Defined Benefit vs Defined Contribution Pension Plans
100Two Types of Pensions
Along with paid vacation time off and health insurance, retirement benefits are probably the most sought after employer provided benefit. Pensions provide employees with the opportunity to accumulate the funds needed to be able to afford to stop working. Pension income, along with income from Social Security usually make up a major portion of the income received in retirement.
Employer pensions come in two main varieties:
- Defined Benefit
- Defined Contribution
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Defined Benefit Plans
Defined benefit plans are plans where the employer guarantees to pay the employee at retirement a fixed monthly income for life. Larger organizations in the United States usually base the monthly income to be paid to the retiree using either a dollars times service calculation, final average pay calculation or some combination or variation of these two methods. There are other ways to calculate the benefit which are mainly used by employers outside the U.S.
A dollars times service calculation is made by multiplying the number of years the employee worked for the company times some dollar amount. For example a plan could call for paying a monthly retirement income of $125 times the number of years worked. Under this method an employee with 30 years of service would receive $3,750 per month ($125 times 30 years), one with 25 years of service $3,125 ($125 times 25 years), one with 19 years of service $2,375 ($125 times 19 years) , etc. Instead of years of service the employer could use months of service or some other time frame. The idea here is that the longer one has been employed by the organization, the greater their monthly income at retirement.
A simple final average pay method bases the monthly retirement income amount on some pre-determined percentage of the employee's salary for the last three (or some other number) years of work. The employer simply sums the employee's annual salary for the last few years of employment, divides that figure by three to get the average for the three years and multiplies that amount by the pre-determined percentage amount. Generally, employers average the three or five highest salary years out of the last ten years rather than simply averaging the salary for the last three or five years. This benefits people who are compensated with a base salary plus variable additions such as commissions, overtime pay, compensation for additional or hazzardous work, etc.
In most cases, defined benefit plans calculate the benefit using one of the above two methods as the base but include other factors in the calculation as well. However, regardless of the method used, the result is a fixed monthly amount that the employer is committed to paying the retiree for the rest of the retiree's life.
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Defined Contribution Plans
Defined contribution plans are plans in which the employer agrees to contribute a fixed amount to the employee's pension fund each year in which the employee is employed. The income that the employee receives during retirement depends upon how much money the plan accumulated and how much income that amount can generate. The 401(k) plans offered by many employers in the private sector and 403(b) plans offered by public and non-profit employers are common examples of defined contribution plans.
Under both types of plans, funding of the pension can be in the form of contributions made by the employer alone or by contributions from both the employer and employee.
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Market Risk
One of the major differences, if not the major difference, between defined benefit and defined contribution plans is market risk. Market risk is the risk associated with changes in the value of the investments in the plan.
In order to grow and have the plan generate sufficient income to provide retirement income, the money put aside for retirement during an employee's working years must be invested in income producing assets. This usually includes investing in things like stocks, bonds, real estate, etc. However, as we saw in the recent 2008 market crash, the value of such assets can fluctuate.
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Market Risk and Defined Benefit Plans
With defined benefit plans the employer assumes the market risk which can be either good or bad. During periods of economic growth and rising asset values, the cost of funding (i.e., contributing money to the plan and investing it to accumulate funds necessary to pay the pensions when employees retire) a pension decreases as the rising values of the investments enables the employer to contribute less out of current revenues and still build the value of the plan to cover the future pension obligations.
Even in periods of little or no growth but rising asset values due to inflation (such as occurred in the 1960s and 1970s in the U.S. due to the government's inflationary fiscal and monetary policies) employers can benefit because their commitment is to pay a fixed dollar amount to employees at retirement and not provide the employee with a fixed purchasing power.
However, when markets go down and asset values decrease with them, the employer is forced to pump more money into the plan in order to meet the future obligation to the retirees.
