PENSION PLANS

PENSION PLANS

DEFINED BENEFIT PLANS vs. DEFINED CONTRIBUTION PLANS

By Allison Daniels

DEFINED BENEFIT PLANS

Defined benefit pension plans are traditional plans that promise employees a specific monthly benefit on retirement. The employee’s future benefit is established by a specific formula, and the plan provides a minimal level of benefits on retirement. The promised amount of the benefit is known in advance, and is usually connected to factors such as age, earnings, and years of service or a combination of these factors. The plan may state this promised benefit as a percentage of salary and years of service with the business (for example, 1 percent of final pay times years of service), or as a specific dollar amount and years of service (for example, $30 per month at retirement for every year a person has worked for the business), or as an exact dollar amount (for example, $100 per month at retirement).

A defined benefit plan is usually not contributory, which means that the employee does not make contributions to it, only the employer. There are also usually no individual accounts kept for each employee. In order to be able to pay the benefits workers are earning, employers are required to make regular and consistent contributions to the plans. These contributions are supplemented by revenues gained through the investment of the plan’s assets. The employer bears the investment risk and normally the investments are made by professional money managers.

Benefits typically are not payable until normal retirement age and usually are paid in the form of a lifetime annuity. Nevertheless, a large minority of plans permit lump sum payments at retirement.

There are several formulas for figuring out final retirement benefits under a defined benefit plan:

Flat-benefit formula
Career-average formula (2 types)
Final-pay formula

A flat-benefit formula pays a flat-dollar amount for every year of service recognized under the plan.

One type of career-average formula is where employee earns a percentage of the pay recognized under the plan for each year they are participants under the plan. The second type of career-average formula averages the employee’s yearly earnings over the period of plan participation. At retirement, the benefit will equal a percentage of the career-average pay multiplied by the employee’s number of years of service with the business.

The final type of formula is called a final-pay formula. Under this formula the employee’s earnings for a number of years near the end of their career with the business are averaged. The number of years used are usually the last five years when earnings would be at their highest. The benefit equals a percentage of the employee’s final average earnings multiplied by the number of years of service. This formula provides the best protection for the employee against inflation, but it is also a higher cost to the employer.

According to www.pbcg.gov, defined benefit pension plans offer both workers and employers a number of distinct advantages.

Worker Advantages:

Workers can know in advance what their retirement benefit will be.
Employers, not workers, are responsible for providing retirement benefits, and the benefits are not dependent upon the amount of salary workers are willing or able to contribute nor are they subject to the fluctuations of the stock or bond markets.
A worker can earn a reasonable retirement benefit under a defined benefit plan, even if the worker has not been covered by a retirement plan earlier in a career.
A retired worker receives a pension annuity, such as a monthly benefit, for life as does the worker’s surviving spouse, unless both the worker and spouse elect otherwise.
Defined benefit plans can provide additional valuable benefits to workers, such as early retirement benefits, extra spousal benefits, disability benefits, benefits for past service, increased benefits, or cost-of-living adjustments.
PBGC [Pension Benefit Guaranty Corporation] guarantees to pay most and often all of the workers earned benefit if the employer cannot afford to pay the benefits or goes out of business.

Employer Advantages:

By providing a predictable, guaranteed benefit at retirement that is valued by workers, a defined benefit plan can promote worker loyalty and help retain valuable workers.
An employer can provide a significant retirement benefit for workers, even older workers for whom no contributions have previously been made, or who did not or could not save for retirement earlier.
Defined benefit plans are flexible and can provide additional valuable benefits to workers.
An employer can design a defined benefit plan to accomplish corporate workplace goals, such as offering enhanced early retirement benefits.
Defined benefit plan assets are collectively invested, which may result in higher investment returns.
While the employer bears the investment risks for the plan, favorable interest rates and economic conditions can reduce or eliminate an employer’s contribution, or make it possible to increase worker benefits at reduced or nominal cost.

DEFINED CONTRIBUTION PLANS

In a defined contribution plan, annual or periodic contributions are made to individual accounts set up for each employee participating in the plan. For this reason, these plans are sometimes referred to as individual account plans. Employees can only contribute a fixed maximum amount to the plan each year. The current contribution is guaranteed and specified in the plan, but the level of benefits at retirement isn’t guaranteed as it is with a defined benefit plan. The contributions to defined contribution plans aren’t based on the employee’s expected retirement benefit. The contributions to these plans may be based on a percentage of the employee’s salary and/or may be related to years of service.

