Current Pension Topics: Case for Defined Contributions

Current Pension Topics

Case for Defined Contributions

By JOEL L. FRANK

(First of two parts)

The unions have been preaching for decades that the Defined Benefit plan is superior to the Defined Contribution plan as a basic retirement scheme, while the Defined Contribution approach (401(a), 401(k), 403(b), 457(b)) should be reserved for supplemental retirement savings only.

The unions pontificate that when it comes to basic retirement security, the employer should bear all investment risk, and that a guaranteed fixed-dollar lifetime pension is far superior to the Defined Contribution approach with the uncertainties of the investment markets.

So why did the unions representing State and City University personnel lobby Albany 40 years ago to give this very small segment of the public employee population a choice of basic retirement plans? Because, they argued, higher education personnel are more mobile than other career civil servants and, as will be shown in this memorandum, the Defined Benefit system is hurtful to such employees.

The unions felt that the prevalence of career mobility in the higher education community required a choice of plans notwithstanding the fact that the employee would be assuming all investment risk and forego a lifetime pension. Are the unions saying that the Defined Contribution approach is so damaging to the longterm financial security of the employee that it should be used as a basic plan just for the higher education crowd because they are more mobile than the balance of the public workforce? When it comes to choosing the type of retirement plan, one size does not fit all. The choice of plan is best left to the individual based on his or her personal circumstances and work pattern. The Defined Contribution plan may very well be "suitable" for the person who cleans the office of the Professor of Greek Mythology but "unsuitable" for the Professor. The State of Florida has come to this conclusion by offering a choice of plans to its entire public employee workforce. http://www.myfrs.com/content/index.html . New York should do the same.

Each type of plan has a different impact on a participant's total compensation, career mobility, and retirement income.

The Defined Contribution Plan

This type of plan makes its pension commitments to participants in the form of monthly contributions that are a stated percentage of current salary. The employer's contributions, along with those of the employee, are deposited each month to the individual retirement investment account of each participant, as are the investment earnings on the accumulating contributions. For the Defined Contribution plan illustrated in this memorandum, contributions are 12 percent of salary, with 7 percent paid by the employer and 5 percent by the employee. (Under the assumptions used, this rate of contribution provides a retirement income of about the same amount as the Defined Benefit plan illustrated after a career of participation.)

During the working years, all funds contributed to a Defined Contribution plan accumulate with investment earnings, and at the time of retirement may be used to provide an annuity income based on the amount of the accumulation. Age, of course, has a material effect on life expectancy and therefore on the rate of monthly pay-out. The younger the age of retirement, the smaller the monthly income per $1,000 of accumulation, because the longer the number of years over which payments will be made.

The Defined Benefit Plan

This type of plan provides that if an employee stays with one employer until retirement, he or she will receive a monthly single-life income equal to a specified percentage of the average salary paid by the employer in the years just prior to retirement, e.g., 50 percent of final-five-year average salary at age 65, after a career of service. The monthly single-life income is therefore the same for all who have identical salary and service histories. The accumulation needed to pay the income is determined by the age, salary and service of the person. The Defined Benefit plan in the illustrations that follow provides that for each year of participation, the plan will pay a retirement income at age 65 equal to 1.5 percent of the average salary paid the employee during the final five years of participation in the plan. This formula therefore promises that after 35 years with one employer, the participant will receive a retirement income equal to 52.5 percent of final-five-year average salary.

Pension Contributions as Deferred Compensation

It is revealing to compare the two plans in terms of how much they add to a participant's total compensation each year. Under the Defined Contribution plan illustrated, employer contributions of 7 percent of salary are credited to the participant's retirement account each month along with the participant's own contributions of 5 percent. Each month the employer is therefore adding 7 percent of salary as deferred compensation to each person's account.

A Defined Benefit plan is more difficult to pin down in terms of how much it adds to a person's compensation each year. Although employer costs are often expressed as a percentage of salary, e.g., "7 percent of covered payroll," this overall percentage is rarely indicative of the value of pension benefits earned by any individual in the plan. Instead, the cost of the defined benefit earned by a year's work depends on a person's age, salary, and years of participation in the plan. If the plan is contributory, participants contribute a stated percentage (5 percent in the illustration), just as in Defined Contribution plans. But the employer's share of the cost varies substantially from person to person, adding little or nothing to a younger person's compensation, and adding a great deal with advancing age and long-term participation in the plan. This is shown in Table I, which illustrates the contribution pattern required to keep each type of plan fully funded for a person who enters at age 30 and stays with one employer until age 65 (see below for assumptions used).

Assumptions

All of the tables below are based on the following assumptions:

• Salary is $8,000 a year at age 30, increasing by 4 percent a year to an average of $28,107 a year between ages 60 and 65.
• The Defined Benefit plan provides that a person who enters at age 30 and stays with one employer until age 65 will receive a retirement income of 52.5 percent of the final-five-year average salary, or $14,756 a year for life. - The level contribution rate for the Defined Contribution plan (12 percent of salary) was selected because under the stated assumptions it, too, will provide a single life annuity of approximately the same amount at age 65. Both plans provide full and immediate vesting and the full accumulation value is assumed to be payable to the participant's family if he or she dies before retirement.
• Employee contributions are 5 percent of salary for both plans. - The investment return is 5 percent for both plans. 

                                              Table I 
                     Contributions as Per Cent of Salary

Employee's	Employee	Employer	Employer
Attained	Contributions	Contribution	Contribution
Age	Either Approach	Defined Contribution Plan	Defined Benefit Plan
30	5%	7%	-2.18%
35	5	7	-0.99
40	5	7	1.02
45	5	7	3.86
50	5	7	7.83
55	5	7	13.38
60	5	7	21.06
64	5	7	29.27

Under the Defined Benefit plan illustrated, the younger employee's own 5-percent contributions are more than enough, with anticipated interest earnings, to cover the full cost of the defined benefits earned at the younger ages, and to cover most of the cost until nearly age 50. Thereafter, for a participant who remains with one employer throughout a career, the employer's share of the cost rises rapidly with advancing age and long service, because each year's pension commitment includes not only (a) the cost of the current year's 1.5-percent benefit, based on the most recent five years' average salary, but also (b) the additional cost of updating all previously earned benefits to the latest five-year average salary. This results in deferring most of the employer's pension commitment for an individual to the final years of long service, as shown. For example, in the Table I illustration about 85 percent of the employer's cost under the Defined Benefit plan is deferred until after the 25th year of participation, between the participant's age 55 and 65.

This deferral has the unfortunate effect of making a disproportionate part of a person's lifetime compensation contingent on age and fealty to one employer. Deferred funding also works to the disadvantage of those who participate at the younger ages but leave the work force during the middle years, say to raise a family. They take little or no deferred compensation with them when they leave, and their re-entry problems, if they later return to work, are exacerbated by the high pension costs at the older ages. A Defined Benefit plan also has worrisome implications for an employer's budgeting and salary administration, especially during periods of salary inflation. For example, under the Defined Benefit plan illustrated, each salary increase of $1,000 at age 60 carries with it a pension cost of approximately $5,800 between ages 60 and 65.

(To be continued next week.)

Mr. Frank is a fee-only Retirement Financial Planner. He can be reached by telephone at (732) 536-9472, by fax at (732) 536-7373, or via e-mail at rollover@optonline.net.