Which is Better for the Participants -
A Defined Benefit or A Defined Contribution Plan
By Michael Sze

• Cost control, in the sense that an employer's obligation to a DC plan can be predicted up front, based on the contribution formula used, 
• Easier administration for DC plans, and 
• Difficulty in communicating the benefits provided by a DB plan.

While all these are legitimate reasons, they are all reasons from an employer's perspective. Traditionally, the employer makes all decisions concerning retirement benefit arrangements. The ultimate choice of benefits often reflects the interest of the employer, even though the Employee Retirement Income Security Act (ERISA) of the United States, and the Pension Benefits Acts (PBA) and Pension Benefits Standards Act (PBSA) in Canada stress that retirement plans are solely for the benefit of the employees.

In this paper, we intend to approach the subject strictly from the perspective of the employee. We will analyze the strengths and weaknesses of these plans in providing retirement financial security for the employees. We shall focus on the risk involved in the arrangements. After all, both the DB and DC plans are intended to provide income security to the retirees. How well they succeed must be judged in the context of the risk to the income security they are meant to protect. We will also compare the values of benefits they provide to employees of various ages. We will conclude with a survey to examine how employees appreciate these plans.

Defined Benefit Plans 

These retirement plans are sponsored by the employers. For each year of service, the employer promises to provide a definite benefit to the employee, which commences upon the employee's retirement, and continues as long as he/she lives. The plan usually also provides some ancillary benefits such as early retirement subsidies, death, disability, and termination benefits. It may also provide cost of living increases for benefits after retirement. There are different types of DBs. However, the benefits are all designed to reflect the economic environment at the retirement age. The amount of retirement benefits is intended to replace a certain percentage of earnings immediately before retirement. The three major types of DB plans are: 

• Flat Dollar Plans. These plans provide a fixed amount of retirement benefits for each year of service. The benefit rate reflects the current economic situation only. Thus, nominally, the benefit is not tied to the situation at retirement. However, through union negotiations or otherwise, the benefit rates are continually updated to the new economic situations. Consequently, the final retirement benefits are related to the situation at retirement. 
• Career Average Pay Plans. These plans provide retirement benefits each year based on the pay for that year. Again, nominally these plans do not fully reflect the economic situation at retirement. However, these plans usually get career average updates at regular intervals. At each update, benefits for all past service are increased to reflect pay close to the date of the update. However, if the career average pay plan is never updated, the retirement benefits provided by the plan will be inadequate. 
• Final Average Pay Plan. The majority of non-union plans are final average pay plans. Each year the participant earns retirement benefits which reflect pay close to the retirement date. The retirement benefits provided by such plans are explicitly tied to the economic conditions at the retirement age, unlike the implicit schemes of the other types of DB plans.

In the following discussion, we shall use the final average pay plan as the representative of DB plans. The same arguments apply to other types of DB plans. With the final average pay plan, the benefit promise is based on pay at retirement. However, if the employee terminates before retirement for whatever reason, be it for employment termination, disability, or death, the benefit that is actually provided will reflect pay at the point of termination. Indeed, if an employee stays with one employer for the entire duration of his/her career, the retirement benefit can be quite satisfactory. However, if there are job changes, the actual benefits provided are substantially reduced. We shall illustrate the effect by the following example.

Consider an employee who starts working at age 25 with an initial pay of $40,000. The DB pension plan provides a benefit of 1.5% of final pay for each year of service. Normal retirement age is 65. Early retirement reduction is on an actuarially equivalent basis. Termination benefits reflect pay and service earned to the date of termination. Assume that the investment return each year is 7.0% and the pay increase is 5.5% each year.

Figure 1 compares the accumulation of retirement benefits through the years under two scenarios: (1) by a full career employee, who stays with the same employer throughout his/her entire career, and (2) by an employee who changes jobs every 5 years. At 5.5% increase each year, the pay increases from $40,000 at age 25 to $323,000 before retirement. For the full career employee, the retirement benefit accumulates to $194,000 at retirement, replacing 60% of pay before retirement. For the employee who changes jobs at regular intervals, the retirement benefit is less than $91,000, which is not even 30% of the pay before retirement.

Figure 2 compares the values of the benefits earned under both scenarios. The value of the benefits provided to the full career employee is about $2,000,000. The value provided to the employee who changes jobs is only about $93,000. Note also that the value of the benefits for the full career employee increases much more rapidly, especially at the higher ages. This exponential escalation rate makes it impossible for the other employee to catch up in the value of benefits.

In order to understand better the reason for the small value of retirement benefits for the employee who changes jobs frequently, we project to retirement the commuted value of benefits that he/she receives from the employer on each employment termination. Figure 3 shows these projected values. The projected commuted values of benefits at younger ages are much smaller than the projected values of benefits at older ages. The reason is that pay increases play an important part in the accrual of DBs. The commuted values of benefits at younger ages increase each year with investment returns only. However, the values of benefits at older ages reflect both the impact of investment returns as well as pay increases, and are thus substantially higher. The difference is especially great for higher ages.

