INTRODUCTION I. HOW ARE THEY DIFFERENT? THE DEFINED BENEFIT AND DEFINED CONTRIBUTION FORMATS CONTRASTED II. WHY DOES IT MATTER? ALLOCATING RISK AND REWARD A. Investment Risk B. Funding Risk C. Longevity Risk D. Qualifications E. Summary III. HOW DID IT HAPPEN? A. The Role of ERISA 1. The Creation of the Individual Retirement Account 2. ERISA's Regulatory Burdens on Defined Benefit Plans 3. ERISA's Fiduciary Rules and Participant-Directed Accounts 4. The Ten Percent Limit on Employer Stock 5. Demographic and Economic Changes Reinforcing ERISA's Effects B. Section 401(k) C. ERTA and TRA86: Expanded Availability of IRAs and the Financial Services Industry D. Flexible Spending Accounts and Medical Savings Accounts E. Section 529, Educational Savings Accounts, and Roth IRAs F. Cash Balance, New Comparability, and Age- Weighted Plans. G. Public Employee Pensions and [section] 457 Plans H. Health Reimbursement Arrangements I. Health Savings Accounts J. Proposals K. Conclusion: The Significance of Enron IV. WHAT DOES IT MEAN?: CONSUMPTION TAXATION, TAX EXPENDITURES, AND THE POSSIBLE FUTURES OF THE INTERNAL REVENUE CODE V. WHAT SHOULD WE DO? A. Clarifying Premises B. The Program CONCLUSION INTRODUCTION
Pension cognoscenti have frequently remarked on the stagnation of defined benefit pensions and the concomitant rise of defined contribution plans. I suggest that, over the last generation, something even more fundamental has occurred, something that can justly be called a paradigm shift. Americans today primarily conceive of and implement retirement savings in the form of individual accounts. Such accounts have become primary instruments of public policy, not just for retirement savings, but increasingly for health care and education as well.
To some, President Bush's proposals to introduce personal accounts to the Social Security system and to revise the individual account provisions of the Internal Revenue Code (1) appear to be radical departures from the status quo. In fact, those proposals continue the process of the last three decades by which the defined contribution plan has become the primary framework for retirement savings and, more broadly, a fundamental tenet of tax and social policy.
Pension mavens (myself included) have framed the choice between the defined benefit and the defined contribution formats as a matter of risk allocation in the design of retirement savings programs. (2) The defined benefit configuration principally assigns risk to the employer because the employer guarantees the employee a specified benefit, while the more privatized defined contribution approach apportions risk to the employee, because the adequacy vel non of the employee's retirement resources in her individual account is the employee's problem. This remains an important truth as far as it goes.
However, the defined contribution society as it has emerged today entails more considerations than this and constitutes a fundamental transformation of the way Americans think about and implement tax and social policy. In a defined contribution society, the policies more likely to be adopted are those that channel government subsidies through individual accounts controlled by the taxpayer herself. In contrast, defined benefit arrangements--as exemplified by the traditional pension plan and the federal Social Security system--are less likely to be proposed, adopted, or expanded. As a result of the increasing prevalence of defined-contribution-type programs, upper-middle-class taxpayers can in practice undertake all of their financial savings for retirement, education, and health outlays through tax-favored individual account devices. If Congress ever formally transformed the Internal Revenue Code into a federal consumption tax, the defined contribution paradigm would have paved the way for that transformation, by acclimating the public to tax-favored accounts for savings.
While the emergence of the defined contribution society has been a quiet, largely unheralded revolution, a revolution it has been, incrementally but fundamentally changing the manner in which Americans think about tax and social policy and in which their governments formulate such policy. Like any other paradigm shift, the emergence of the defined contribution society has both opened opportunities and foreclosed possibilities. As the members of the Baby Boom generation provide for their retirements, educate their offspring, and prepare for the medical costs of their older years, the defined contribution paradigm will be the framework governing their choices.
