Defined benefit plans still measure up

Before trading in your company's defined benefit retirement plan for a defined contribution program, carefully consider the traditional plan's advantages.

Are you embarrassed by the fact that your company still has a traditional defined benefit (DB) pension plan? Does the plan seem too big and bloated - a relic from another era? If you've secretly envied other firms' sleek new defined contribution (DC), cash balance or pension equity plans, hide your head no longer. Here are great arguments you can use in defense of your company's plan.(*)

Even if you haven't already read the statistics, you're probably aware of the trend in the number of defined benefit vs. the number of defined contribution plans. According to Watson Wyatt Worldwide, the total number of DB plans has shrunk from 168,000 in 1984 to 78,000 in 1995. During that same period the total number of DC plans has risen from 436,000 to 660,000.

What those statistics do not reveal is that the total enrollment in DB plans has remained at about 40 million and total assets invested are still higher than for DC plans. According to the EBRI Quarterly Investment Report, 1st Quarter 1996, $1.46 trillion was invested in DB plans at the beginning of 1996, vs. about $1.30 trillion invested in DC plans. Many larger employers have simply added a 401(k)-type plan to their existing pension plan. Most of the DB plans that have been discontinued were small plans covering fewer than 10 employees.

BENEFITS PER DOLLAR

Many people think that a defined benefit plan is costly and that going with a defined contribution plan will save money. That is simply not true. Benefits paid out in a retirement plan, whether a DB or a DC type, cannot be higher than contributions made into the plan plus investment income earned. A DC plan could only "save" money - that is, reduce contributions - if it either reduced benefits or increased investment earnings. Because DB plans can usually earn a higher rate of return - especially compared with DC plans in which employees make their own investment decisions - there is no reason to believe a DC plan saves money.

Actually, a defined benefit plan almost always delivers more retirement benefits per dollar of contribution. Here's why a DB program is more effective at providing retirement benefits:

As you may know, the benefit value that a participant accrues in a DB plan increases faster and faster as the participant ages. The value of DB benefits at younger ages is very low but increases dramatically as a participant nears retirement. In a DC plan, benefit value is accrued more linearly, which means that participants at younger ages have more benefit value in a DC plan than in a DB plan. Some hybrid plans, like pension equity plans, provide benefit value somewhere between pure DB and DC approaches.

Since more value is accrued at younger ages in a DC plan, more money is paid to participants who terminate employment at an early age and less money is available for retirement benefits.

Let's take a look at what happens when five employees retire from a company and 10 other employees leave during a year. If these 15 participants' benefits were worth a total of $1 million, a typical DB plan might pay benefits worth $750,000 to the retirees and $250,000 to the 10 terminated participants. In a typical DC plan, the five retirees would have benefits worth $500,000 and the other 10 participants' benefits would also be worth $500,000. The DC plan pays more benefits to terminated employees and less to retirees.

Of course, in DC plans like 401(k) plans, much of the cost is shifted from employer to employee, and DC plans are not required to pay premiums to the Pension Benefit Guaranty Corp. (PBGC). However, other costs may favor DB plans when compared to 401(k) plans and similar arrangements in which employees direct their own investments. These include lower administrative costs and, most important, higher investment earnings.

EQUITABLE OUTCOMES

In a DC plan, in which benefits are almost always available as lump sums, some participants are going to retire with more money than they will ever use and some will retire with less income than they need. DB plans, which often do not pay lump sum benefits at retirement, are more likely to make retirement income "just right."

Consider Joe, a widower who retired from Western Widget Works with $500,000 of employer money in his DC plan account. Unfortunately, Joe died soon after he retired and Western Widget's retirement program provided Joe's kids with a pile of cash.

Another of Western Widget's retirees, Julie, also retired with $500,000 in her account. In contrast to Joe, Julie lived a long and happy life. Well, it was happy until she reached 90 and her lump sum was used up, even though she had spent it frugally. Too bad that some of those retirement funds that Joe's kids were spending on fancy cars and designer clothes couldn't have been shifted to Julie instead.

A more appropriate allocation between Joe and Julie is exactly what a DB plan accomplishes through its annuity payments. Joe gets one month of retirement benefits and Julie gets higher income for her long life. The employer thereby provides better retirement benefits for everyone. It is also worth mentioning that the annuity a pension plan provides will cost significantly less than an annuity purchased from an insurance company.

BABY BOOMER PREFERENCES

DC plans are widely regarded as better appreciated by employees and more popular than DB plans. A DC plan works a lot like a bank account or mutual fired, and employees love to watch the account grow. DB plans are full of actuarial concepts, and the benefit is something payable many years in the future.

But wait a minute. Isn't the retirement of the future right around the corner for the "boomers," those 40-plus-year-olds who probably make up more than half of your company's workforce? Shouldn't they be waking up to the fact that an annuity for life is going to be a very nice benefit, allowing them to plan for a secure retirement? You bet they should!

