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Defined Benefit vs. Defined Contribution - the armwrestling continues!


jlf
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Wow. Not that I know of. Possibly something pre-ERISA.

Besides, the PBGC frowns on this and treats the transaction as a termination of the DB plan. Also see IRC 414.

I'm a retirement actuary. Nothing about my comments is intended or should be construed as investment, tax, legal or accounting advice. Occasionally, but not all the time, it might be reasonable to interpret my comments as actuarial or consulting advice.

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Sort of... I believe that the case is Hickerson v. Velsicol Chemical.

The employer started crediting "interest" on DC accounts, in effect converting a DC plan to a cash balance plan (This action preceded the creation of cash balance plans). After the stock market took off in the early 80s, the employees sued in order to obtain actual investment returns (as in how a DC plan is supposed to operate). The Circuit Court of Appeals (I forget which one.) decided for the company. This opinion has not been overturned. The IRS has since issued regulations which, if valid, would prohibit employers from doing this sort of thing.

Why did you ask?

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Dear IRC 401(a) , A DB plan, in contrast to a DC plan, is a wealth builder and income provider for the plan sponsor not the employee. Even one that provides a COLA does not provide what the employee/retiree is clearly entitled to.....the full economic value of the employer's contributions (invested assets). A DC plan is the hero of the employee!!

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Interesting editorial. Problem is, the market sometimes goes SOUTH (and some of us are old enough to remember that...)! DB plans have a place in society (and don't create wealth for employers - merely provide a funding vehicle for an obligation). Wait and see. When boomers start retiring in record numbers, we'll find that most people haven't saved enough, haven't invested aggresively enough, and outlive their DC plan assets. Something that can't happen with a DB plan.

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MoJo's talking truth here. The nature of the promise is the key; depending on your circumstances, the promise of a calculable benefit may be more valuable than the promise of a calculable contribution + 'market performance'.

By the way, the quasi-libertarian position jlf takes (& one I subscribe to, most days, because I'm an opportunity costs buff) is one that labor's embraced & neglected off & on for years with regard to benefits of all kinds, not just retirement benefits. In other words, the notion is that benefit promises, when considered as deferred 'real' wages, have usually been discounted too greatly when offered unilaterally by employers. Said yet another way--in a hypothetical employer's voice-- "we'll offer benefits because benefits tomorrow are cheaper than cash today".

Naturally, it's a position about which there can be endless discussion/analysis/debate.

[This message has been edited by Greg Judd (edited 10-19-1999).]

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To Mojo; I am not editorializing as you assert. There are fundamentals of each type of plan that work in favor of the employer or the employee. Let's examine some of these fundamentals.

Fundamental 1. PENSION CONTRIBUTIONS AS DEFERRED COMPENSATION: In a DC plan the employer's contribution is a stated per cent of the employee's salary. Each month the employer is therefore adding this % as deferred compensation to the employee's account. With a DB plan, in contrast, the cost of the defined benefit earned by a year's work depends on a person's age, salary, and years of participation in the plan. The employer's cost varies substantially from person to person, adding little or nothing to a younger person's compensation, and adding a great deal with advancing age and long-term participation in the plan.

Under a typical DB plan the younger employee's own contributions are more than enough to cover the full cost of the defined benefits earned at the younger ages, and to cover most of the cost until nearly age 50. Thereafter, for a participant who remains with an employer for an entire career, the employer's share of the cost rises rapidly with advancing age and long service. In a typical plan with the employee starting at age 30 and retiring at age 65 more than 80% of the employer's cost is deferred until after the age of 55 or until after the 25th year of participation.

This deferral has the unfortunate effect of making a disproportionate part of a person's lifetime compenstion contingent to age and loyalty to one employer. This favors the employer.

Fundamental 2. DEATH BENEFIT PRIOR TO RETIREMENT: In most DB plans the employer's contributions are forfeited should death occur prior to retirement. These contributions with investment earnings are used to pay the employer's pension costs. For this discussion, however, let's assume full and immediate vesting in our typical DB plan. Because of the deferred funding pattern of a DB plan the account balance and therefore the death benefit is substantially smaller in a DB plan than in a DC plan throughout a career of service. At age 50 the death benefit is more than twice as large in a typical DC plan assuming identical salaries and interest credits.