The initial Part of this Article describes the differences between defined benefit and defined contribution plans as retirement savings devices. In this Part, I emphasize the characteristics of the traditional defined benefit pension, which pays a deferred retirement annuity based on the participant's salary and work history, and the contemporary defined contribution plan, largely self-funded by the participant's salary reduction contributions to his or her own account. Part II discusses these differences as a matter of retirement plan design: Defined benefit arrangements principally allocate risk and reward to the sponsoring employer, while defined contribution devices assign such risk and reward to the participant. In the third Part, I sketch the major features of the contemporary defined contribution paradigm and its development to date. This sketch highlights, inter alia, the extent to which the paradigm today determines how middle-class individuals and households undertake their medical and educational savings, making the defined contribution format the norm for such savings. The fourth Part places the defined contribution paradigm in the context of the possible futures of the Internal Revenue Code and emphasizes the extent to which the paradigm has effectively converted the Code into a consumption tax for middle-class taxpayers. Finally, I label the choices presented to us by the defined contribution paradigm and identify those that I think are best.
HOW ARE THEY DIFFERENT? THE DEFINED BENEFIT AND DEFINED CONTRIBUTION FORMATS CONTRASTED
In the often opaque morass of pension terminology, the distinction between defined benefit and defined contribution plans is surprisingly clear. A defined benefit pension, as its name implies, specifies an output for the participant. Traditionally, such plans defined benefits for particular employees based on the employees' respective salary histories and their periods of employment. (3) Thus, for example, a prototypical defined benefit formula specifies that a participant is entitled at retirement to an annual income equal to a percentage of her average salary times the number of years of her employment with the sponsoring employer. (4)
In contrast, a defined contribution arrangement, as its equally apt moniker indicates, specifies an input for the participant. Commonly, the plan defines the employer's contribution for each participant as a percentage of the participant's salary for that year. Having made that contribution, the employer's obligation to fund is over because the employee is not guaranteed a particular benefit, just a specified input. In a defined contribution context, the participant's ultimate economic entitlement is the amount to which the defined contributions for her, plus earnings, grow or shrink.
Defined contribution plans classically took the form of employer-sponsored pensions (often denoted "money purchase pensions") and of employment-based profit-sharing arrangements. In the pension incarnation, the employer sponsoring a defined contribution arrangement has a fixed annual obligation to contribute, typically a percentage of the participant's salary. The profit-sharing alternative, on the other hand, gives the employer flexibility in determining its contribution. Most obviously, the sponsoring employer need not contribute anything in a year without profits, unlike a pension obligation, which is a fixed cost unrelated to profitability. (5) Profit sharing plans can also be designed to permit the employer to decide annually how much of its profits it wants to contribute. The great flexibility of profit-sharing plans explains their increasing popularity in recent years, particularly when that flexibility is contrasted with the regulatory rigidities surrounding defined benefit pensions.
Traditionally, defined benefit arrangements have promised participants benefits at retirement in the form of periodic (typically monthly) payments for the duration of the retired participant's life. Amounts to fund these benefits (paid by the employer, sometimes augmented by employee contributions) are invested in a trust fund supervised by trustees. At retirement, the fund pays the now-retired employee her defined benefit or purchases an annuity contract for her to provide such periodic benefit.
Thus, for purposes of this discussion, traditional defined benefit pensions have four major characteristics as a matter of plan design. First, they provide income on a deferred basis at retirement and not before then. (6) Second, traditional defined benefit plans provide such retirement income as periodic, annuity-type payments rather than as single lump sums. Third, traditional defined benefit plans are funded collectively, the employer's contributions being pooled in a common trust fund from which all participants receive their benefits. Finally, the defined benefit format places on the employer rather than the employee the obligation to fund the benefit promised to the participating employee. If the funds in the trust are inadequate to pay promised benefits, the employer is obligated to make up the shortfall. Thus, as I shall discuss in the next Part, the risks associated with funding a defined benefit pension fall principally on the employer. (7)
In all four respects, today's prototypical defined contribution plan differs. The contemporary defined contribution...