In summary: the risks for DB participants are unfulfilled expectations caused by employee termination, plan termination, or insufficient plan assets. Unfortunately, many of these events are not under the control of the employees. Thus employees often feel unfairly treated when the above-mentioned events occur.

On the other hand, a financially sound DB plan can indeed provide much retirement income security. A definite amount of retirement benefits is provided by the plan. The payout of these benefits are further guaranteed by the assets which are set aside from the general revenue of the company in a pension trust. Many such plans also provide inflation indexation and generous ancillary benefits.
 

Defined Contribution Plan 

A DC plan provides a definite amount of contribution into each individual participant's account each year. This account accumulates with contribution and investment returns each year. Upon retirement, the accumulated fund is used to provide lifetime retirement income to the participant. In Canada, the typical types of DC plans include money purchase pension plans (MPPP), deferred profit sharing plans (DPSP), registered retirement savings plans (RRSP), locked-in retirement account (LIRA), registered retirement income funds (RRIF), lifetime income funds (LIF), and locked-in retirement income funds (LRIF). Many employers like these arrangements because their obligation is only to contribute into the individual account each year. Thus the cost is easier to control. Many employees like these arrangements because there is money deposited into their accounts each year, and they are often given the right to choose their own investments. Thus they feel more in control. However, we must remember that these are not ordinary savings accounts. These plans are for the purpose of providing retirement incomes. Therefore, they must be analyzed in the context of the amount of lifetime retirement income they can provide, and how much risk is involved in such arrangements. We shall analyze the strengths and weaknesses of DC plans using the same participant as in the DB discussion. Figure 4 shows that the annual contribution rate required to produce a retirement income which replaces 60% of income before retirement is more than 11%, assuming an annual investment return of 7%. Furthermore, the required contribution is highly dependent on the investment return that can be achieved. If the average return over the years is 10%, the required contribution will be less than 6%. However, if the average investment return is only 4%, then the required contribution will be almost 20%. With the volatility in investment returns, there is much uncertainty in the amount of retirement income which can be provided by such a plan.

Comparison of DB and DC plans 

Let us now compare the values of benefits provided by the DB and the DC plans for the same sample employee. A DB plan which provides 1.5% final pay for each year of service is compared to two DC plans which provide annual contribution rates of 9% and 6% respectively. Figure 5 shows how the values of the benefits accumulate over the years. Even though the ultimate value of the DB benefits is substantially greater than that of the DC accounts, the cross over points are at very high ages. The DB value overtakes the 9% DC value at age 60 and the 6% DC value at age 54.

The above example points out the fact that the DC plan is more valuable to the younger employees, whereas the DB plan is far more valuable to the older employees. Consequently, the DB plan is better than the DC plan for a full career employee. However, the benefits provided by a DB plan will be far less than that by a DC plan for an employee who changes jobs frequently. The best arrangement is to have a DC plan while the employee is young, and gradually switch to a DC plan when he/she gets older.

Questionnaire on employee preference 

Many pension plan experts believe that DB arrangements are far superior to the DC arrangement. They think that employees generally favour DC arrangements because of inadequate knowledge of both plans. To test the validity of these opinions, we conducted an indirect survey of the employees. The survey was indirect in the sense that the questionnaires were given to pension plan professionals who have had substantial experience dealing with the employees. They were asked to assess the typical opinions of the younger and older employees respectively on each of the following major objectives of a retirement savings vehicle:

1. Predictability of the benefits prior to the actual retirement 
2. Stability of the benefit stream from year to year after retirement 
3. Inflation protection for the retirement benefits against cost of living increases 
4. Post-retirement spouse protection upon the death of the retiree 
5. Pre-retirement benefit protection for the employee in the event of job termination, disability and death 
6. Employee's control over the value of the benefits during his/her working years 
7. Ease to understand the accumulated benefits

The pension professionals were asked to assess how employees would rank the relative importance of the objectives, as well as to predict how the employees would rate from 5 to 1 (5 being the highest) how well the DB and DC plans fulfill each objective. The following summarizes the survey results of ninety professionals covering over 10,000 employees.

Relative Importance of Major Objectives for Retirement Savings

It is interesting to note that the objectives deemed to be most important for younger employees are better attained by a DC plan and the objectives deemed most important for older employees are better met by a DB plan.

Rating (5 to 1) of DB and DC Plans in Fulfilling the Major Objectives

The above tables show that both the younger employees and the older employees choose what they consider best to their advantage. The younger employees generally favour DC plans, because these plans rate very highly on the two issues considered to be most important for the younger employees: control and understanding. The older employees choose DB for their extremely high scores on stability and predictability, considered to be of paramount importance to the older employees.

The survey clearly indicates that the employees are more informed than what some pension experts believe them to be. The employees may not fully understand the technical details of the DB and DC plans, but they know essentially what they need and what types of arrangements would be best to provide for these needs. The challenge is for the pension experts and plan sponsors to establish plans that will cater to their needs.

To better understand the indirect survey, and participate in a follow-up survey of greater scope, the readers are encouraged to visit the author's website at www.szeassociates.com

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