This favors the employer.

Fundamental 3. RETIREMENT INCOME AND CAREER MOBILITY: Let's assume that an employee accrues the same DC or DB benefits regardless of whether or not the person works for one or several employers. The DC participant's ultimate benefit is the same whether the person works for one or several employers. The ultimate Defind Benefit pension,in contrast, equals the Defined Contribution pension ONLY if the DB participant remains with one employer. If we assume the DB participant changes jobs at age 40 and then again at age 50 and retires at age 65 from the last employer he or she will earn an ultimate DB equal to 70% of his or her counterpart in a DC plan; assuming the same salary history and interest credits. This occurs because the "cold storage vesting" of most DB plans provides no way for vested benefits to increase between termination of employment and retirement. This favors the employer.

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[This message has been edited by jlf (edited 10-21-1999).]

[This message has been edited by jlf (edited 10-24-1999).]

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If you're offering an opinion (regardless of whether your viewpoint is well-informed and well-reasoned), then it's an editorial. There's no need to take offense when someone begins a comment with "interesting editorial."

Moving on to the more substantive points, I've not heard of any litigation to compel an employer to convert a DB plan to a DC plan. I doubt such litigation would be successful. As long as the plan complies with applicable law, the employer is free to offer whatever type of retirement plan, if any, it wants to.

In regard to your comment that an employee is entitled to the full economic value of an employer's contributions, keep in mind that if we compare plan designs with the same expected long-term cost to the employer, then there's a link between who is enjoying the investment returns and what those contributions will be. I'm involved currently in a plan redesign project for a large company with a cash balance plan. The company is considering changing to an all defined contribution approach but to provide benefits at the same accounting cost as the cash balance contribution credits (for which the employees get a fixed rate of return that's fairly modest), it would have to halve approximately the level of the stated contributions. Hence, giving investment direction to the employees doesn't just shift the investment risk for better or worse but also significantly decreases the level of contributions.

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<< The company is considering changing to an all defined contribution approach but to provide benefits at the same accounting cost as the cash balance contribution credits (for which the employees get a fixed rate of return that's fairly modest), it would have to halve approximately the level of the stated contributions. Hence, giving investment direction to the employees doesn't just shift the investment risk for

better or worse but also significantly decreases the level of contributions.>>

If I understand what you are proposing, you are drawing the wrong conclusion. Let's assume for example, that your cash balance plan credits 6% of compensation each year and credits "interest" at 4%. The actual company contribution each year is not 6% of compensation but whatever amount is needed under IRC 412 to fund the plan.

If the plan is changed to have a 3% "contribution" plus an "interest rate" equal to directed investment results, the actual company contribution could go up or down depending on what the actuaries assume, but it does not automatically get cut in half. What gets cut in half is the amount of "contribution" allocated to accounts each year.

If your client uses "directed investments", how will the actuaries perform the 401(a)(4) test? What kind of rate of return will they use to project benefits to the testing age? Is it permissible (or reasonable) to assume the same rate of return for everyone? It seems to me that if one of the HCEs is the best investor, you have a 401(a)(4) problem.