With defined benefit plans retirees continue to receive the same dollar income each month regardless of market conditions. When markets decline, employees are not affected but the employer is hurt because the employer now has to divert more money from current revenue into the pension plan thereby increasing its costs at the expense of its profit. When markets rise, the employer reaps the benefit of the rising values and can reduce its pension contributions and increase its profits while the retiree continues to receive the same promised income.
The retirees are not harmed as their income does not decrease but they also do not receive any benefit (in terms of their pension income) from the economic growth. When inflation drives market values up the employer again benefits by being able to maintain the monthly pension income for the retirees while paying fewer dollars to do so. The retirees, however, are harmed because, while the dollar amount of their pension income remains constant the purchasing power of those dollars decreases thereby reducing their standard of living.
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Market Risk and Defined Contribution Pension Plans
With defined contribution plans market risk and reward are reversed as the retirees assume most of the risks and reap most of the benefits.
When economic growth causes investment values to increase, the retirees see their wealth and income increase while employers are unable to adjust their contributions downward.
Similarly, when inflation causes investment values to rise, employers are again unable to adjust their contributions while retirees see the dollar value of their pension funds rise.
While inflation induced increases in pension values and income generated by these rising values doesn't increase the retirees' spending power (as all prices in the economy are increasing due to inflation) the inflation induced increases in their pension values and income offset the rise in prices thereby allowing their standard of living to remain unchanged.
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Comments
Good information. A couple of additional considerations occur to me. There is a conceptual flaw in defined benefit plans in that the funding requirements assume that the company will continue in business and be able to make actuarily required contributions to the fund in order to provide the pensions promised to its employees. In practice many if not most companies go out of business or are acquired by another company and stop making the contributions required to provide the contemplated benefits. I recall reading recently that only three companies from the Dow Industrials in the 1930s survive today or are still in the Dow Jones Industrials: GE, Exxon and one other. The others have disappeared. The Pension Benefit Guarantee Corporation provides only a partial backstop for defined benefit pension plans at failed companies. A second disadvantage of defined benefit pension plans is that they aren't portable when a beneficiary employee changes jobs, as many if not most people do. The days of working for the same employer for an entire career are over for most people. Most defined benefit plans vest after five years, but due to inflation the benefits from vested pension plans from former employers don't amount to much.
There are problems withe 401k plans as well. The plans provided by many employers charge excessive administrative fees and offer investment options in mutual funds that are operated more for the benefit of the mutual fund company rather than for the benefit of the employee investors. In recent years there have been a number of scandals in the mutual fund industry including funds allowing favored customers to trade their shares after the markets are closed and allowing the mutual fund traders to accept gifts from brokers in return for business rather than sending the trades to brokers who provide the best executions at the lowest price in the interest of the mutual fund investors. Moreover, most financial advisers say that 401k plans plus Social Security don't provide enough income for the kind of retirement to which most people aspire. Therefore, planning for a comfortable retirement requires additional savings beyond contributions to a good 401k plan. 401k plans are portable when an individual changes jobs and for this reason are preferable to defined benefit pensions, in my opinion. The ideal situation is to work for an employer who provides a defined benefit pension AND a 401k plan with a generous employer match. That will provide two legs in addition to Social Security completing the traditional 3-legged stool of retirement security.
bobmnu - thanks for your comment.
You are correct in stating that when big companies go broke and file for bankruptcy pensioners can lose. In the 1960s and 1970s many large unionized corporations brought settled strikes and brought labor peace by promising overly generous pensions for their employees when they retired. Defined benefit plans were the most common type of plan in those days and this is what most of these companies offered. They also agreed to continue their employer paid health coverage in these pensions. Managers at the time then attempted to keep costs down by making very liberal assumptions about future investment returns (i.e., assumed that returns would be greater than what turned out to be what they actually were). Now, years later, when the employees who were promised these overly generous plans retired the current managers were suddenly faced with skyrocketing retirement costs which they could not afford to pay. The result was that many large companies in the steel, airline and now the auto industries filed for bankruptcy to shed their pensions and get out from under the obligations. The government's Pension Benefit Guaranty Corporation had to take over these pensions and reduce them. This meant that retirees in their seventies and eighties suddenly found their monthly pension check reduced and, at the same time, were notified that they would have to begin paying part of their health care expenses.
