Defined Benefit versus Contribution Plans
- Last Updated: Thursday, 02 April 2020
Over the last several decades, there has been a rapid increase in the number of participants in what are known as defined contribution programs. At the same time, we're seeing a slow decline in the number of participants in traditional pension plans, also known as defined benefit programs. As individuals plan for retirement, it's important to understand the difference between these two benefits programs.
In this article, we're going to start by describing the difference between defined benefit programs and defined contribution plans. Next, we'll look at some statistical data on the participation rates in both of these retirement plans. Finally, we'll talk about the pros and cons of these programs, and why some employers have chosen to freeze benefits under their old pension plans and start new ones.
Contribution versus Benefit
Both employees and employers are permitted to contribute funds into a defined contribution plan. Employer contributions are usually formula based. For example, the level of the employer's contributions might be a function of the employee's salary, their age, and years of service with the company. A new employee, that is also relatively young, might receive an annual employer contribution equal to 2% of their salary. An older employee, with 30 plus years of service, might receive a contribution closer to 12% of their salary.
The money placed in the employee's account may be invested in a combination of common stock, fixed income securities, annuities, and stable value funds. While employers can readily calculate their contributions to these funds each year, employees have less certainty around retirement income withdrawals. That's because the money received, once retired, depends on the performance of the account's investments.
A defined benefit plan provides employees with a predetermined benefit in retirement. Once again, that benefit is normally calculated using a combination of the employee's salary and years of service. This type of calculation is commonly used, and is known as a final average pay (FAP) plan.
Employers are responsible for making all of the required contributions to the employee's account in a defined benefit program. Money placed in the account is professionally managed. Since the employee is guaranteed a certain level of income in retirement, the employer assumes the risk associated with an underperforming investment. When investments do underperform relative to forecasts, employers are forced to subsequently increase the level of funding placed into the account.
To summarize the difference between defined contribution and benefit plans:
- Employees and employers can provide funding to defined contribution plans. While the employer contributions are formula-driven and guaranteed, retirement income will depend on the performance of the fund's investments.
- Employers are responsible for supplying all funding to defined benefit plans. The employee's retirement income is both formula-driven and guaranteed.
Plan Participation RatesAccording to surveys conducted by the U.S. Department of Labor's Employee Benefits Security Administration, participation in defined benefit plans peaked back in 1980. At that time, there were 30.1 million participants in these retirement plans. Over the next 30 years, participation decreased by nearly 40%.
Not surprisingly, participation in defined contribution plans increased 281% from 18.9 million to 72.0 million participants over that same timeframe. This increase is attributed to both the scaling back of defined benefit offerings by employers as well as the rapid rise in the popularity of 401(k)-type plans.
Looking at the pros and cons of these two retirement plans provides insights into the answer to the question:
Why are fewer companies offering employees traditional pension plans?
Pros and Cons of Defined Benefit Plans
As mentioned earlier, defined benefit plans are often referred to as "traditional" pension plans. These are the same retirement benefits the leadership of many collective bargaining units fought so hard to obtain for their membership. Employees covered by these plans didn't have to worry about saving for retirement. These plans were typically generous, and long-term employees were often rewarded with pensions that allowed them to live comfortably in retirement.
These plans also placed a large financial burden on employers. Since the return on the fund's investments is uncertain, it's possible that employer contributions may not be sufficient to meet its obligations to present and future retirees. Normally, a fund is evaluated each year to determine the level of funding required to match assets with liabilities. When investments perform poorly, the employer's contributions need to increase, and this added expense can significantly impact earnings.
Pros and Cons of Defined Contribution Plans
Since the performance of an investment will always carry some uncertainty, the employee can never be 100% confident of their benefits derived from a defined contribution plan. The employer's obligation can be readily calculated each year, and does not rise or fall as the performance of the retirement account fluctuates. This provides a significant advantage to employers versus a defined benefit plan.
Unfortunately, this means employees bear the risk their retirement funds may not be sufficient to provide them with a comfortable standard of living once retired. When that occurs, the employee may be faced with a decision to delay retirement or find a source of supplemental income when they retire.
Portability of Funds
Since defined benefit plans consist of employer / employee contributions plus the growth of those funds over time, the value of an employee's account is readily calculated. For this reason, defined contribution plans are usually more portable than traditional pension plans. Portability is the term used to describe the movement of the employee's assets from one plan to another as they change employers.
The money in a defined benefit plan can be portable too; however the calculation needed to determine the fund's value requires the skill of an actuarial. This is why portability is a feature that is more commonly found in defined contribution plans.
It should be no surprise that defined benefit plans are on the decline. The cost associated with these programs is unknown and can be burdensome if investments, especially the stock market, are underperforming versus expectations. Employers have slowly shifted the risks associated with retirement benefits from their investment professionals to their employees.
Employees that want more control over their retirement money will embrace a contribution plan. However, the movement away from traditional pensions is often criticized, since it shifts investment risk from trained professionals to employees, which frequently have no investment experience.
Fortunately, employers often combine their retirement benefits plans with self directed plans such as 401k and 403(b)-type plans. These are tax-advantaged offerings that allow employees to set money aside for retirement. To encourage participation, employers often match employee contributions at a pre-determined rate.
In the end, it's a good idea for employees to participate in as many plans as financially feasible. If a 401(k) or 403(b) isn't offered at work, a comprehensive retirement strategy will look to fund a Roth or Traditional IRA account.
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