Defined Benefit and Defined Contribution Pension Plans Explained

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Pension plans are held to be given to working individuals after they retire. There are a variety of different plans depending on the work placements individuals work at. Generally, pension plans include payment of certain contributions to a fund during the employee's work life till retirement time. After retirement, the individual receives an income either as a lump sum or a certain amounts divided throughout the retirement life. There are two main pension plans that will be discussed in this report; Defined Contribution (DC) and Defined Benefit (DB) ¹.

In recent years DC plan has become more common than DB (Gordon 2002); The United States Department of Labor (2010) shows that in the period of 1990-1991 DB plans have decreased by 30% in the United States and further by 20% in 2008; and the drop is continuing. DB plan lost its dominance for many reasons that will be discussed later on.

The aim of this report is to examine the shift from DB plans to DC by assessing the differences between DB and DC plans, with a focus on differences regarding risk distribution, and explaining the benefits of choosing DC pension plans from different perspectives. Examples will be given from countries with mature funded occupational pension systems like USA and UK. Then the report will be concluded with personal thoughts and conclusions.

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Throughout the report, Defined Benefit will be referred to as DB and Defined Contribution as DC

2.0 Differences between DB & DC Pension Plans

Many countries with mature pension system have optional pension plans available to working individuals. Sponsors of those plans could be either the employer, labour unions or any specialised organisation. Traditionally, the aim of any pension plans is to provide retiring individuals with certain income for life. Recently, this has been changing.

2.1 Defined Benefit Pension Plan

DB plan, as it sounds, is a promise of definite future payments after employer's retirement till his/her death. Typically the benefit is calculated in advance using a formula based on the salary, years of service and age. Sometimes, this pension could be indexed to inflation rates. The promised benefit is a percentage of the final salary or salaries of the working individual. Employers are responsible to make payments at time of retirement. So basically, a DB pension plan is pre-funded account by employers and should have sufficient money to be paid to employees for the rest of their retirement lives (Zelinsky 2004).

DB plans include risks for both the employers and employees. Generally, employers face three major risks; firstly, employer bears the risk of making an advance promise to pay an amount in the future which depends on a specific rate of gross earnings. Secondly, employers bear the market risk in which DB assets may fall short from the promised obligation at time of retirement and so employers are obliged to pump more money to match their retirement obligations. Thirdly, "investment" risk is a burden on employers where there is a possibility that the returns on the assets related to the pension fund fall short from the promised expected retirement payments (Zelinsky 2004).

On the other hand, sometimes, the retiring individual may face the risk of insolvency if the sponsoring firm went bankrupt (Davis and Sarra 2010). This risk was decreased by creating specialised organisations to protect pension; for example, in the USA Pension Benefit Guaranty Corporation (PBGC) was created and the UK Pension Protection Fund was founded in the UK (Zelinsky 2004). Also employees bear the impact of inflation risk (Bateman 2002) since, generally, DB plans do not index inflation.

Finally, "portability" risk represents the major risk that an employee may face (Klaff 2007); usually DB plans rely on long term employment relationship between employee and employer since the later is fully sponsoring the pension fund. Changing work affect the percentage of future pension payments negatively. For example, Blake (2003) found that the employee in UK who changes work 6 times during his/her work life, could lose around 25-30% of retirement payments compared to employees who stayed at the same job during their work life. Figure 1 summarises the distribution of risk among employees and employers:

Figure 1: Risks faced by both Employers and Employees under the DB pension Plan

Source: (Broadbent et al. 2000)

2.2 Defined Contribution Pension Plan

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Unlike the DB plan, employees involved in DC plan pay fixed contribution, deposited in an individual fund sponsored by the employer, throughout career life. This contribution is deducted directly from their salary and usually the portion deducted is matched by employer. The retirement income is not known since it depends on the contributions made through career life by the employee and the return on the fund investment. Therefore, there is no guaranteed retirement benefit since not only is it based on contributions, but also on investment earnings. Examples of the DC plan is the traditional purchase plan (MPP) organised as a trust in the UK.

The risks are reversed under the DC plan where the employees bear most of risks but reap most of benefits at the same time. The employers have no financial obligations except to make periodic payments into the plan. Also they are longevity risks free under the DC plan (Zelinsky 2004).

In DC plans the main differences from DB plan are mainly about choice and flexibility; Employees are given the choice to select which investments to invest their funds in among a selection of given investments by employers. This allows employees, to an extent, build their own pension fund portfolio and undertake risks to the extent they desire. Also, DC plans are more flexible since they are portable among employers; the plan assets in DC belong to the employee and are controlled by him/her. For example, an employee under the DC pension plan could choose to leave the plan assets with previous employers or transfer them to new employers (Zanglein 2001).

Replacement risk is another risk faced by employees who should make complex continuous investment decisions to reach the desired retirement goal. It is true that DC plan gives more options regarding choice of participation, amount of contribution and sometimes time of withdrawal, but employees could get confused with the wide variety of investment decisions to be made. In other cases, employees should bear investment risks without controlling the mix of assets or they may have limited alternatives of investment options (Zelinsky 2004).

