Current Pension Topics

More 'Contributions' Pluses

By JOEL L. FRANK

(Second of two parts)

Last week's column dealt with why a Defined Contribution retirement plan - under which benefits are determined by set contributions from both employers and employees - is often more advantageous to the employee than a Defined Benefit plan, under which an employee who remains with a single employer receives a retirement income based on a percentage of their final earnings pegged against years of service.

This week's installment focuses on the differences between the two types of plans when it comes to death benefits and moving from one employer to another over the course of a person's career.

The tables below are based on the following assumptions:

A salary of $8,000 a year at age 30, increasing by 4 percent a year to an average of $28,107 between ages 60 and 65;

A pension under the Defined Benefit plan for an employee who works from 30 to 65 of $14,756;

Employee contributions of 5 percent under both plans and investment returns of 5 percent under both.

Death Benefit Prior to Retirement

It is interesting to compare the amount that accumulates on behalf of each participant during the working years. Under Defined Contribution plans, the accumulated funds are payable to the participant's beneficiary if the participant dies prior to retirement. Under the Defined Benefit system, any employer funding on behalf of an employee is forfeited upon death prior to retirement. The funds revert to the pension plan and help pay the employer's pension costs for other participants. But Table II shows the combined amounts of accumulated employer and employee contributions at five-year intervals, and assumes that under both plans the full amount would be payable to the beneficiary or estate of a participant who remains at one employer until the ages shown and then dies.

Table II
Accumulated Death Benefit Prior to Retirement
(Assuming participant remains at one employer until death at age shown)
Age Attained             Defined Contribution           Defined Benefit
at Time of Death                   Plan                               Plan
30                                          $     953                              $      223
35                                              7,166                                   1,951
40                                            16,476                                   5,621
45                                            30,066                                 12,846
50                                            49,521                                 26,495
55                                            76,964                                 51,545
60                                           115,225                                96,572
64                                           156,115                              156,523

Retirement Income and Career Mobility

The effect of career mobility on the end product of each plan also bears examining. A person who moves among several employers having identical Defined Contribution plans will reach retirement with the same level of retirement income that would have been produced staying at one employer for an entire career. On the other hand, a person who moves among several employers having identical Defined Benefit plans will reach retirement with substantially less retirement income than by staying at one of these employers for an entire career. Consider Jack and Jill.

Jack is covered from age 30 to age 65 by the 12 percent Defined Contribution plan illustrated. He will receive $14,718 a year at age 65, or about 52.4 percent of his final-five-year average salary whether he remains at one employer throughout his career or moves among several employers having identical plans.

Jill is covered by the Defined Benefit plan illustrated, and if she stays at one employer from age 30 to age 65 she will receive a retirement income of $14,756 a year, or 52.5 percent of final-five-year average salary. But if, for example, she changes employers at age 40 and again at age 50, remaining at the third employer until age 65, her retirement income will be $10,246, even though all three institutions have identical Defined Benefit plans and provide full and immediate vesting. This occurs because when she leaves an employer, the defined benefits earned at that employer are related to the participant's five-year average salary just before leaving, not to the five-year average salary just before retirement.

The "cold storage vesting" of Defined Benefit plans provides no way for vested benefits to increase between termination of employment and retirement. The calculation is shown below:

                                                                    Table III
            Average Salary
            Last 5 Years                             Years
            at Each                                         of                                            Yearly Income
            Employer                     x           Service             x           1.5%   =   at age 65
----------------------------------------------------------------------------------------
Employer 1   $10,543                x           10                     x           .015     =           $1,581
Employer 2   15,606                  x           10                     x           .015     =             2,341
Employer 3   28,107                  x           15                     x           .015     =            6,324 
                                                                                                                            $10,246

Advantages of Each Plan

The main advantage of a Defined Benefit plan is that it assures retiring employees with equal periods of service at a given employer a consistent ratio of retirement income to final average salary. And this ratio (although not the amount of retirement income) is predictable if it can be assumed that the employee will stay with a given employer until retirement.

A major advantage of the Defined Contribution plan is that it adds a consistent and visible percentage of salary to each employee's total compensation at the time the compensation is earned. If one person's salary is more than another's, the deferred compensation is greater by the same percentage, not warped out of proportion by age or length of service. This pattern of funding, unlike a pattern that defers most of the employer's commitment to the final years of long service, helps keep the pension plan a neutral factor when the person is deciding about joining or leaving an employer (also when the employer is making the decision). Shouldn't the individual have a full measure of benefits whether staying at one employer or moving among several?

The Defined Contribution plan also has budgeting advantages for the employer. Pension costs are a constant percentage of salary each year. And the employer's pension obligation for each person is fully and permanently funded at the time the obligation is incurred, not left as an open liability tied to whatever salary levels the future brings.

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.