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Still an interesting editorial, jlf. You are making several assumptions here: First, you are assuming that younger workers are "entitled" to the same level of benefits as longer term, as you put it "more loyal" employees. I disagree. Loyalty is in fact a legitimate goal of an employer, and rewards for it may be justified. Costs of employee acquisition, and training, can be significant, and encouraging employment longevity is a primary goal of retirement plans. Remember, this is a capitalist economy. If an employee doesn't like the arrangement, they can vote - with their feet. Second, the advantage of a db plan to the employer is the ability to "fund" a plan with reasonably level contributions, over a working employee's career. Accrual rates may not impact employer cost - depending on the funding method used. In addition, guess who bears the burden of market losses in the db plan. WHEN the market goes south (and it will), the costs to employers may be staggering, but the benefits will be guaranteed.... Third, you assume that longer term employees receive a greater annual benefit accrual in a db plan. Well, maybe, but see my first point above, and also consider that longer term employees also tend to be more valuable to the employer, and hence deserve a bigger comp package. Look at cash comp - older long term employees take home more. Perhaps its not inequitable that they also accrue more. Finally, in the job hopper scenario. Yes, employees lose db accruals (typically). So? Every decision we make is a choice. Perhaps the loss of unearned future benfit accruals should be a factor. If a new job has other benefits, then so be it. You assume an employee is better of in a dc plan. My experience has been that about 80% of the rank and file spend their rollover-able distributions.... At least in the db plan, the earned benefit typically stays till retirements. I don't understand the death fundamental. db plans provide the same protection through a QPSA as any dc plan. You could argue about the absolute dollar value of that benefit, but it's typically the amount of benefit earned to date of death....

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I'll try to clarify.

The company I'm working with currently has a cash balance plan contribution credit of 4% per year. Because interest credits are computed based on T-bill rates and the plan assets are assumed to earn more than that (and the plan has been experiencing investment returns in excess of the assumptions, although this doesn't have an immediate impact on the expense), actual cost to the employer is more like 2% currently. My client is considering replacing it with a profit-sharing contribution. The problem is that a 4% profit-sharing contribution will cost 4% of course. Well, after a few years there'll be some forfeitures so in the long run it'll cost somewhat less than 4%, but the cost is still nearly double. I'm just offering this as an illustration: these figures will vary from one employer to the next.

In my client's case, if we're to compare plans with the same expense, we'd compare the 4% cash balance plan to a 2% profit-sharing plan.

The point I was trying (unsuccessfully?) to illustrate is there's a trade-off involved. Even if one agrees with jlf's point that employees should prefer to bear the investment risk, the stated contribution rate will fall significantly, by 50% in my client's situation, if we want to compare plans of the same expense. Simply observing that a 4% annual profit sharing contribution is better than a 4% cash balance plan contribution, not that jlf expressed the comparison in those precise terms, doesn't end the debate.

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jlf,

I'd like some clarifiaction of some of the things you've said above: You said "A DB plan, in contrast to a DC plan, is a wealth builder and income provider for the plan sponsor not the employee." How is a DB plan a wealth builder for the plan sponsor? The plan sponsor has no access to the plan assets without terminating the plan.

You said "A DC plan is the hero of the employee!!" Did you mean any DC plan, including target plans, age-weighted profit sharing plans, 401(k) deferral only plans, etc.? Or did you mean only a level % of compensation money purchase plan?

If you were trying to convince an employer about what type of qualified plan they should adopt, what argument would you use to convince the employer to sponsor a DC plan, given that you believe a DB plan favors the employer?

If you are saying that DB plans have sometimes (often?) been used for the primary purpose of being tax-deduction vehicles for small business owners, I would agree. I'm sure most practitioners have dealt with small business owners who have asked, "How can I contribute as much as possible for myself while minimizing the contributions I have to make for other employees?" DC plans are also sometimes used for this purpose. And fortunately there are also many employers who sincerely want to provide meaningful benefits to their employees!

Have you considered some of the following situations:

1) In a DC plan that allows participant direction of investments, 2 employees that start with the company at the same age and always earn the same salary get vastly different investment returns. When they reach retirement age, the poor investor cannot afford to retire while the good investor is wealthy. Would the poor investor have preferred a DB plan?

2) 2 identical job-hoppers, 1 always in DB plans and 1 always in DC plans, finally each settle in one company for the last 10 years of their employment. They have each spent every cent of any distribution received from earlier employer plans. What type of plan would these employees prefer for their last stretch of employment?

3)An employer decides it will spend $X every year on its qualified plans, no matter what the investment experience is. The goal is to provide a meaningful retirement to any employee that retires from this employer at a reasonable retirement age. Most employees are primarily concerned that they will have an adequate retirement income. What type of plan should this employer adopt?