Sometimes there are only employer contributions, sometimes only employee contributions, and sometimes both. The benefits at retirement are related to the money accumulated in each employee’s account. The accumulated money reflects the contributions made by the employer, the employee, or both, and the investment gains and losses of the account over the years of participation in the plan. The accumulated amount may also reflect contributions made to other employee’s accounts when those employees have left before they were vested, if these amounts are redistributed to the accounts of the employees who remained with the company.

At retirement, defined contribution plan benefits are typically paid in installments or as a lump sum; however, they may also be paid as an annuity.

There are several types of defined contribution plans:

Savings, or thrift, plan
Profit-sharing plan
Money purchase plan
Employee stock ownership plan
401(k) arrangement

A savings, or thrift, plan is a plan where the employee makes contributions to an account set up in their own name. The contribution is usually a percentage of their pay on an after-tax basis. These contributions may be matched in full or in part by the employer but there is no obligation based on statute for the employer to do this.

In a profit-sharing plan contributions are sometimes based on annual profits for the previous year, but profits aren’t required for contributions. Under this type of plan, a company isn’t under an obligation to make contributions on a regular basis. Contributions are usually divided among the employees in proportion to their respective earnings.

Under a money purchase plan, employer contributions are mandatory and they are usually a percentage of the employee’s salary. Retirement benefits are the amount that is in the individual account at retirement.

An employee stock ownership plan provides shares of stock in the sponsoring company to the employee. These plans are required to invest primarily in the employer’s stock.

A 401(k) arrangement is where a portion of the employee’s compensation is put directly into one of these other plans. The contribution is then treated as a pretax reduction in salary.

According to www.turbotax.com, defined contribution plans can be any or all of the following:

Profit-sharing Plan

· A plan for sharing the profits of the business with employees; contribution percentages may vary from year to year.

· Business owners can contribute up to 20% to the profit-sharing plan on their own behalf (for their account) and up to 25% to an employee’s plan.

Maximum contribution for 2002 = $40,000.
This is a "Defined Contribution Plan".

Money-purchase Plan

· Contributions are a fixed amount (i.e., you use the same percentage of the participant’s earnings each year) and are not based on the employer’s profits. Business owners must contribute that percentage each year, unless their business shows no income.

· Business owners can contribute to their own account, putting up to 20% of their net earnings (up to a maximum of $200,000 of earnings, including earnings that would be considered self-employment earnings if not covered by a religious exemption).

· Business owners can contribute up to 100% of an employee’s income to the employee’s plan account.

· Maximum contribution for 2002 = $40,000.

· This is a "Defined Contribution Plan".

Paired Plan

· This is a combination of the profit-sharing and money-purchase plans.

· Maximum contribution for 2002 = $40,000.

Defined-benefit Plan

· A defined-benefit plan is any plan that is not a defined-contribution plan; the level of benefits to be provided to each participant is spelled out in the plan.

· Maximum benefit for 2002 = $160,000.

· There is no maximum contribution.

The Motley Fool website, at www.fool.com, describes defined contribution plans this way:

Profit-Sharing Plan

The most popular type of qualified defined contribution plan, in 2002 and thereafter annual contribution limits are 25% of pay or $40,000, respectively.
The dollar limit will be adjusted for inflation in $1,000 increments beginning in 2003.
Originally designed to encourage productivity and to reward employees with part of a firm's annual profits, today employers may make contributions even when the business earns no profits in the year; however, no contribution by the employer is required during a profitable year.
These plans are often coupled with a 401(k) arrangement to allow voluntary pre-tax contributions by employees from their wages.
Contributions and earnings accumulate tax free until withdrawn by the participant.

Money Purchase Plan

Also a qualified defined contribution plan, a money purchase plan is one in which the employer is required to make an annual contribution to each employee's account regardless of the firm's profitability for the year.
Contributions are usually specified as a percentage of annual compensation, and in 2001 are capped at the lesser of $35,000 or 25% of an individual's annual salary.
In 2002 and thereafter, these limits increase to 25% of pay or $40,000.
The dollar limit will be adjusted for inflation in $1,000 increments beginning in 2003.
Contributions and earnings accumulate tax-free until withdrawn by the participant.