As I pointed out in my Hub http://hubpages.com/hub/Bailing-out-Americas-Big-T , the American manufacturing sector in general and Detroit auto industry in particular are some of the most efficient companies in the world in terms of producing the highest quality product with the highest paid workers and the lowest production costs in the world. What has been killing them is not inefficiency or high wages but the huge cost of paying for these overly generous and underfunded legacy costs (i.e., their pension and retiree health care expenses).
As to Social Security, I pointed out in my Hub http://hubpages.com/hub/The-Social-Security-System that that program is not only NOT a pension plan but that the Supreme Court has twice ruled that Congress with a simple 51% majority vote can cancel that program at any time - the government can shed that program easily without having to go through bankruptcy.
thanks again for your comment.
Ralph - thanks for your comments and added information.
I agree with you that people changing jobs and companies changing hands adds to the problems in this area. There have been a number of articles in recent years about people spending months trying to straighten out problems with their pensions due to confusion resulting from job changes, changes in ownership of companies and changes in the companies that administer and act as trustees for company plans.
A number of retirees have suddenly found their monthly payments reduced when a new trustee confuses their plan with that of another plan from a company that was taken over by their employer (or they were in the company taken over) and not only cuts their benefit (to bring it in line with they think the person is under) but ask for the retiree to re-pay what the administrator feels they were over paid.
A few years ago my sister spent three or four months attempting to get my Mother's health insurance re-instated after the company that was handling some of the retiree health plans for the company my Father had retired from. The bank he had worked at for over 30 years had changed hands a couple of times while he was employed there and a few more times after he had retired. The current incarnation of the bank he had worked for had ended up with dozens of different plans to administer and not only outsourced different plans to different companies to administer but also, in some cases including my Mother's, used separate trustees for the health plan portion and pension payment portion of some of the plans. My sister's problem was that no one knew who handled what plan and it took her four months of telephone calls to finally find the company in charge of the health plan my Mother had and get them to contact the health insurance provider and get the health insurance re-instated.
The 401(k) and similar portable plans are better in the sense that the employee can not only take those plans with them when they leave or retire but can also roll them into another 401(k) or IRA plan upon leaving the company - this allows them to avoid the confusion of the plan getting lost in a merger as well as giving them a chance to select a new provider with lower fees and/or better choice of investments.
Unfortunately, as you state, while a person is employed with a given employer they are stuck with whatever provider and investments the employer chooses.
As to your statement that the best situation is an employer that offers a good defined benefit plan along with a 401(k) - I totally agree with you. However, defined employers with defined benefit plans are becoming fewer and fewer.
I have a defined benefit plan to which both my employer and I contribute as well as a 403(b) (the college and school version of a 401(k) plan) to which only I contribute. Up until this year my employer only offered the choice of three providers for the 403(b) plans and all were insurance companies that only offered variable annuities for investment choices - these, of course, have some of the largest fees. This year they finally offered a company with mutual fund as an option. The defined benefit plan I have is very good in terms of the benefit, but given what I have been reading about the problems I cited in my comment above with companies going bankrupt and reducing the benefits, I have decided to take early retirement when I am eligible, get another job and invest the pension income in a fixed annuity while I am still working - this way I should be able to get back my contributions and have a back up income in the event the pension payments are cut in the future.
Thanks again.
Chuck
Today, the market is not good, so the pension fund is not good too, I think.
Chuck, you and I are among the fewer and fewer lucky ones to have both types of plans. I am able to continue to live about as well as before I retired on a defined benefit pension (although unadjusted for inflation), and IRA (rolled over 401k) and Social Security. I would be pinched if I lost any one of the three. Also, I continue to work part-time as does my wife.
Ralph, I agree that you and I are in a good position with the pension and IRA/401(k) plans we have and that a loss or reduction of any one of them would hurt our retirement standard of living.