When a young employee leaves a level % of compensation DC plan after becoming fully vested, all of the money contributed for that employee leaves the plan and is unavailable to provide for the retirement of other employees. The same is true when a young employee dies after becoming fully vested. Since the money contributed for this same employee in a DB plan will generally be much less, there is more money available to apply to other employees who retire.

In general, DB plans are designed to provide RETIREMENT benefits. DC plans are designed to provide SAVINGS benefits. Ideally, I'd love to see employers adopt 1 of each type of plan. Each type has advantages and disadvantages for both employers and employees.

A DB plan guarantees a monthly benefit at retirement, insured by the PBGC. A DC plan makes no guarantee as to the account balance that will be available at retirement. In this way,the DB plan favors the employee.

If the investment return is negative for a year, the sponsor of a DB plan must increase the contribution amount to make up for it. In a DC plan, the employees, even if it is the year prior to their retirement, take the loss, which could be devastating to someone who had counted on what the account balance was the year before. In this way, the DB plan favors the employee.

In most DB plans, the participants are not asked to contribute to the plan. In many 401(k) plans, employees bear the cost of funding their own retirement, with a minimum of contributions from the employer. In this way, DB plans favor the employee.

In many profit sharing plans, the spouse basically has no rights pertaining to payment from the plan. In DB plans, there are rules to protect the spouse. In this way, DB plans favor the spouse of the employee.

jlf, I believe that in many cases, DC plans ARE the hero of the employee, especially if the employee is young, and a disciplined planner and saver, and if necessary, a good investor. I also believe a DB plan CAN BE the hero of the employee, if the plan has been written to provide a meaningful retirement benefit.

The best plan for a particular employer should make BOTH the employer AND the employee happy to have the plan!

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Dear John A: Thank you for your considered reply. I am referring to a level % of salary plan. To the extent that investment earnings are not needed to pay a defined benefit the invested assets become a wealth builder and income provider to the plan sponsor because the plan sponsor owns the invested assets. Even if we assume a DB equal to 100% of the last year's salary the retiree can never expect to improve his or her standard of living

because of NON-PARTICIPATION IN THE "EXCESS EARNINGS".

History has shown that the best the fixed-income pensioner can expect from the DB plan(public or private)is an annual COLA with a cap. The "excess earnigs" are simply used to balance the employer's budget, public or private as the case may be.(leveraging in perpetuity)

This practice flys in the face of the principle that a pension is deferred compensation. Using my assumptions the typical DB plan empowers the employer while the DC plan empowers the employee. Paternalism is alive and well with the DB plan I outlined above.

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Thank you John A for your well versed discussion.

With respect to jlf comment immediately above, he notes an important characteristic, although some may put it in the category of "philosophy".

That is, the term "deferred compensation" has come to be applied to all DB and DC plans, pimarily because that is how the US laws, especially tax laws, treat and label them. However, throughout the history of DB plans, it would be more correct to view them as related to "paternalism" rather than "compensation". I know that this is an overgeneraization, but consider taht this is very often the difference between DB and DC plans.

I'm a retirement actuary. Nothing about my comments is intended or should be construed as investment, tax, legal or accounting advice. Occasionally, but not all the time, it might be reasonable to interpret my comments as actuarial or consulting advice.

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Pax; you're on point. The relationship between a DB retiree and the Plan is akin to a creditor and debtor. The only claim the retiree has against the invested assets is the timely payment of benefits.

As far as philosophy is concerned doesn't the DB System help maintain a second class citizenship?

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Not sure what you mean by "second class citizen". If you refer to the dependence of the the DB plan participant on the plan and the employer, I think you are being overly cynical (admittedly, there are some employers that no one should be dependent upon).

If there is any maintenance of second class citizenship in our society, I would be reluctant to blame it on a tax-advantaged employee benefit, especially one that is voluntary on the part of the plan sponsor.

I'm a retirement actuary. Nothing about my comments is intended or should be construed as investment, tax, legal or accounting advice. Occasionally, but not all the time, it might be reasonable to interpret my comments as actuarial or consulting advice.

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A second class citizenry is the the result because the DB IS GUARANTEED TO LOSE IT'S PURCHASING POWER. Rest assure, however, this was all the DB design was INTENDED TO DO! This REALITY should not be defended based on the retirement benefit being voluntary.

