“We presently have a defined benefit (DB) [pension] plan,” says Sackett. “It’s been in place for 20 years. Our workforce was less mobile when the plan was created. Now, we’re conducting an informal poll among our staff to see what type of [retirement] plan they’d like. And, of course, we have to consider the costs.”
Sackett’s situation isn’t uncommon. With older workers retiring, baby boomers turning 50 and Generation Xers joining the workforce en masse, its a given that most organizations have to reevaluate their retirement plan offerings -- pensions that include either a defined benefit or defined contribution (DC) plan. When your company is ready, consider several factors. What’s right for one company isn’t necessarily right for another. Each company must assess its own circumstances, strategies and goals. Among the issues to consider are who you want to recruit and retain, your financial goals and restrictions, administrative ease, and the message you want to convey. The bottom line: Make sure your retirement plan supports your overall business direction.
What has been the trend?
Pensions are one of the most cherished workplace institutions today. Without them, employees would only have a shaky two-legged retirement plan (Social Security and savings).
Within the last 15 years, most companies providing retirement plans primarily offered defined benefit plans. In a DB plan, the benefits are computed as a percent of the last few or the highest years of earnings multiplied by years of service. They’re then paid in the form of life annuities.
Starting in the mid-’80s, however, employers increasingly added 401(k) tax-deferred provisions to their defined contribution plans or established new plans with 401(k) provisions. Defined contribution plans thus became popular -- particularly among younger workers. Their popularity also was part of the larger movement to empower workers to control their own retirement savings and investments. In addition to the 401(k) plans, employers offered workers a variety of other investment options, such as thrift plans, profit-sharing plans, ESOPs, stock options and money-purchase plans. Today, employers are offering between five and 10 investment options -- allowing more options than in the past. With defined contribution plans, benefits usually are paid in the form of lump-sum distributions, which the employees may spend as they please.
Another trend is that many medium- and large-size companies (those with at least 1,000 employees) increasingly are providing both types of pension plans, says Michael F. Carter, vice president of Philadelphia-based The Hay Group, a benefits and actuarial consulting firm. His company, he says, conducted its annual benefits survey among 1,017 medium- and large-size U.S. companies earlier this year.
Balance employee preference with your recruitment and retention goals.
Conventional wisdom may posit that workers’ interest in defined benefit plans are waning. But the U.S. Census Bureau has gathered data indicating that the age of the worker bears heavily on his or her plan preference. Defined benefit plans clearly are oriented toward those who expect to work for the same company throughout their career. Such workers tend to prefer a guaranteed monthly income, think more long term and save more money than their younger, mobile counterparts.
“Where there are long-term benefits, the defined benefit plan operates to protect, bond and ensure this long-term relationship,” says Christopher Cornwell, associate professor of economics at Athens, Georgia-based University of Georgia. “It typically rewards long tenure and penalizes late retirement.” In other words, defined benefit plans not only help retain older, experienced workers, but also can help employers ease those workers out of their jobs as younger employees join the workforce.
Once you’ve considered your employees’ preferences, consider your recruitment and retention strategies. For example, a new upstart company in the software industry isn’t likely to offer a defined benefit plan. The typical worker is younger and mobile, thereby canceling out the benefits of a defined benefit plan. Defined contribution plans may better serve the recruitment and retention strategies for this sector.
Keep in mind that employees like the control and independence that DC plans provide. They’re able to save directly into some portfolio assets of their own choosing. DC plans also tend to be easier to understand because the statements aren’t projected based on life expectancy, interest rate and salary projections -- they’re reported at their present value. Employers also like the simplicity. “It’s easier for employers to offer because it sets up a framework from which workers can save and make investments -- but they bear the risk,” says Cornwell.
If an employer has a high-turnover environment, then defined contribution might be a better choice, says Steve Vernon, a consulting actuary with Watson Wyatt Worldwide in Los Angeles. One of the positive features of defined contribution plans is portability. But before you switch from one to another, measure what the value being lost to your workers would be, and weigh that against the estimated costs you’re willing to assume.
Weigh the cost variables and risks.
