September 2003

In Defense of Defined Contribution Plans

By Brad Brewer

The number of defined benefit plans has steadily decreased over the last several years. According to Department of Labor data collected from Form 5500s, 31% of all active plan participants were covered under a defined benefit plan in 1998, down from 63% in 1979. Corporate concerns over funding, high administrative costs, and annual Pension Benefit Guaranty Corporation (PBGC) premiums are factors in the decline. During the same time, average employee tenure has fallen, making defined benefit plans less of a perceived benefit because of their lack of portability and back-loading of benefits near retirement age. Defined contribution assets, on the other hand, increased from approximately $126 billion to over $2 trillion dollars from 1979 to 1998. They provided solutions to both sets of concerns, with set contribution rates, lower administrative fees, no PBGC premiums, and portable benefits.

Defined benefit plans do have a place in employee benefit plan design, but their role is best suited to a limited number of plan sponsors, for two main reasons. First, one role of retirement plans is to attract and retain employees. Defined benefit plans are designed to reward employees for long-term service with a guaranteed monthly benefit payment for life. But in today’s labor market, defined benefit plans typically will not attract employees. Most job candidates are hopeful a job is for the long haul, but few will accept a job because of its defined benefit plan. Reduced eligibility periods, competitive matching formulas, and shortened vesting schedules are more likely to attract employees.

The Exhibit compares the benefits payable upon termination of a defined benefit plan as compared to a defined contribution plan. Designed to replace 40–50% of preretirement income for a 25–35-year employee, the defined benefit formula is 1.5% of the final average compensation for each year of service, with a subsidized early retirement benefit at age 55. Combined with a 40% preretirement income replacement from Social Security, the total benefits received by a 25–35-year employee would be approximately 80–90%. The lump-sum payout is calculated assuming a 6% discount rate and the 1983 Group Annuity Mortality table. The defined contribution plan assumes 10% in contributions, whether from the employee, employer, or the sum of both. Both scenarios assume that a 37-year-old employee is hired on January 1, 2001, starting at $48,300, and receives 5% annual salary increases.

Consider the corporate or public employee working the median tenure, 3.5 or 7 years, respectively. The benefit payable from the defined contribution plan is more than double that of the defined benefit plan, even under the 6% earnings assumption. This example underscores why a defined contribution plan is a more effective recruiting tool.

As stock market returns bounce back, participants will again appreciate the fact that they have control over their own asset allocations. Participants can take on more risk in pursuit of higher investment returns. From Callan’s database of public defined benefit plans, the typical portfolio is a “middle of the road” allocation of 60% equity and 40% fixed income. Defined benefit plan participants do not get the choice of accepting above-average risk for the opportunity of above-average returns.

The second reason defined benefit plans have limited application is that the impact of funding obligations is very unattractive to corporate and public finance professionals. A recent study by Wilshire Associates of Santa Monica, California, reports that over 50% of public-employee plans are underfunded, up from 31% a year ago. Furthermore, the study estimates that the level of underfunding could grow to 75% in the coming months.

Considering the drawbacks of defined benefit plans, why are they considered as an answer to the current “retirement crisis”? The motives of defined benefit plan proponents yield the answer. Life insurance companies and actuarial societies are strong proponents of defined benefit plans. They would directly benefit from increased annuity sales and actuarial fees—services with typically higher margins than defined contribution recordkeeping services. Life insurance companies are finding stiff competition in the mid-sized and large defined contribution plan marketplace, forcing them to look elsewhere.

A second group of defined benefit plan proponents are near-term retirees in management positions who have not saved or invested wisely for retirement. It is a conflict of interest for them to implement or convert a plan that remedies their individual retirement shortfall but potentially short-changes the employees overall. If employees, particularly younger employees, understand that funds previously allocated to the defined contribution plan based on salary or employee contributions will be allocated mostly to older employees under a defined benefit plan, morale will suffer. Companies asking employees to purchase increased benefits in the defined benefit plan with their existing defined contribution plan balance should be very careful. With the stock market at its bottom, the level of increased benefits purchased today would be much less than three years ago, or maybe three years from now.

Some commentators contend that it is an employer’s obligation to ensure its employees have a retirement benefit. Good employee benefit design, however, is achieved through balancing workforce demographics, employer financial constraints, and the labor market. A sense of entitlement does little to motivate employees to further their own success and inhibits the long-term success of the plan sponsor.

While the weak stock market has had negative impacts on participant account balances, defined benefit plans are not the quick-fix solution.

In this environment, plan sponsors should give their participants access to financial education or advice. Unfortunately, many vendors offer poor educational programs, often centered on the Internet because of its lower costs. A comprehensive educational campaign is focused not on minimizing costs but on communicating key financial knowledge to plan participants, enabling them to identify what they need to save for retirement and how they can invest their savings in order to have a more comfortable retirement.

One hurdle facing plan sponsors is the potential legal liability for providing investment education, particularly investment advice. Proposed legislation would allow plan providers to offer advice as long as they disclose any conflicts of interest. It would also protect plan sponsors against liability from the outcome of the advice. A drawback is that the plan sponsor would be liable to monitor the service to ensure the advice is impartial. The form of any final legislation remains unseen, but hopefully it will be a step in the right direction.

Brad Brewer, CEBS, CPA, is an investment consultant with Innovest Portfolio Solutions, LLC.

Sheldon M. Geller, Esq.
Geller & Wind, Ltd.

Mitchell J. Smilowtiz
Charles W. Cammack Associates, Inc.

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