And, in fact, they probably are. Look at the table below. On behalf of the Department of Labor, the Census Bureau surveyed people whose employers provided both a DB and a DC plan. Predictably, younger employees viewed the DC plan as more important. However, you may be surprised by the fact that employees over age 45 overwhelmingly viewed the DB plan as more important.

MANAGING THE MONEY

Generally, defined benefit plans place control in the hands of employers while defined contribution plans shift risk and decision making to employees. The question is, is that shift appropriate?

Okay, so companies have long outgrown the paternalistic culture of the past. It's time for employees to take care of themselves, right? Maybe, but let's face it, we're dealing with an extremely complicated subject. How much money do employees need for retirement? How should it be invested? How much should they use each year after retirement? When should they retire? A defined benefit plan, by its very nature, goes much further toward helping employees answer those questions.

The account balance concept may be better appreciated by younger employees, but when people actually start thinking about retirement, a monthly benefit is easier to understand. After all, most people make purchase decisions based on monthly payments, not the actual cost of a good. The same planning process applies to pension benefits. Most retirees probably have no idea how long $200,000 will last in retirement, but $1,500 a month is something they can base their financial planning on.

In addition, it's much easier and less expensive for the company to hire professional money managers than it is for employees to hire someone or try to become expert investors themselves. Proper investing is the single most important factor in making the most of retirement savings. Is it better for the company to make the relatively easy arrangements for the money to be managed professionally? Or should employees be left to their own devices, with some worksheets and brochures to help them learn how to invest?

A TOOL FOR STAFFING

You've probably read the stories about how many people are going to have to work during retirement because they are not financially prepared. You may also understand that there are not going to be as many "working age" folks left and, if all the baby boomers really do retire, there won't be enough worker bees left to keep things going. With issues like that looming, a retirement program that helps to adjust the size and demographics of a company's workforce could be a real asset.

A DB plan does allow an employer to plan for a desired career pattern. Certain ages or age and service combinations at which retirement makes sense can be identified. For example, it may be possible to identify certain ages or age and service combinations at which employee productivity starts to decline. Partial retirement in which a portion of a retirement benefit is paid as an employee reduces hours worked may well provide help in the future labor market.

On the other hand, consider this DC scenario: The economy hits a rut - profits are down and so are your employees' DC account balances. The company wants to downsize, preferably from among the ranks of older, more highly paid employees. Unfortunately, those employees are reluctant to leave because their retirement savings have recently become inadequate. With a DB plan, the company would be able to make periodic adjustments in the workforce through early retirement windows.

DESIGNING THE BEST PLAN

We haven't even covered arguments such as how traditional DB plans reward high-performing employees, while DC plans leave them with lower benefits as a percent of pay than others receive. Still, despite all the arguments in favor of DB plans, I do not mean to imply that every company should have a traditional defined benefit plan. But employers should not be too quick to jump off the defined benefit bandwagon without considering all the advantages they're leaving behind.

When weighing the pros and cons of DB and DC plans for your organization, do not get hung up on preconceived notions about "defined benefit" and "defined contribution." Consider the "hybrid" plan types that combine elements of traditional DB and traditional DC plans-for example, "cash balance," "pension equity" and "floor" plans. And remember, a few key modifications to any basic DB, DC or hybrid plan can make it look and feel just like any of the others.

It is, in fact, helpful to completely do away with the terms "defined benefit" and "defined contribution" when considering the appropriate plan design for your organization. Rather than deal with specific types of plans, analyze retirement plans by breaking them down into their key components and make decisions about each of those components. This will ensure that whichever basic design is used, it will have the features appropriate for your organization. Here are a few key questions to consider:

* What should the relative value of benefits for older and younger employees be?

* Who should provide the contributions - employees or employer?

* Who should invest the pension funds - employees or employer?

* Who should benefit from good investment performance - employees or employer?

* Should lump sum benefits, annuities or both be emphasized?

* How can the retirement program help mold the workforce?

* Should benefits be linked to performance of employees or the company?

* How should the program be communicated?

There is no one right answer to any of those questions. To make the best decisions, you'll need to be aware of the advantages and disadvantages of each of the possible answers and be able to relate them to your organization's values and human resource objectives.

In general, it can be said that a traditional DB plan, with its accruals at older ages, annuity payments, and professional investment management is better at delivering retirement benefits. A standard DC plan, with its account balances, lump sum payments, and self-directed accounts, is more of a savings plan. It may be more appreciated by younger employees and involve employees more directly in the retirement planning process.

All employers have to start with the question, "Why do we offer retirement benefits?" and develop specific objectives for their own programs.

* Note: With the advent of cash balance, pension equity and other creative retirement plan designs, the meaning of "defined benefit" and "defined contribution" is not always clear. In this article, "DB plan" generally means a traditional defined benefit pension plan and "DC plan" refers to a traditional defined contribution plan such as a money purchase or run-of the-mill 401(k), 403(b) or 457 plan.

R. Evan Inglis, FSA, is a consulting actuary with Watson Wyatt Worldwide in Seattle.

COPYRIGHT 1997 Society for Human Resource Management
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