In my case I am still working and contributing to my retirement plans but plan to take early retirement in the near future. To prepare for retirement I have been working on developing some side ventures which I am using the income from now to pay down things like our mortgage so as to reduce future expenses.
I hope things continue to go well for you and look forward to getting together with you the next time you are in Tucson.
Chuck
Chuck, can't you bring yourself to give a little credit to Social Security? My wife and I get around $2500 a month total from Social Security. Not exactly chump change! I expect that before I pass from this "mortal coil," my social security benefit will exceed my pension benefit which has not been adjusted for increases in the CPI since I retired (early) in 1994 to take a job in the Clinton administration. [Another strike against me! :-)] After 3.5 years in Washington, I managed to score an appointment in Lansing from GOP governor John Engler. Those two appointments saved my bacon because I maxed out my 401k contribution and got a generous match. Anyway, I think I'm a textbook case on preparing for retirement. My only issue is a pretty big home mortgage due to financing three kids in college at once! We would be on gravy street were it not for the mortgage and the big decline in the market value of our home in Michigan!
Ralph, You have had quite a career and I admire your for having done so well.
I,too, will probably get to collect at least some Social Security income but because of uncertainties about the underlying finances am reluctant to include it in my current planning.
The system obviously cannot go on forever the way it is funded and, the law as written and interpreted by the Supreme Court, provides no guarantees that anyone will collect it. So my concern with the system is will the day of reckoning come in my time or not.
I am hoping to collect it and expect to get at least some of my money back but am relying on other sources of funding in my retirement planning.
In the mean time I am trying to get my four children through college without having to refinance my mortgage. Fortunately one of the fringe benefits of working at a community college is that they can attend there for their first two years tuition free so long as I am employed which only leaves the last two years which, so far, hasn't been too bad given that college costs in Arizona are not as high as in many eastern states.
Chuck
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Pension Plans are only guaranteed as long as the government or company is financially well. If not, it is going to be a burden to the next generation paying the taxes. The Baby Boomers is too many to support based on sheer numbers. We need to think of a better way. I found out of a Billionaire Mentor here: http://www.billionairelist.blogspot.com
Thanks for the breakdown on these pension benefits. Sadly it seems many companies now are not offering such benefits but as unstable as many turn out to be in the long run this is probably for the better for the employees.
justemailme - thanks for your comment and observation. However, the risk that you cite refers to unfunded plans where the funds to pay the pensions come out of the current revenues of the company or government (Social Security is an example of an unfunded plan where the Social Security payments to current retirees comes from the Social Security taxes paid by workers each payday).
For funded plans in which money is invested over time before the workers retire this risk is not present as the funds to pay the pensions to the retirees has already been set aside. In some cases funded plans are controlled and managed by the company the retirees worked for, while in other cases whenever a worker retires the company simply withdraws from the fund the amount needed to purchase an annuity (for more on annuities click here http://hubpages.com/hub/Using-Annuities-to-Guarant ) that will pay the promised monthly pension amount to the retiring worker for life. In this case no matter what happens to the company the retiree's pension came from the retiree is unaffected as his/her pension is now independent of that company and what happens to it.
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The only "company" that can guarantee anything is the United States Government. Because they have the ability to tax to fund. If we have learned anything from the recent and on going recession it's that no company is immune!
From a USA Today Report.
Currently, GM's pension plan is underfunded by $20 billion, says Douglas Elliott, an economics fellow at the Brookings Institution. The restructured company will need to use some of its operating profits to close the gap, he says. If those profits fail to materialize, the company could end up filing for a second bankruptcy and transferring its pension obligations to the Pension Benefit Guaranty Corp., Elliott says. The PBGC is a federal agency that insures defined pension plans.
