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FEBRUARY 2004
Defined benefit benefit plans plans are are not not extinct
extinct
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uncommon for for an an in in di di vid vid u u al al to
to
work for for the the same same em em ploy ploy er er for for 25+
25+
years, the defined benefit plan (the
traditional “pen sion plan”) was the
ultimate reward for a committed
employee from an appreciative employ
er. Then along came the 401(k),
and the face of employer-sponsored
retirement plans changed forever.
The old DB plan, however, is not yet
totally extinct.
DB v. DC
For purposes of this article it may first be
beneficial to highlight the differences between
defined benefit (DB) and de fined
contribution (DC) plans. While components
such as the degree of design flexi
bil i ty and the ap proach used in re gard to
in vest ment advice differ between the two
types of retirement plans, this ar ti cle will
fo cus on three ma jor dif fer enc es be tween
DB and DC plans.
The first major dif fer ence is whether the
con tri bu tions to and the benefits paid
from the plan are con sid ered “fixed” or
Figure 1. The difference between a defi ned benefi t plan and
a defi ned contribution plan can be determined by whether the
contributions and benefi ts are fi xed (“defi ned”) or variable.
Update
Employee Benefi t News for Members of AAPG
page 2
“vari able” (il lus trat ed in Fig ure 1). Un der
a DB plan, the ben e fit an em ploy ee gets
is fixed or de fined (hence, “de fined benefit”
plan) and is usu al ly re lat ed in some
way to an em ploy ee’s length of service
with the em ploy er and/or pay. Since the
ben e fit is fixed, the employer’s con tri -
bu tion is what ev er amount is nec es sary
to pro vide the ben e fit spec i fied (thus it
is “vari able”). Conversely, under a DC
plan, the em ploy er’s con tri bu tion and/or
em ploy ee’s con tri bu tion is fixed or defined,
usu al ly ex pressed in terms of a percent
age of pay. The con tri bu tions then
ac cu mu late to pro vide what ev er amount
of benefit it can pur chase based on the
mix of in vest ment funds se lect ed and the
per for mance of the stock mar ket; thus
the ben e fit un der a DC plan is vari able.
Another significant difference between
the two types of plans is who bears the
risk for faltering in vest ments. Under a
DB plan, the em ploy er bears such risk
and is required to keep the plan fund ed
for fu ture ben e fits. Thus if the in vest -
ments per form poor ly, the em ploy er is
liable for any short fall in the fund ed status
of the plan. The in di vid u al em ploy ees,
on the other hand, bear
the investment risk un der
a DC plan since under a
DC plan it is up to the
sole dis cre tion of the employ
ee as to which mix of
investment funds he or
she chooses.
A third important difference
between DB and DC
is the accrual patterns
and port a bil i ty under the
two plans. DB pro vides
great er ac cru als for older,
long er-service employees:
the longer you stay,
the higher the benefit. If you do leave
before you re tire, the money stays in
the employer’s DB plan and the ben e fit
will be wait ing for you when you reach
the Normal Re tire ment Age un der the
plan. Al ter na tive ly, DC fa vors young er,
short er-service em ploy ees with large accru
als ear li er on in the work ing career. If
you terminate em ploy ment, you can pack
up your DC ac count balance and take it
with you by rolling it to an IRA or new
em ploy er’s plan if al lowed.
Why the shift to DC?
Employers who have abandoned their
DB plans in favor of DC plans or who
are just implementing a new retirement
pro gram and opt for the DC over the
DB have done so primarily in response
to perceived wants by their employees.
Since DB plans favor older, longer-service
workers, such plans just are not
seen as much of a reward in the eyes of a
tran sient workforce that tends to move
from em ploy er to em ploy er several times
through out their working careers. Incidentally,
the growth in DC plans in the
last 20 years was also trig gered by the
num ber of Baby Boomers who were in
their 20s and 30s at that time, a mas sive
group of young er work ers look ing for
benefits targeted for them.
The boom ing stock mar ket of the ‘90s
also impacted the shift from DB to
DC in two ways. First, many DB plans
be came great ly overfunded due to high
in vest ment re turns and were con se -
quent ly ter mi nat ed by em ploy ers in or der
to re gain some of that funding. Sec ond,
be cause the stock market seemed to head
no where but up, many em ploy ees convinced
them selves they could invest for
re tire ment as well as or bet ter than the
in vest ment pro fes sion als and con vinced