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Defined Benefit vs. Defined Contribution

December 1, 1998
Two of the most common terms used in describing retirement plans are "Defined Benefit" (often thought of as traditional pensions) and "Defined Contribution" (often thought of as 401k) plans. This chart should help you compare the two.

Comparison of Traditional Defined Benefit with Traditional Defined Contribution Plans

 

Defined Benefit

Defined Contribution

Strategic Business Considerations

Employees Attracted and/or Most Benefited

Longer-tenure and/ or older employees

Shorter-tenure and/or younger employees

Job Tenure Patterns Encouraged

Longer-tenure because employees receive greatest benefit accruals at end of long-time service. May lock people into jobs they would otherwise leave.

Although employees receive benefits based on salary, not tenure, may encourage employees to change jobs in order to receive access to lump-sum distribution from retirement accounts.

Influence on Retirement Patterns

Can be designed to encourage early retirement; may financially penalize workers for working additional years beyond the NRA.* May pressure workers who would not otherwise retire to do so.

Cannot be designed to encourage early retirement but instead rewards employees for working additional years.*

Cost/Funding Flexibility Concerns

  1. Cost variability/risk*
  2. Annual funding flexibility
  3. Termination benefits
  4. Plan termination
  5. Administrative costs

a. Employer assumes investment and possibly pre-retirement inflation risk* 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 investment returns on past contributions.

a. Employer assumes none of the investment risk* on retirement fund assets. As a result, annual costs are more predictable although the employer cannot take advantage of high stock market or other investment returns on retirement plans assets.

b. However, there tends to be more flexibility as to when employer may meet these costs contributions in defined benefit plans

b. However, money purchase and some types of profit sharing plans have less flexibility in when those costs are to be paid. In addition, defined contribution accounts can be designed to entail no employer contributions at all, unlike defined benefit plans.

c. Termination benefits are usually small for employees with less job tenure

c. Termination benefits equal account balances, when vested, based on both salary and years of plan participation. Tend to be larger than those for defined benefit plans, cet. par.

d. Can be very costly if plan is underfunded.

d. Not applicable, becausedefined contribution plans are by definition never underfunded

e. Managing a large pool of funds 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 ensure compliance with regulations.

e. While actuarial services are not required to the extent necessary for defined benefit plans, the provision of participant investment education and the cost of administering many individual funds for loans, hardship, and/or retirement benefits may make defined contribution plans more expensive. Generally, however defined contribution plans are less expensive to administer, especially for smaller employers.

Administrative Complexity

more

Less

Integration with Social Security Benefits*

Employers fulfill a specific retirement income objective (e.g., to replace 60 percent of preretirement income with Social Security and pension benefits), and therefore Social Security integration is accomplished more efficiently under defined benefit plans.*

Integration can be accomplished, but the process focuses on disparity in contributions and does not attempt to target a specific replacement ratio

Providing Substantial Benefits Over a Short Time Period

Employees can be grandfathered into a new defined benefit system so as to provide special benefits that are not possible under a defined contribution approach (e.g., the quick accumulation of benefits to participants who have not participated in the system for a substantial period of time).

Unless grandfathered into a defined benefit plan, shorter tenure workers leave service with more substantial benefits under a defined contribution arrangement.

Collective Bargaining

Unions prefer defined benefit plans.

Less favored as primary plans by union leaders.

Flexible Benefit Retirement Plan Provision

Defined benefit plans cannot be part of a flexible benefit package.

Some types of defined contribution plans (401(k) and profit sharing) may be included in a flexible benefit package.

Company Identity/ Linking Benefits with Company Performance

Investment of pension assets in company stock is prohibited beyond 10 percent of assets.

Employer contributions may be in the form of employer stock so as to tie company performance to retirement funds. In addition, profit-sharing defined contribution plans tie employee productivity to retirement security.

More Philosophically-Oriented Considerations

Paternalistic View

  1. responsibility given to participants
  2. investment risk given to participants*
  3. inflation risk given to participants*
  4. opportunities given to participants
  5. benefit provided at retirement
  6. automatic enrollment?

a. Generally do not require employee contributions. Employer says, "Don’t worry about your retirement plan. We’ll take care of your retirement plan."

a. Employees usually help fund their own retirement accounts. Employer says, "We’ll help you help yourself." Participant-directed accounts encourage financial literacy and awareness of savings.

b. Employer absorbs investment risk in exchange for investment control.*

b. Employees absorb investment risk in exchange for potential investment rewards .*

c. COLAs may be provided and are often done so for public plans. Employer may share responsibility for inflation after retirement if ad hoc COLAs are used in private plans.* Employer assumes preretirement risk if defined benefit formula is based on final averages.

c. No room in plan design for COLA adjustments. Employees assume risk for inflation both prior to and after retirement.*

d. No preretirement access to accounts is usually provided.

d. Preretirement access to accounts is often provided.

e. Benefits are usually paid in the form of life annuities.

e. Benefits are usually paid in the form of lump-sum distributions, with which the employee may spend as they please.

f. enrollment is automatic

f. enrollment is usually not automatic

Investment Horizons and Expected Impact on Investment Income *

A defined benefit plan allows the burden of retirement security (including the attendant investment risk) to be spread over a long period of time. In theory, defined benefit plans may be expected to hold a larger percentage of more risky (and higher yielding) investments since their relevant investment horizon spans several decades if the plan is assumed to be an ongoing operation.

A defined contribution plan usually requires employees to invest for their retirement on an individual basis. This may cause them to increase their asset allocation in less risky (and lower yielding) investments to mitigate the impact of market downturns near retirement age.*

Tax Advantages

In defined benefit plans, only employer contributions are given tax-favored status.

In defined contribution plans, both employer and employee contributions may be given tax-favored status.

Approach to Informational Parity

Dedicated governance: investment expertise means that those buying and selling pension investment services have informational parity.

Employers sometimes offer participant education to increase informational parity between investors and investment services.

* Fundamental features of defined benefit and defined contribution plans that cannot be modified without changing the plan into another type.

1—Normal retirement age

2—Fundamental features of DB and DC plans that cannot be modified without changing the plan into another type

3—Exception in state and local plans

4—Cost of living adjustments

SOURCE: Employee Benefits Research Institute, Special Report and Issue Brief Number 190, Washington, D.C.