Cash Balance Plan

While technically a defined benefit plan, a cash balance plan is actually a hybrid plan.
In such plans, the employer credits the participant's account with a "pay credit" (such as 5% of compensation from his or her employer) and an "interest credit" (either a fixed rate or a variable rate that is linked to an index such as the one-year Treasury bill rate).
Increases and decreases in the value of the plan's investments do not directly affect the benefit amounts promised to participants.
Thus, the investment risks and rewards on plan assets are borne solely by the employer.
When a participant becomes entitled to receive benefits under a cash balance plan, the benefits that are received are defined in terms of an account balance. For example, assume that a participant has an account balance of $100,000 when he or she reaches age 65. If the participant decides to retire at that time, he or she would have the right to an annuity. Such an annuity might be approximately $10,000 per year for life. In many cash balance plans, however, the participant could instead choose (with consent from his or her spouse) to take a lump sum benefit equal to the $100,000 account balance.
In addition to generally permitting participants to take their benefits as lump sum benefits at retirement, cash balance plans often permit vested participants to choose (with consent from their spouses) to receive their accrued benefits in lump sums if they terminate employment prior to retirement age.

Target Benefit Plan

While technically a defined contribution plan, a target benefit plan is actually a hybrid plan.
In such plans, the employer sets a target benefit for employees.
Each year contributions are made to the employee's account based on actuarial assumptions that project the annual funding needed to reach that benefit.
In that sense, the target benefit plan mimics a defined benefit plan.
However, the actual earnings on the individual accounts may differ from the estimated earnings used in the assumptions.
Thus, because the benefit actually received cannot be determined in advance, the target benefit plan is like a defined contribution plan.
Regardless, contributions and earnings accumulate tax free until withdrawn by the participant.

Employee Stock Ownership Plan (ESOP)

An ESOP is a qualified defined contribution plan in which the assets are invested mostly in qualifying employer stock.
Usually, purchases of this stock are funded by employer contributions made to the plan based on total employee compensation.
The plan may permit purchase of stock by employees as a plan option.
When combined with a 401(k) plan, an ESOP is sometimes called a KSOP.
On leaving the firm through separation or retirement, the participant will receive all vested interests in the form of the actual shares in the account.
Alternatively, he or she may demand a cash distribution in lieu of the shares.

401(k) Plan

Also known as a cash or deferred arrangement (CODA) plan, a 401(k) is a qualified defined contribution plan that takes its name from the section of the Internal Revenue Code that prescribes the rules under which it operates.
It is a retirement plan in which an employer permits an employee to defer receipt of part of his or her compensation by contributing that part to his or her account in the 401(k) plan.
Deferred contributions are made on a pre-tax basis, and those contributions and all earnings remain untaxed until withdrawn from the plan.
The 401(k) may permit voluntary, after-tax contributions by employees.
Earnings on after-tax contributions accumulate tax free until withdrawn.
Many 401(k) plans include a matching contribution from the employer according to a set formula (e.g., 50% of the employee's contribution up to a maximum of 6% of compensation).
Employers may also make contributions to an employee's account independent of the employee's contribution, and these contributions may be tied to a firm's profits as part of a profit sharing plan.
In 2001, a participant's pre-tax contributions are limited to the lesser of 25% of pay or $10,500. Many plans impose a lower percentage limit on contributions. That percentage limitation varies from employer to employer depending on a number of factors, but generally ranges from 12% to 20% of annual compensation.
In 2002, a plan participant may contribute up to the lesser of 100% of pay or the annual dollar limit shown for each of the following years:

2002: $11,000
2003: $12,000
2004: $13,000
2005: $14,000
2006: $15,000

In 2007 and thereafter, the $15,000 limit will increase in $500 increments whenever the cumulative effects of inflation indicate such a rise is needed.
In addition to the normal contribution limits outlined above, starting in 2002 those over the age of 50 may make an additional "catch-up" contribution in the following amounts:

2002: $1,000
2003: $2,000
2004: $3,000
2005: $4,000
2006: $5,000

In 2007 and thereafter, the $5,000 "catch-up" limit will increase in $500 increments whenever the cumulative effects of inflation indicate such a rise is needed.
Beginning in 2006, 401(k) plans may allow participants to make contributions through those plans to a Roth-401(k) account. The decision to offer this option is entirely up to the employer. Under this new arrangement, contributions to the Roth-401(k) account will be taxed in the year made, but future qualified distributions from that account will not be taxed. Contributions to a Roth-401(k) account may be made up to the $15,000 maximum yearly limit.
A 401(k) plan generally offers participants an opportunity to direct their account contributions to a broad range of investment options from conservative risk to aggressive risk. These options may include institutional or mutual funds investing in the money market, bond market, or stock market; annuities; guaranteed investment contracts (GICs); company stock; and self-directed brokerage accounts. A typical plan will offer a selection of a money market fund, a bond fund, and a stock fund.
In general, a 401(k) plan limits withdrawals of assets to five occasions: Termination from employment, disability, reaching the age of 59 1/2, retirement, and death. Additionally, the plan may optionally include provisions for loans and/or hardship withdrawals.
State and local governments are prohibited from offering 401(k) plans to their employees. This was once true of private, tax-exempt employers as well; however, as of January 1, 1997, the latter may now establish a 401(k) plan for their qualified employees.

DEFINED BENEFIT PLANS vs. DEFINED CONTRIBUTION PLANS

According to www.turbotax.com, the differences between defined benefit plans and defined contribution plans are as follows:

· A defined contribution plan defines how much you, and perhaps your employer, will contribute as you go, without specifying exactly how much you will receive in benefits, at retirement.

· A defined benefit plan spells out how much money you will get at retirement, and figures out how much you need to contribute, to reach that goal.

The recent trend has been the decline of employees covered by defined benefit plans and the increase of employees covered by defined contribution plans. This declining trend isn’t so much due to the ending of defined benefit plans as it is because of the decline of certain industries, unionized and manufacturing, which mostly used these plans. However, some smaller firms have also discontinued using defined benefit plans.

According to www.pbcg.gov, since the mid-1980's there has been a shift away from defined benefit plans toward defined contribution plans, especially 401(k) plans. In 1980, defined benefit plans were the primary pension plan for over 80 percent of workers with private pensions. By 1998, this share had fallen to less than 45 percent. By 1998, 401(k) plans had become the primary plan for 35 percent of workers with private pensions.

Some additional statistics from www.pbcg.gov are:

· While the number of participants in private-sector defined benefit plans has remained stable at about 40 million from 1985 to 1994, the number of active participants in these plans declined from 29 million in 1985 to less than 25 million in 1994.

· The number of single-employer defined benefit plans insured by PBGC fell by about 60% from 1985 to 1995 (112,000 to 43,000). Most of this decline was in plans with fewer than 100 participants.

· Between 1979 and 1996, the percentage of pension-covered workers whose primary pension was a defined benefit plan (i.e., had a defined benefit plan or a defined benefit plan and a defined contribution plan) dropped from 83% to 50%. Much of this decline was a result of the introduction and growth of 401(k) plans. In 1996, one in four pension-covered workers had only a 401(k) plan. The change was greatest in smaller employers. (The largest firms continued to maintain defined benefit plans.)

The biggest increase in defined contribution plans is the increase in employees using 401(k) plans. This growth didn’t directly replace defined benefit plans because employers with defined benefit plans usually offered 401(k) plans as an addition to current defined benefit plans. It seems that a lot of 401(k) plans are often used together with defined benefit plans. Some employees often use 401(k) plans for additional savings and not instead of or in place of defined benefit plans.

For some businesses, 401(k) plans may well have replaced defined benefit plans. Many employers switch from defined benefit plans to defined contribution plans to save on the per-employee administrative costs of a defined benefit plan. Employees or participants in a typical 401(k) plan bear the investment management fees. On the other hand, with a defined benefit plan, the employer bears the investment management fees.

Other reasons given for defined benefit plans being unattractive are: high administrative cost and complexity, volatile funding, a perception of government cutting back on defined benefit plans to raise revenue with little concern about retirement policy, etc. Also, employers want flexibility to design plans that fit their workforce.

Regulatory complexity, administrative costs and unpredictable and volatile contributions are some of the reasons against defined benefit plans for small companies. Administrative cost and government regulation are some of the reasons why these types of small plans are canceled for businesses. Larger plans tend to be canceled for business consideration reasons, such as, that they didn’t meet the needs of employees or employers and asset reversion.

