In defense of the defined benefit plan.

• Author: Findlay, Gary W.

The mainstay of public employee retirement income packages has, for decades, been the defined benefit (DB) plan. The DB name is derived from the fact that benefits are defined by the plan, usually expressed as a percentage of salary for some designated period just before retirement, multiplied by years of service credit.

Periodically, interest in an alternative plan design emerges. The alternative is referred to as a defined contribution (DC) plan, which derives its name from the fact that contributions are defined by the plan, usually expressed as a periodic dollar amount or percentage of compensation. At termination (which may be at or before retirement), the balance in a former employee's DC account is available for use as the individual wishes (i.e., transfer to another plan or IRA, purchase of an immediate or deferred annuity, or a lump sum settlement for immediate or deferred consumption).

Employee interest in the DC alternative is usually greatest during a protracted bull market. Employees are generally aware that the double-digit rates of return on investments over a period of years could have produced huge sums in individual DC accounts. On the other hand, employer interest in the DC alternative is usually greatest when there is a belief that pension plan contributions will be reduced through the adoption of such a plan. While these tend to be the primary motivations for considering an alternative to a DB plan, there are a number of other factors worthy of consideration. The purpose of this article is to identify features of these plans which may be overlooked when comparisons are being made.

Basic Financing Equation

An understanding of the financial mechanism behind the operation of both types of plans can be very useful to those wishing to become conversant with the fundamental financial differences between the two types of plans. Reduced to its simplest form, it may be described by the formula:

C + I = B + E

Where:

C = Contributions (employer, employee, or both)

I = Income from investments

B = Benefits paid

E = Expenses for plan administration

Defined Benefit Plans (Financial Activity). In a DB plan, benefits (B) can be thought of as a moving target. As salary increases and service is extended, "B" becomes larger. Based on complex actuarial calculations, a contribution amount (C) is determined which will allow for the accumulation of the assets needed to pay for "B." "C" will be a variable, based on plan experience. Consider what happens if "B" is predicted accurately but income (I) is less than expected. The only alternative for bringing the formula back into balance is to increase "C." If "I" is greater than expected, "C" will be reduced. In most cases, the variable "C" is the responsibility of the employer. The employer takes the risk if "I" is less than expected, and thus must increase contributions; conversely, the employer is rewarded with lower contributions if "I" is greater than expected. (This is consistent with the fundamental rule of investing, which...