DB Plans vs. DC Plans
|
» Threats to Retirement Security |
Why Defined Benefit Plans are Better than Defined Contribution Plans
Almost all of our public pension and Taft-Hartley funds are defined benefit ("DB") funds, which guarantee a participant a pension for as long as he/she and his/her spouse are alive. The amount of the pension is generally based on a formula which takes into account a participant's final average earnings, age at retirement and years of service.
The purpose of a defined benefit fund is to provide employees who retire with as much replacement income as possible for as long as they live. This places on the employer - and not the employee -- the burden of ensuring sufficient assets to pay this pension. The employer meets this obligation by making sufficient contributions to the fund. The fund then makes prudent investments of the fund's assets and regardless of how well these investments perform, the obligation to fund the guaranteed pension benefits rests with the employer.
Unfortunately many employers are trying to shift the burden of paying for retirement benefits onto their employees by shifting from defined benefit plans to defined contribution ("DC") plans.
Click the links below to learn more about the advantages of defined benefit plans over defined contribution plans.
- Defined Contribution Plans Put Our Members Retirement at Risk
- Defined Benefit Plans Provide Supplemental Benefits
- Defined Benefit Plans Outperform Defined Contribution Plans
- The Attack on Defined Benefit Pension Plans
Defined Contribution Plans Put Our Members Retirement at Risk
In a defined contribution plan, an employer contributes each year a percentage of an employee's salary into a 401(k)-type individual account and leaves it up to the employee the responsibility of investing these assets prudently. If an employees' investments do not turn out well, or if the employee retires during a period of declining stock values, or if the employee outlives the value of his assets, then the employee is stuck without a core retirement income, and risks becoming a member of the elderly poor.
Defined Benefit Plans Provide Supplemental Benefits
Most defined benefit plans provide supplemental benefits, including early disability, cost of living adjustments, retiree health coverage, and death benefits. Most defined contribution plans provide no such benefits.
Defined Benefit Plans Outperform Defined Contribution Plans
According to a leading benefits consulting firm, the returns achieved by DC plan participants have lagged defined benefit plan investments' returns by 2% annually. Lest anyone mistake this rate of underperformance for a small number, note that $100,000 invested at 10% for thirty years grows to $1,744,940, while the same amount invested at 8% for thirty years grows to only $1,006,266. The missing 2% compounds to nearly three-quarters of a million missing dollars for a hypothetical investor with a 30-year time horizon, roughly the average time between mid-career and mid-retirement for today's long-lived individuals.
Defined benefit plans outperform defined contribution plans for a number or reasons:
- Education Programs Fail to Deliver
The educational programs available to Defined Contribution plan participants generally don't provide them with the tools necessary to select an investment strategy that maximizes returns at an appropriate level of risk. Most educational programs are provided by the plan administrators themselves, who are therefore in a position to encourage participants to buy their products. Many DC education programs emphasize fund selection without a prior clarification of the key concepts (mean-variance analysis, asset allocation, the "efficient frontier") that guide the investment professionals employed by Defined Benefit pension funds. Moreover, even when the educational program is well designed, the overwhelming majority of participants simply do not have the time, energy, or expertise necessary to make investment decisions in as well-informed a manner as the full-time, dedicated, and well-educated professionals who manage Defined Benefit plan investments. - Costs Are Too High
Despite the fact that investment fees, commissions, and other costs can be controlled and minimized, DC plan participants typically pay much higher costs than other investors. Mutual funds, which make up the majority of investment choices typically offered in DC plans, charge fees that can be twice as high as otherwise comparable institutional funds. These higher costs result in part from an emphasis on the recent short term performance of individual funds. This emphasis in turn leads participants to invest too heavily in actively managed funds that charge much higher fees than passively managed, index funds. However, high costs also stem from the "bundling" of administration and record keeping and investment management: through such bundling, the investment company administering the DC plan performs for "free" the bookkeeping tasks that would otherwise fall to the pension fund. These companies effectively subsidize the sponsor's cost of administration through the excessive fees charged to participants by its actively managed funds. Such arrangements clearly present a conflict of interest between plan sponsors and participants, and one that invisibly reduces the participant's likely retirement income. - Participants Take on Too Much or Too Little Risk
When DC plans first began to spread in the 1980's and early 1990's, plan sponsors and administrators had a very difficult time convincing participants to invest in relatively risky securities (equities in particular). Whereas Defined Benefit funds usually put 50 to 60 % of their assets in equities, as recently as 1990 DC plan participants invested only 45% of their assets in stocks. Many participants continue to have the vast bulk of their DC assets in low-risk, low-return instruments such as Guaranteed Investment Contracts. More recently, with the long bull market of the 1990's, DC account holders dramatically increased their allocations to equities: equities now constitute over 70% of aggregate DC holdings, and some participants have 100% of their investments in the stock markets. Thus, having long undershot the reasonable 50-60% allocations of the Defined Benefit plans, by the late 1990's DC participants became overly-exposed to this riskier asset class just as the markets prepared to go south. - Participants Take on Too Much Active Risk
In addition to the failures of educational programs and the conflict of interest between plan sponsors and participants, the common focus on recent short-term fund performance encourages participants to put most of their money in actively managed funds. The risk that an active investment manager will fail to meet average returns, called "active risk," ought to be compensated by better-than-average earnings, but typically is not. Only a very small number of such funds actually beat average market returns on a consistent, long term basis: indeed, it is impossible for all active managers to "beat the market" simultaneously, and therefore the returns to individual managers are very widely dispersed (some years well above average, some years well below). Conversely, Defined Benefit pension funds invest heavily in passively managed accounts indexed to market averages. Such index based investment vehicles not only produce reliable returns at low risk, they also minimize the various fees, commissions, and other costs that eat into returns.
The Attack on Defined Benefit Pension Plans
Some employers are increasing their attack on the retirement security of our members by advocating and lobbying for the conversion of defined benefit pension plans to defined contribution pension plans. In the public sector this attack is led by the American Legislative Exchange Council (ALEC). 14 states have already adopted some form of compulsory or voluntary conversion to defined contribution plans. ALEC has promoted legislation in an additional 12 states to convert defined benefit plans to some form of defined contribution plans.
Details about states that have adopted defined contribution plans for their public pension funds or have proposed legislation to do so are as follows:
|
Full DC Conversion Option |
|
DC Limited to Small Group of Employees |
|
Supplemental DC/ Hybrid Plan |
|
States Where Legislation Proposing Defined Contribution Reform Has Been Introduced |
Issues
A Solution for Our Health Care Crisis
We all know our health care system is broken. See why working people, business, and elected officials must fix it together. More »
