February 2015 Why have so many employers gone to this Defined Contribution Plan instead of the traditional Defined Benefit Plan? Cost and Risk. Here is how our Defined Benefit (traditional) Pension is calculated: the highest average monthly salary during 5 consecutive years of service in the last 10 years X # years of service X 1.45% = your monthly pension. Kaiser guarantees you that amount
until death or you could take a lump sum. Cost: It is much, much, much more cost effective for Kaiser to pay 6 to 9% of your yearly salary for 40 years rather than pay for a traditional pension. Plus, Kaiser would not have to pay a financial services company to manage those millions of dollars in the pension fund. More importantly, it has to manage the risk. Risk: In a Defined Benefit (traditional) Pension, the employee bears NO risk
in the fluctuations of the stock market. In a Defined Contribution (401k type) Plan, the employee bears ALL the risk. There are three areas of risk: • Risk in how much to invest. Do you really want to gamble with your retirement savings in the stock
market? We have seen terrific returns in the stock market recently, but remember, in 2000 the stock market dipped 36% and in 2008, the market dipped 53%. Please also remember, it takes a 16% contribution (not 9%) for a Defined Contribution Plan to equal a Defined Benefit Plan.That estimate is based upon a guaranteed yearly wage increase between 2 to 4% AND a guaranteed yearly return in investment between 5 to 7% with NO negative returns in ANY years. As pharmacists, are we trained and skilled enough in investing to generate those types of returns? We would much rather have Kaiser take that risk. If you have an hour, please watch the Frontline documentary on PBS: The Retirement Gamble. Defined Benefit and Defined Contribution ��������� As stated earlier qualified plans can either be classified as defined benefit or defined contribution plans. Defined benefits are the most common. Most people have this type of plan where they work. In this type of plan employees makes contributions to their individual accounts and, in most instance, employers make some sort of matching contribution usually as a percentage of the employee�s yearly earnings. These employer contributions are added to the individual�s account and are invested at the employee�s discretion into the employer�s plan. Upon retirement, the employee ultimately receives the balance of the account, which is based on their contributions which will have been affected by capital gains and losses. The value of the account will fluctuate due to changes in the value of the underlying investment and market conditions. Examples of such plans include 401(k) plans, 403 (b) plans, profit sharing and other which will be discussed later in more detail. ����������� A defined contribution plan (traditional pension plans) is a promise to pay a specific monthly benefit upon the participant�s retirement and thereafter to any surviving spouse. It can be stated as a fixed monthly dollar figure or the plan may use a benefit formula to calculate an amount based on salary and years of service. Defined benefit plans traditionally encompassed most of working American�s retirement incomes but over the last two decades there has been a trend to replace them with defined contribution plans. Defined benefit plans are insured, to some degree, by the Pension Benefit Guaranty Corporation (PBGC). Defined Benefit vs. Defined Contribution Plan In the later part of the 1990s many people who had contributed to defined contribution plans saw the value of their retirement accounts explode with the �over exuberance� of the stock market. Those same people saw their retirement accounts decimated with the aftermath of the bursting of the stock market bubble while those in defined benefit plans retained a relatively stable and secure return. In essence there are some advantages and disadvantages and arguments can be made for and against both types of plans. Defined benefit advantages from the perspective of the employee: � Defined benefit plans provide a degree of security to workers for retirement. They are not affected by market risk, outliving their retirement, or if an employee becomes disabled. � Employees are not subject to investment risk. Pension funds minimize their investment in financially risky assets. They invest in a mix of assets that provided optimum growth and risk exposure that outpace inflation. � Defined benefit plans are not subject to employees� ability to save. Low wage earners are disadvantaged with defined contribution plans. In addition, employer contributions are usually tied to employee savings. Defined benefit plans have compulsory employee contributions that provide workers a secure retirement. � Most defined benefits plans have cost of living adjustments (COLA) and pension formulas that are tied to the employee�s highest paid years adding an inflation guard to the benefit. � Defined benefit plans usually provide death and disability insurance adding increased security. Under defined contribution plans employees must purchase these types of insurance. � Defined benefit plans usually have provisions that allow for portability with shorter vesting periods, reciprocity agreements, and buyback for prior years or related service. Defined contribution plans allow for borrowing. Defined contribution plans from the perspective of the employer:
Public policy may actually be enhanced from the use of defined benefit plans. Recent trends reflect a shift of administrative cost incurred by employers, who use defined contribution plans, to employees. There are significant management fees paid to various financial intermediaries that come out of these savings whereas pension funds typically have their own management. In addition, defined contribution plans may add to the burden on society if participants fail to save enough, make poor investment choices, or if they outlive their retirements. This may instigate the need for financial assistance and social welfare programs such as Medicaid and welfare benefits. Alternatively, many defined contribution plans have become insolvent in recent year which resulted in taxpayers paying millions of dollars for the bailout via the PBGC and consequently had the same affect of dependence on social assistance to many retirees. By mandating retirement savings which comes in the form of a small employee contribution, defined benefit plans allow low wage-earns to secure a retirement that they might not otherwise have achieved.