Defined Benefit vs Defined Contribution Pension Plans
Two 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
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 hazardous 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.
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.
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.
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.
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.
Links to My Other Hubs on Retirement
- Role of Annuities in Retirement Income Planning
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- How to Payoff Your Mortgage Early
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© 2009 Chuck Nugent