A defined contribution plan is a viable alternative to the traditional defined benefit retirement plan.

• Author: Todd, Fred D.

Historically, public-sector employers have embraced the traditional defined benefit retirement (DB) plan as the mechanism to compensate their employees in retirement for many years of loyal service. With the introduction of Section 401(k) retirement plans in the U.S. Tax Code during the late 1970s, the public sector has become increasingly aware of defined contribution (DC) plans and their advantages over DB plans.

The two plan designs differ in that a DB plan defines the employee's pension benefit in terms of an annual or monthly benefit payable for life. The pension benefit is usually calculated by a formula which multiplies final average compensation by a certain percentage for each year of service. For example, a 25-year employee who earns $40,000 per year and receives a credit of 2 percent for each year of service would receive a straight, lifetime benefit of $20,000 per year ($40,000 x 25 years x 2 percent). Conversely, in a DC plan, the employer and employee "contribute" to the plan a certain specified percentage of employee compensation each year. These contributions are held in an employee's account and invested by the employee. At retirement, the pension benefit payable to the employee is dependent upon the employee's account, investment earnings, and timing of the retirement or withdrawal. The benefit may be more or less than the DB plan.

In a DC plan, pension benefits are based on the assets available in an employee's individual account at retirement. The employer and employee's annual contribution are usually stated as a percentage of the employee's compensation. Each employee has a separate account and generally directs the investments. Investment performance and risk is borne by the employee. Upon retirement, the employee receives the dollar amount in his/her account in a lump sum, monthly payments, or through the employee's choice of whatever payment plans may be offered by the plan. There is no guarantee of a specified monthly payment. A major advantage of a DC plan is that when an employee separates from service, the account value is portable. This generally is not the case with a DB plan.

Many critics of DB plans have labeled them "20th-century dinosaurs." From an employee and employer perspective, DB plans are not responsive to the current employee retirement needs, given the demographics of an ever-changing workforce. Research has shown that most employees have between six and eight jobs during their 35- to 45-year working careers. Given that people now are living longer and social security has increased the age for full benefits to 67 or later, the traditional retirement age of...