One of the problems with defined contribution plans as opposed to defined benefit plans is that employers have been contributing less to the defined contribution plans than they had to the defined benefit plans. So despite the savings to employers in administrative costs, they are not passing those savings along to their employees in their pension plans. The overall amount of assets in defined contribution plans is also lower than it is in defined benefit plans.

According to http://www.afscme.org/wrkplace/pensfact.htm, defined benefit pension plans are better than defined contribution pension plans:

Much has been made of the growth of defined contribution (401K type) pension plans for American workers. Despite claims to the contrary, defined benefit pension plans still provide the best benefit to retired workers and to workers planning their retirement. Defined benefit plans are not only better for employees, but are also better for employers, and are simply better public policy.

Defined Benefit Pension Plans are Better for Employees

· Defined benefit pension plans provide guaranteed income security to workers for their retirement; no matter what happens in the stock market, how long an employee lives after retirement, or whether he or she becomes disabled.

· Employees are not subject to investment risk. Pension funds invest assets with an optimum mix of growth potential and risk. Studies show that individuals responsible for their own retirement income typically invest too conservatively, and thus do not adequately protect their retirement benefits from inflation.

· Retirement benefits are not dependent on employees’ ability to save. Lower-income workers and workers facing declining incomes lose twice under defined contribution plans, where employer contributions are often tied to employee savings. While defined benefit plans often have mandatory employee contributions, their contributions provide workers a secure retirement.

· Defined benefit plans provide cost of living adjustments and pension formulas that are tied to the highest-paid years, which protect employees from inflation while they save throughout their working lives.

· Death and disability insurance, which are typically provided under defined benefit plans, provide income security for participants. Defined contribution plans provide no insurance benefit in case of an employee’s death or disability; employees must purchase this coverage at additional cost.

· Defined benefit plans provisions can allow for portability with shorter vesting periods, reciprocity agreements, and buybacks for prior or related service. Defined benefit plans may also allow employee borrowing.

Defined Benefit Pension Plans are Better for Employers

· Defined benefit plans allow employers to set and to guarantee income-replacement goals for their workforce. Employees with inadequate retirement income may work longer at higher wage rates than their younger replacements, negotiate higher employer contributions to their 401K type pension plans, or even sue employers for not providing enough investment and retirement-planning education.

· Employers benefit from the favorable investment performance of pooled pension fund assets. The wide range of investment options open to large funds makes it possible for employers to provide adequate benefits to employees while limiting contributions. Studies of some pension funds show that investment earnings have exceeded both actuarial assumptions and the interest credited to employee accounts over the last two decades.

· Defined contribution plans are not a "magic pill" to solve employers’ budget constraints. Defined contribution plans are not more efficient at providing benefits equal to defined benefit plans. Comparable benefits often require comparable employer contributions. Plus, features such as employee loans, investment options, education and information obligations, and periodic statements can make defined contribution plans expensive to administer.

· Employers face high costs to switch to defined contribution plans. For example, Michigan offered early retirement to employees — at a cost of $270 million — to win support for a switch to a defined contribution plan. The high cost of defined benefit plans today is often the result of large, unfunded liabilities accumulated for years, that still have to be paid even if the employer switches to a defined contribution plan. This is why states like West Virginia, which moved certain employees to a defined contribution plan, now favor switching back.

· Defined benefit plans offer an incentive for government employees to stay in public service. Many valuable employees, who would earn a higher salary in the private sector, stay in public service because of the guarantee of income security when they retire.

· Defined benefit plans are not hard to budget. Actuarial projections are made each year and announced months in advance, allowing employers adequate time to budget the expense. Pension liability in mature, ongoing plans typically changes little from year to year.

Defined Benefit Pension Plans are Better Public Policy

· Defined contribution plans shift the cost of administration onto employees. Employees pay significant management fees to mutual funds and other plan services directly out of their retirement savings, whereas pension funds use their own managers.

· Defined contribution plans can create other social costs. Individuals who fare poorly investing their defined contribution plan account, or who outlive their retirement benefit, may use more social services and need financial assistance such as Medicaid and welfare benefits in their retirement years, offsetting any perceived "savings" to taxpayers.

· Defined benefit plans promote retirement savings among lower-income workers, by mandating a single, low level of employee contribution to participate.

· Many defined contribution advocates resent pension fund power and influence on corporate governance issues. Corporations and executives who don’t like pension fund activism hope to use defined contribution plans to erode investor power, by breaking up large pension plans into small pools of individuals’ savings.