Additionally, market timing risk, which applies to both available cash balances at time of retirement and amount of pension is another risk faced by employees. Any movement in the market can highly affect the cash balance in this pension plan. For example, employees retiring at a time of recession may end up with smaller annuity than employees who retire at time of a booming economy (Zelinsky 2004).

Finally, the risks faced by the employees and employers in the DC plan are quite different from the risks faced in the DB plan as shown in figure 2; in DC pension plan, employees face more weighted risks than employers. However, employers face the risk of losing their employees due to less loyalty and may face higher turnover compared to having DB pension plan (Barr 2007).

Figure 2: Risks faced by both Employers and Employees under the DC pension Plan

Source: (Broadbent et al. 2000)

3.0 Causes of the Shift

There are different explanations for the shift from DB pension plan to DC in countries with mature pension systems. The acceleration of the shift to DC plan in USA, as shown in figure 3, is mainly employer driven influenced by confluence of factors. The main factors can be summarised as:

Figure 3: the Decline in DB Pension Plans in USA

Source: (Crowley 2009)

3.1 Changes in Regulation and Taxation

In many countries, the pension sector is in the mid of continuous regulatory reforms. At one point, DB pension funds became governed by very complex regulations and acts. For example, the USA Employee Retirement Income Security Act of 1974 (ERISA) which govern every aspect of the private pension plans such as reporting and funding decreased the incentive of employers to sponsor this plan (Zelinsky 2004).

During 2000s and due to the increasing concerns of the opaque and complex DB pension accounting methods and due to the deteriorating in the funding of DB plans, new regulations and accounting methods were aimed to introduce a simpler method than the DB plan and show more transparency in pension evaluation and help in more volatility in the financial statements of sponsors. This all helped in the shift to DC pension plan (Zelinsky 2004).

3.2 Growing Costs of DB Pension Plans

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Present value of DB pension payments aims to at least equal the present value of salaries an employee can get in the spot market. Practically, on the long run, the DB pension plan has an increased cost. This is due to the higher value of pension payments and the increased period of post-retirement as a result of increased longevity and early retirements. Also, the increased risk of the uncertainty of future benefit under the DB plan pushed employers to improve their risk management skills. Under the DC plans, employers' responsibilities are limited to fixed payrolls that reduce balance sheets and earning volatility over the long run (Zelinsky 2004).

Also there are administrative costs for current retirees and continued maintenance costs of the DB plan which usually run for long time to keep DB benefit able to cover retirement payments for long periods (Zelinsky 2004). Figure 3 shows the total DB plan costs:

Figure 4: DB cost components.

Source: (Hess and Kupferschmidt 2010)

3.3 Change of Employment Industry

Historically, DB plans were mainly held by large companies like the steel and other large and heavily unionized industries. Since these industries have recently declined, the DB plans have almost disappeared (Broadbent et al 2006).

3.4 Increased Workforce Mobility

This is known as the "accrual risk". Demographic and Industrial change contributed to the increase in labour mobility. Surveys suggested that, in USA, the changes in demographic composition of workers, technology revolution and industry composition affected the shift towards DC plans. Many employees now are more mobile, so they prefer DC plans since traditional DB formulas favoured long-tenured employees. Besides, DB is not portable from employer to another. DC plans avoid the accrual risks and gives more flexibility to employees to move among different employers without losing their pension savings (Broadbent et al 2006).

3.5 Market Increasing Knowledge

The spread of mutual funds and individual saving accounts in the 80s made households more acquainted with the stock market. The dramatic rise in equity prices during the mid 90s pushed the DC plan to be hugely spread all over US; employees became more interested to run their own pension funds personally (Broadbent et al 2006).

3.6 401(K) Plans

The development of plan 401 (K), figure 5, in 1983 accelerated the growth of DC plans in the USA. This plan allows employees to defer tax payment by deducting portions of their salaries to their DC accounts. Also this plan allows early withdrawal for the employee before reaching retirement age. Therefore this plan provides more desired flexibility and tax advantage that encouraged the tendency to go for it rather than DB (Agnew, Bulduzzi and Sunden 2003).

Figure 5: Plan 401(K) Process

4.0 Conclusion

Recently, DB pension plans are losing their dominance gradually in many countries with mature pension plans. Basically, shifting from DB to DC offers many advantages for employees when it comes to changing jobs. Since DC plans are portable, the problem of accrual risk is not an issue, nor the risk of employers' insolvency. Also DC plans are controlled by employers who have the choice to manage their pension savings the way they prefer.

At the same time, changing to DC plans shifts additional challenges and risks to employees that were not present with the DB plan. Employees under DC plans assume market and longevity risks which were formerly borne by the sponsors under the DB plan. Also, Researchers showed that employees haven't managed their pension account savings very well since they do not make best asset allocation or make use of available financial products to control longevity risks (Broadbent et al 2006).

As a matter of fact, employees, to an extent, do not have the choice whether to enroll in DC or DB pension plans. Eventually they are the choice of employers. Recently DC plans spread since they shift many risks from the employer to employees. However, DC plans are also, arguably, less risky to employees. And the potential implications from implementing DC pension plans are to reach financial stability.