MikeNV - theoretically the U.S. government, using its power to tax and/or print money, is the only entity in the United States that can guaranty pensions. However, as a sovereign entity it can also repudiate its obligations as governments in other nations have done in the past. Further, as I have pointed out in my Hub on Social Security ( http://hubpages.com/hub/The-Social-Security-System ) the system is legally not a pension plan in which contributors have a property right and own the money they and their employers pay into the system but, rather, two separate laws - one a welfare law that provides for the Federal government to transfer income from workers to retirees and the other an income tax law that imposes a special income tax on worker's paychecks (unlike the regular income tax law the Social Security tax does not tax investment income, royalty income, etc. but only wage income). The Supreme Court has ruled on two separate occasions that workers have no right to the money they have put into the system and have reaffirmed the right of Congress to repeal either or both the the laws that make up the Social Security system at any time by a simple 51% vote.
Because of the voting power of those already retired and those nearing retirement there is little danger of Social Security being repealed any time soon. However, should the balance of voting power tip in the direction of younger workers who rebel at paying the increased taxes needed to continue to pay retirees the law could be repealed. So there is a very real political danger to this system.
The PBGC is a Federal government corporation that insures private pensions. However, in order to preserve their capital to cover as many failures as possible, they generally, upon taking over a failing and underfunded pension fund, set about reducing monthly benefits to the retirees. So, while the PBGC provides some security, it does not provide complete protection to a person's defined benefit pension.
Thanks for commenting.
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Thank.
thanks for the info Chuck. Lot of things to think about and consider here.
- joe
Interest post. The differences between DB and DC are enormous. One of the problems with DC is that we don't stay in control of our money because we don't take the time to learn about money. Therefore, we let the money mangers lose money for us. In his book "Prophecy" Robert Kiosaki (not sure of spelling, but he has the Rich Dad Poor Dad company) spends a lot of time talking about the differences. It is a very interesting and informative book.
The Rising Glory - thanks for your comments.
I am familiar with Robert Kiyosaki having read a couple of his books and attended one of his company's seminars. He has a lot of good ideas and I have the greatest respect and admiration for him and his ideas.
You are correct that one of the problems with defined contribution plans is that people don't take the time to learn about money and therefore may not manage their plans as well as they could. However, most defined contribution plans are not only portable in that employees can take the plan and money contributed to date with them when they leave an employer but, at that time they can also change managers if they so desire. Also, regardless of how much or how little a person knows about money, they do have control over these plans which is not the case with defined benefit plans. Finally, as to financial knowledge and management, I have seen some studies that showed people who set up automatic deposits to such plans and then basically ignore them for years often do as well or better than many who actively manage such plans.
Thanks again for your comment.
Thanks for going into such depth, I didn't realize there was such a difference between the two.
"Today, the market is not good, so the pension fund is not good too, I think."
Me too.
I thought the Pension Benefit Guarantee Corporation took care of the risks with pensions but I see there are still downsides to the system. Scary stuff.
jrcmail - As Benjamin Franklin reminded us "The only things certain in life are death and taxes."
Thanks for a very informative hub on pensions.
Good hub about Defined Benefit vs Defined Contribution Pension Plans
.
Thanks
You have a good taste.
I like it.
Thank.
Thanks Chuck! Very informative article. To the point with no bs on the side. Unfortunately in this country the most recent financial crisis has caused many companies to not only lower or stop their employer matches completely, but also terminations of defined contribution plans are on the rise. I am afraid that the next generation is going to have to completely do it on their own and as you know, most decisions in youth are not exactly forward looking.
cool info thx
Hey Chhuck, good infomation here. And reading the comments enlightened me even more
nice effort there , will definately consider some point there :)
Good work.
i think this is not safe
The only "company" that can guarantee anything is the United States Government. Because they have the ability to tax to fund. If we have learned anything from the recent and on going recession it's that no company is immune!
onewaythinky - thanks for visiting.
As to your comment, I don't know if you mean that one or both types of pension plans are not safe or something else.
