Magazine article The CPA Journal

In Defense of Defined Contribution Plans

Magazine article The CPA Journal

In Defense of Defined Contribution Plans

Article excerpt

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 com-pensation 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. …

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