensioners in their respective countries. However, in order to cushion the pensioners from the effects of a failed investment, the United States government requires private pension plans to remit premiums similar to insurance payments to the Pension Benefit Guaranty Corporation which is the government agency that will move in and meet these obligations in the short term as such a sponsor recovers from the loss of investment.

Shortcomings of defined benefit plans

As mentioned before, many pensioners are opting for defined contribution schemes and converting their defined benefit plans into hybrid plans. This has been driven by real or perceived shortcomings of the traditional DB plans and an attempt to move to more favorable systems.

First of all, the defined benefits plan has an age bias. Consequently, it is more expensive to fund the benefits of an older worker than that of a younger one stemming from the fact that the present benefit value tends to increase modestly during the early parts of employment and then accelerates as the worker comes to the middle sections of the career resulting in a J-shaped accrual pattern. All this stems from the effects of a flat accrual rate and the fact that as employees approach the age of retirement there is a reduction in the period the time for interest discounting reduces (Gale et al. 1999).

Secondly, the defined benefits plan carries an open-ended risk to the sponsor; this risk stems from the fact that the sponsor bears all the risk of investment and the pensioner none at all. Additionally, the sponsor also carries the risk of having a pensioner outlive their retirement income. This factor has been attributed as one of the several that are motivating private firms to change to a defined contribution scheme.

Thirdly, the defined benefit plans have a significantly reduced portability compared to their contribution counterparts. Even though arrangements can be made to have the payment made in one installment, most plans make pension payments in form of an annuity. These three shortcomings render defined benefits plans less suitable for firms whose staff is small and mobile; and more suited for large firms and the civil service (which always has an option of digging into public coffers to cover any deficits in funds available to finance pension payments).

Defined Contribution Plans

As opposed to the defined benefits plans, in defined contribution plans, the contributions are made directly into the workers individual account. The funds in the account are then invested in conventional sectors such as the stock market and the returns of the venture are credited to such account (Gale et al. 1999; Papke, 1999). When the employee attains retirement age, the funds in the account are used to finance the pension payment. The contributions to the fund are made either by the employee through salary deductions; or by the employer as part of the employment package.

There has been a radical shift in the recent past from defined benefits to defined contribution plans in the recent past; in many countries, the latter has attained a dominant position as the plan of choice in many private pension schemes. In the United States, many firms are opting to avoid signing their workforce into DB schemes with the aim of reducing their expenditure on worker benefits and transferring the risk of investing such funds to the worker.

The defined contribution plans have solved the issue of lack of portability raised with the defined benefits contemporary. As defined by regulation, the two plans have a similar amount of portability; however, for all practical purposes, it is much easier to compute the liability of the member without having to procure the services of an actuary in the defined contribution plan.

In a defined contribution plan, the individual (that is the employee waiting for retirement) assumes all the risk of investment; such also benefits from the rewards of such a venture. Upon attainment of the retirement age, most countries require a retiree to purchase an annuity; however, this is not mandatory and the pensioner thus bears an additional risk of outliving his/her assets. In order to mitigate some of this risk, some countries for example the United Kingdom require a pensioner to use a large portion of the money to purchase an annuity.

A worker who is not directly involved in financial markets may not have the know-how on the best investment at the time; giving complete freedom to such an employee to make under-informed decisions would be putting such funds into an unreasonable amount of risk. Under normal circumstances, the employee/sponsor retains a significant amount of power in determining how such funds will be invested; and in selecting the best financial management provider to carry out the task in the best interest of the employee.

Examples of defined benefit plans in the United States include Individual retirement accounts and 401(k) plans (Papke, 1999).

Hybrid Pension Schemes

These are designed with the aim of reaping the benefits of both the defined benefits and the defined contributions plans; and as vehicles to transition pensioners in the former to the latter. A good example of this is the Cash balance plan and Target benefit plans (Campbell, 1996).

These plans have been shown to increase the portability of the defined benefits plan due to easier computation of the benefit value; however, such calculations still require the services of an actuary.

Trends in Pension Schemes

As mentioned before, there has been a major shift in the outlook of the retirement benefits sector; in the last approximately quarter of a century, there has been a sustained change from defined benefits to defined contribution plans (Gale et al 1999; Gustman and Steinmeier, 1992). Additionally, even within the latter, there has been a sustained preference for 401(k) plans. There also has been a change from the traditional DB plans to hybrid plans (Papke, 1999).

These trends can be attributed to changes in the economy including tax regimes, regulations, increased mobility of workers, financial considerations among others (Bernheim and Garret, 1995). With an increasingly volatile economy, many firms are seeking to minimize the amount of risk they enter into at any one time; the shift from DB to DC has offered these firms a perfect opportunity to do so by transferring this risk to the employee.

Additionally, the financial situation has led to reduced job security in almost all economies; the increased portability of DC compared to DB makes it, therefore, more attractive to the employees in general. In the future, this trend is therefore likely to continue.

References

Bernheim B. Douglas and Daniel M. Garret (1995): The determinants and Consequences of Financial Education in the Workplace: Evidence from a Survey of Households: Mimeo, Stanford University
Campbell S. (1996): Hybrid Retirement Plans: The Retirement income System continues to Evolve: EBRI Special Report and Issue Brief No. 171. Washington D. C
Gale W. G., Leslie E. P., VanDerhei J. (1999): Understanding the Shift From Defined Benefit To Defined Contribution Plans: Paper Submitted At The ERISA After 25: A Framework For Evaluating Pension Schemes. 1999.
Gustman A. L and Steinmeier T. L. (1992): The Stampede towards Defined Contribution plans: Fact or Fiction? Industrial Relations 31(2): 361-69
Kruse D. L (1995): Pension Substitution In The 1980s: Why The Shift Towards Defined Contribution Plans? Industrial Relations 34(2): 218-241
Papke L. E. (1999): Are 401(k) Plans Replacing Other Employer-Provided Pensions? Evidence from Panel Data: Journal of Human Resources 34(2): 346-368

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