Of course, pensions like any other type of investment, or anything else in life for that matter, are not 100% guaranteed. However, the defined benefit pensions of most companies are conservatively funded and there is the government's Pension Benefit Guaranty Fund which tries to insure them and rescue those that run into trouble. As to 401k plans, the individual usually has considerable control over what to invest in which should provide security for those who are very concerned about that (of course, the more secure the investments the less opportunity for growth so there is always a trade off between safety and rate of return).
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hay...you have provided great information, good vision about pensions,discuss good plane and business risk, for all these i will point out 90 points out of 100.
The world is changing. I don't think we can rely on our company or government to give us a peaceful retirement. The recent financial crisis shows us that many MNCs are having problem surviving themselves, let alone provide us a good pension benefits. No my friends... We have to look after our own future. No one will cares about you more than you yourself.
alexchia01 - I agree with you that people would be better off being left alone to manage their own retirement planning as we cannot count of employers or business for this as both of those organizations will naturally put their own interests and financial survival before that of individuals.
Thanks again for visiting and for your comments.
Hi Chuck,
I have created a blog about best hubs just now and posted link to this article there at the top.
Thanks,
Jyoti Kothari
JYOTI KOTHARI - Thank you. I am honored that you think so highly of my writing that you included it in a list of best Hubs on your blog.
I clicked on the links to your blogs from your profile page and found all three of them very interesting as are your Hubs.
Here are links to your Hub Profile and three blogs for others to check out:
Profile: http://hubpages.com/profile/JYOTI+KOTHARI
Blog 1 - Vardhaman Gems: http://www.vardhamangems-jaipur.blogspot.com/
Blog 2 - Hubbers India (which has an index of all the Hubbers from India): http://hubpages-india.blogspot.com/
Blog 3 - My Articles: http://jyoti-articles.blogspot.com/
Thanks again
Chuck
Chuck
Most of the people in the private sector that are not executives or union members don't have any more retirement at their company than SS, IRA or 401K.
Yet, the Federal Government Employees have Defined Benefit plans augmented by the people and paid for with tax revenue.
Most of the private employers are lucky if they stay in business and they cannot afford the luxury given by the government to their employees.
Why is it that the servants get better benefits than their masters, the people?
We the people can't afford those government employee benefits.
In troubled times like the one we're living in for the last year and a half this information we're giving is valuable. Thanks!
Nice Hub!
Thanks for all of the great information on pension plans.
Great hub! One of the items not mentioned during the banking bailout was the possible ramifications for the pension funds - the define benefit pension funds. I ran fixed income portfolios and sat on an advisory committee for Police and Fire pensions - both defined benefit. The bailout was needed from a practical standpoint - just wish it made sense on a philosophical standpoint. Pensions are an important topic and a must learn for our baby-boomer set. Thank you very much!
Nice hub! I've learned how to optimize my finances only recently, and the difference has been amazing. We've saved more than 10,000$/year just by using a bit of common sense and shopping around for the best deals.
good clear information on pension plans
"Defined benefit plans are plans where the employer guarantees to pay the employee at retirement a fixed monthly income for life" did not know about that. I do not know about pension plans and all.. but I lioked your hub the way you have defined the pension plans is really great..
Where I come from, people are just lucky to have a job...benefits are mostly dreams.
We only have a few big employers in my area, and they all work exclusively through a temp service. So you work full time but get a fraction of the pay and no benefits.
Then when your 90 days roll around, they let you go so they don't have to hire you, and replace you with some other poor sod and work him for next to nothing for 90 days.
They've been doing it for years now.
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Thanks apperciate it im new to this and dont understand it fully yet
Really nice hubpage :). Well done.
great hub thank you
very informative. Since Singapore government rolled out national annuity program, the subject of annuity becomes the national discussion topic.
bobmnu says:
3 months ago
What happens to a defined benifit when the company goes broke? Don't the pensioners lose. The real benifit that President Reagan gave the average person was the creation of the private pension plans by employees. One now has the option to balance the defined Benifit with a defined contribution and protect thems selves. Some in Congress see this pool of investment money as a potential "fix" for Social Security by the government taking them over andincreasing Social Security benifits for all. Becareful.