When considering costs, remember that you can design with price in mind. “You can set up a defined benefit or defined contribution plan to meet a certain percentage of your overall budget,” says Carter. One type of plan isn’t necessarily cheaper than the other. However, with a defined benefit plan, the problem is that the funding isn’t consistent. The employer’s plan may be overfunded one year and underfunded the next. Defined benefit plans require funding based on plan experience and asset performance, says Curt Morgan, principal with PricewaterhouseCoopers, Kwasha HR Solutions in Fort Lee, New Jersey. “The employer has somewhat less control over the cost of the plan.”
DB plans are trickier in that regard, according to Washington, D.C.-based Employee Benefits Research Institute (EBRI). The employer assumes investment and possibly preretirement inflation risks and therefore annual plan costs are less predictable. While costs might be higher than anticipated, pension costs in a booming stock market may be zero because of the investment returns on past contributions.
However, one of the bright spots over the last 15 years in the defined benefit arena has been cash balance plans, pension equities and life-cycle plans. “These plans all translate the somewhat nebulous defined benefit promise of retirement income into current lump-sum values,” says Morgan. These newer options better enable employers to incorporate these values into their overall retirement planning strategies.
With DC plans, the employer also assumes none of the investment risk on retirement fund assets. Because the investment risks are assumed by the employee, however, employers need to ensure they offer a variety of options. Only offering stock options, for example, could be calamitous if the company went bankrupt. Employees would end up with no pensions at all.
Why provide both?
There are many reasons why employers might offer both types of plans, according to Morgan. Each plan is intended to address different goals. Together, they can form a powerful benefits package.
Defined benefit plans offer a more efficient mechanism to provide benefits as employers can hire and follow the advice of investment experts -- investing plan assets for the long term and absorbing short-term fluctuations better. Based on these long-term expected results, defined benefits plans are a more efficient means of providing benefits. Also, defined benefits plans can be used to ensure there’s a floor of retirement income -- a guarantee that can’t be made through defined contribution plans alone. Defined contribution plans, however, do provide greater employee appreciation and involvement, with a ready mechanism for employee participation in retirement funding.
In terms of the Internal Revenue Code, Morgan explains higher paid employees -- read: executives -- reap greater benefits via a combination of DB and DC plans provided under a single mechanism. By offering two plans, employers are better able to recruit and retain workers with different retirement needs.
Consider administrative ease.
When comparing both plans, also keep in mind that defined benefits plans require more administrative effort than defined contribution plans. DB plans require an annual actuarial evaluation that’s not required by DC plans, says Julie Gebauer, principal at New York City-based Towers Perrin. They require tracking of breaks in service, compensation over long periods of time, and additional reporting requirements to the Pension Benefits Guarantee Corporation, which guarantees certain levels of pension in company plans.
Therefore, providing both plans assumes even greater administrative effort. Says Vernon: “I have a general rule of thumb. Those organizations with less than 500 employees shouldn’t have a defined benefit plan -- just from an administrative point of view. If you’re spreading your costs among a small number of employees, you’ll end up spending as much on administrative costs as the benefits themselves.”
With larger companies, he continues, offering both plans is more feasible. “More often than not, they’re going to have an HR staff,” he says. Defined benefit plans, he notes, are sophisticated retirement tools that should be used with sophisticated users.
Managing a large pool of DB funds, according to EBRI, is less expensive than managing individual accounts, but may be more expensive because of the provision of annuities (which can be relatively complex to administer) and the need for professional actuarial and investment advice to comply with regulations.
With DC plans, while actuarial services aren’t required to the extent necessary for DB plans, the provision of participant investment education and the cost of adminstering many individual funds for loans, hardship and/or retirement benefits may make DC plans more expensive. However, DC plans generally are less expensive to administer, especially for smaller employers.
Convey the appropriate message.
Given today’s competitive market for talent, pension benefits also can be a powerful recruitment and retention tool. They send messages to current and prospective employees. Under a defined benefit plan, employers are saying there are incentives to work until age 55 and to leave around age 60. This message has greater appeal to those who want to stay long term, retire in their 60s, and reap the benefits of the company’s training investments.
Defined contribution plans convey a more age-neutral message. The employer doesn’t show favor for one group over another. That may be an important factor, particularly if age isn’t a major factor in performance and you value such diversity.
But whichever design plan you may choose, the main idea to remember is that each plan has certain advantages and features that cater to different situations. Hone in on your demographics and keep your business strategy in mind. Then you’ll be able to weigh one plan against the other -- or possibly offer both.
Workforce, December 1998, Vol. 77, No. 12, pp. 106-108.