Tuesday, September 05, 2006

Defined Benefit Vs. Defined Contribuition Plans - Which Is Better?

Over the last decade there has been an explosion of defined contribution (401k) plans in the business community. In fact the Federal Government switched to the defined contribution plan for it's new employees in the mid 90s. The advantages of the defined contribution plan is it's portability (you can move from job to job) and employer match (free money). However, is it better than a defined benefit plan? Apparently, the answer is a loud no!

A study by a Boston research group on pensions found that the average defined benefit plan outperformed the average defined contribution plan by 1% annually and the average defined benefit pension was 20% greater than the definded contribution plan for the same period of time (20 years). Why such a difference? Because defined benefit plans are run by professional investment companies who are always rebalancing their allocation between stocks, bonds, and cash. On the other hand, the defined contribution plan is controlled by the employee who are either too conservative (money market fund) or too risky (company stock - think of Enron). Furthermore, the definded contribution plan has higher fees than the defined benefit plan and many defined benefit pensions have a COLA adjustment, the defined contribution plans do not. Therefore, it is accurate to say the longer a person works on the job, the greater the difference between the defined benefit pension and the defined contribution pension.

Unfortunantly, the defined benefit pension is under attack. Recently, IBM and Verizon have terminated their defined benefit plans and only about 28% of all companies have a defined benefit plan (1n the 1970's it was 86%). Mayor Bloomberg and the MTA have proposed a Tier V pension which can either be a less generous defined benefit pension or a defined contribution pension. Even the labor-friendly New York Times has jumped on the Tier V pension as a way to save money. While the New York State constitution does not allow for pension changes for existing employees, unless they are pension improvements, new employees may find themselves on the receiving end of a vastly inferior pension plan.

The New York Teachers Retirement System (TRS) provides a defined contribution (403b) plan that suffers from not including an option that should be included in all defined contribution plans. A life cycle fund. Depending on your age and date of expected retirement, the life cycle fund would automatically be rebalanced between stocks, bonds, and cash with little cost to the employee. However, presently the TRS has not proposed any changes to their fund and without a company match, the annuity generated by the 403b plan is inferior to the NYC defined benefit plans that include the life cycle funds.

If the future for new employees is a defined contribution plan then these plans should be low cost, have life cycle or retirement funds, and professional investment advise.

By the way, the fixed income investment return of the TRS 403b plan is 8.25% and this value will not change until June of 2009. If inflation stays between 3-6%, you get a minimum return of 2.25% above the rate of inflation, not a bad deal. I suggest that all teachers put at least 50% of all new money into this fund and take any money you have in Option "B" and switch it to the fixed fund (it takes one year to complete the switch).

4 comments:

NYC Educator said...

I've got everything in variable A. Am I nuts?

Chaz said...

nyc educator:

No, you are not. However, if you are in the 40s. You might want to consider putting 25-50% of your future eanings into the fixed option. I don't see variable A doing better.

Jonathan said...

I'm in my 40s with 75% fixed. Overly cautious?

Chaz said...

Jonathan:

Normally, I would say yes. But it's hard to beat 8.25% and have piece of mind.