Comparing The Defined Benefit Plan With The Defined Contribution Plan.

 




There has been an ongoing discussion about pension reform and the Detroit bankruptcy has put the spotlight on the affordability of the defined benefit plans that many State and Local governments provide their employees.  With the bankruptcies of Detroit and some California cities many pension reform groups are seizing the opportunity to demand that the public employee pension plans be converted to a defined contribution plan.

Historically, most public and private pension plans were defined benefit plans since their workers rarely changed jobs and stayed with the company or department for decades.  However, in our more mobile and restless society, more workers are job hopping or being laid off.  The result, is that these workers cannot qualify for an adequate pension since the defined benefit plan is based upon years of service.  However, in the 1980's the Internal Revenue Service allowed an obscure alternate tax deferred instrument to become available and this was known as the 401{k} plan.  The 401{k} plan morphed into the defined contribution plan.  At first, the 401{k} plan was a supplemental plan that allowed all workers to stash away tax deferred money until they withdraw it.  Eventually, many private companies soon realized that the 401{k} plan could replaced the existing defined benefit plan as the primary savings vehicle and many dropped their defined benefit plans for the defined contribution plans (401{k} or 403{b} plans}. The defined contribution plan became the retirement plan and the companies advertized the use of the defined contribution plan as a better way for their employees to save for retirement since it allowed the employee to choose different investment options and they can take the defined contribution plan to other employers. 

For the companies, the defined contribution plan had the advantage to save the employer significant money that can be used to grow the business instead of paying out pensions.  With the defined contribution plan (401{k}, 403{b) plans) the company is paying a maximum of a 3% employer match yearly to the employee and pays nothing in pension costs down the road.  While the defined benefit plan puts the company on the hook to pay out pension costs to the retired employee and spouse for decades after the worker no longer is an asset to the company.  Is it any wonder that private companies have eliminated or frozen their defined benefit plans and now only 8% have defined benefit plans. For the short-term employee in the private sector, the defined contribution plan makes sense since it allows the job changer to take the pension money with them.  This "portability" is important  since the employee's pension can continue to grow no matter how many employers he or she has during his working life..

By contrast, in the public sector, the defined benefit plan is still the retirement plan of choice.  Only Alaska and Michigan have gone to a defined contribution plan while a few states have a hybrid plan.   The reason is that public sector workers are usually older and long-term employees and stay in service because of the superior health benefits that private sector workers don't enjoy, especially in retirement.

For example on how the defined benefit plan works Let's take a New York City public school teacher who has 25 years of service in the City's schools and retires at top salary  at 62 years of age. The NYC teacher pension formula is as follows.

*Final Average Salary x Years of Service x Correction Factor = Annual Pension.

$100,049 x 25 years of service x 0.02 = $50,000 Annual Pension.

On the other hand, let's look art the typical 28 year old Educators 4 Excellence (E4E) drone who lasted barely five years in the
City schools before jumping ship to work for her education reform group masters.

$51,747 x 5 years of service x 0.0167 = $4,321 Annual Pension.

That only happens when she reaches age 62 at least 30 years down the road.

Final Average Salary = Top three consecutive years.

Obviously, for the E4E drone the defined contribution plan would be preferable since her money could continue to grow tax-deferred rather than be frozen for thirty or more years under the defined contribution plan.  The bottom line, the defined benefit plan is superior for a worker who stays with an employer for much or his or her working lifetime while the "portability" of a defined contribution plan  is preferable for the worker who changes jobs frequently.