[1] Finally, defined benefit plans actually can contribute to corporate governance. An example is the California Public Employees Retirement System (CalPers). They have significant influence (similar to a small country) in the corporate world. They recently led the charge and made �road kill� out of Dick Grasso who was expelled from his CEO position on the New York Stock Exchange (NYSE) for a questionable compensation package. There are some advantages to defined contributions as well: � Employees have more control over their investment choices. Typically there are multitude choices of financial intermediaries and investment vehicles. In defined contribution plans, employees have not say as to how fund assets are invested. � Growth could be more significant over time and has the potential to significantly outpace inflation. There is historical evidence that suggest that stock market returns (on average), over significant time, has had a larger return than the (safe) investments made by defined contribution plans. The disadvantage is the lack of investor knowledge and investment risk as previously pointed out. � Employees who maximize their contribution can realize a significant reduction in their annual tax obligations. Contributions made on a pre-tax basis are deferred until the benefit is actually taken at retirement. � Growth on the underlying investment(s) is also deferred until the benefit is taken. � There are some distinctive benefits with regard to distribution as opposed to a defined benefit plan. These include being able to access the account at age 55. Some defined benefit plans have a higher retirement age. � Tax deductibility makes it attractive for employers to utilize this type of plan. � Employers can use high contributions to attract and retain employees. Example of Defined Benefit Plans Starting in about 1999, some of the largest firms turned to benefit innovation and adopted a new type of pension plan commonly referred to as a �Cash�balance plan.� It is also a way of addressing employees wants verses needs and can also be construed as looking at the external competitive environment as a means of attracting and retaining employees. This type of plan has some distinct advantages and disadvantages. The foremost benefit is that it is attractive to younger workers especially those in their 20s and 30s because of the plans portability if the employee switches jobs. Older workers, those 40 and older, are disadvantaged because this plan can eliminate new benefits in the near term. It seems that employers choose this type of pension plan when it best suits their needs. However, like all benefit plan changes it must be approved by the Department of Labor. The cash balance plans are a type of defined benefit plan. Participants of these plans each have a separate account into which employers make contributions. These contributions are based on a percentage of pay and are credited with interest. Plan providers, by law, must provide annuity payouts options. This type of plan is differentiated from defined contribution plans in that it do not define the employers� contributions but as an alternative it defines future accrued benefits in each individual account. These plans are unique because they look at the lump sum of an individual�s plan verses the plan�s overall assets which are not directly tied to the individual�s account. The employer�s contributions are determined by using actuarial estimation and figured in present value calculations, so the employers match may be less than the sum of the additions to that of the plan participant�s account. This is an effective way of controlling an internal coststructure to employers. Interest rates are generally tied to some type of risk free security or bond index such as Treasury bill fund rates. Something else that is distinctive about this particular plan is that the employer/sponsor determines how the assets will be invested and therefore assumes 100 percent of the risk. The cash balance plan can be highly lucrative to the employer if there is a positive difference in the amount invested and the rate of return (ROR) promised to the employee. These gain/losses also affect future contributions in fully funding the plan. If ROR are high enough then funding will be self-perpetuating. Cash balance funds seek the highest ROR that is consistent with the level of acceptable risk (as stated above, in most cases, these are a relative safe investment) and over an extended time period, management is likely to receive a higher return than the stated rate especially if the stated rate is low. ����������� Employers who offer cash balance plans are subject to same vesting and funding requirements as other defined benefit plans that fall under ERISA regulations. The only difference is that unlike defined contribution plans, cash balance plans must be insured by PBGC because it is possible for participants to loose part of their accrued contributions. ����������� These plans could be a real inducement to employers who are looking to control there cost. The mixture of being a defined benefit plan (affects taxation as it is a write-off to the employer), having a comparatively low stated interest rate, and assuming a viable ROR in the equity markets, could alleviate any funding by the employer and thus eliminate the employer�s future obligations. �������� Traditionally, most retirement plans are geared in the direction of the total retirement benefit and take into account age and length of employment but cash balance plans accentuate annual accumulations and thus may not be quite as flexible as the more traditional plans in providing specific levels of retirement. Would you prefer a defined benefit plan or a defined contribution plan Why?As someone who is self-employed, which type of retirement plan is best? In short, if you would like a tax-deductible contribution of at least $60,000 per year, a Defined Benefit Plan is likely a better fit. Otherwise, a Defined Contribution Plan, such as a 401(k) Plan, generally will be a better option.
What is better a defined benefit or defined contribution pension?A defined-contribution plan is more popular with employers than the traditional defined-benefit plan for a few reasons. With the former, employers are no longer responsible for managing investments on behalf of employees and ensuring that they receive specific amounts of money in retirement.
Are employees more likely to favor defined contribution plans over defined benefit plans?Answer and Explanation: A defined benefit plan is likely to be more favored by employees because employers typically fund this type of retirement account.
Why defined contribution is better than defined benefit?The main difference between a defined benefit scheme and a defined contribution scheme is that the former promises a specific income and the latter depends on factors such as the amount you pay into the pension and the fund's investment performance.
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Most employers prefer defined contribution pension plans to defined benefit plans.
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