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I don't agree. If a DB plan is guaranteed to lose its purchasing power, then one can conclude that inflation is guaranteed. Not so, although it does seem to be fairly common. However, that also means that any EE's pay is equally guaranteed to lose its purchasing power.

jlf,

you seem to be cynical about DB plans (or perhaps about their sponsors). Rather than just complain, what is your suggestion for improvement? (Try to keep it short.)

I'm a retirement actuary. Nothing about my comments is intended or should be construed as investment, tax, legal or accounting advice. Occasionally, but not all the time, it might be reasonable to interpret my comments as actuarial or consulting advice.

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jlf, what about multiemployer DB plans as the "champion" of the working man.

1) contributions are almost always collectively bargained so money goes "in" even if it is in excess of the minimum funding standard,

2) multiemployer nature provides portability

3) benefit levels are sometimes bargained, but even when they are not "Taft-Hartley" funds require equal employee representation on the Board for both setting benefit levels and investments.

4) For larger plans, trustee directed nature allows a percentage of the assets to be invested "cutting edge" investment opportunities not usually afforded in participant directed plans such as VCOCs REOCs etc. Given recent investment returns, some multiemployer plans have 415(B) 100% of comp problems.

5) DB nature provides guaranteed benefits in retirement for the life of the participant.

Finally, if DB Plans are so much more favorable for employers, why have large corporate employers moved away from traditional DB Plans to DC Plans over the past 20 years? I am sure that regulatory complexity and employee desire for portability and "control" of investments are factors. However, I would think that the "bottom line" analysis by these employers is that, in the long run, the DC Plan is generally less of a financial commitment.

[This message has been edited by KJohnson (edited 11-01-1999).]

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DB plans may be guaranteed to lose their purchasing power, but that shouldn't necessarily be the concern of the employer. Come on, the employees have to take some responsibility for their own retirement.... Private pensions are but one of the legs on the "three legged stool" of financial security in retirement. Besides, It is still yet to be seen how many boomers run out of money before they run out of life. Stuidies still suggest that assets in participant directed DC plans will be insufficient for retirement.... the last 10 years notwithstanding....

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jlf, Thank you for your explanation. I am a little confused about the idea that the plan sponsor owns the plan assets since, upon plan termination, a very large portion or the excess assets must either go to the government or to both plan participants and the goverment.

Just to clarify one thing about your perspective for me, which of the following would be your choice (I'm not saying the choice is realistic, I'd just like to understand your perspective)assuming the following represented your only source of retirement income (no other savings, etc.):

Choice 1: $200,000 will be used to purchase a monthly life annuity for you from an insurance company. This obviously presents some problems: inflation will erode the value, there is no death benefit, there is a dependence on the insurance company to be able to pay, and you do not share in any investment performance above whatever the assumed interest rate was in determining the annuity. On the other hand, the money will continue to be paid no matter how long you live.

Choice 2: You will be given $100,000 as a lump sum. This obviously presents some problems: Each year, you must decide how much of this you can withdraw to use for living expenses. You must decide how much liquidity you need, how much safety you need, how much risk you need to take to meet the threat of inflation. There is the possibility that the assets will run out while you are still living. On the other hand, your fate is under your own control. If you die with assets remaining, there is a death benefit. If you invest and do well, you may more than make up for inflation.

So, jlf, for you personally (not what would be good for others), if you only had 1 source of retirement income, would you prefer a life annuity valued at $200,000, or a lump sum of $100,000?

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Pax; A wage freeze at the discretion of the employer would be unthinkable! Why?, because of lost purchasing power. When it comes, however, to our retired brothers and sisters a pension income freeze doesn't seem to matter because they have been "pensioned off". This is how we treat our second class citizenry.

The solution to the problem is to provide a CHOICE of plans. I venture to say that personal savings from take-home-pay is not as important to one's overall financial plan if one partipates in a DC plan rather than a DB plan. This is so because the DC account is a wealth builder as well as an income provider. BUT WE ALL RECOGNIZE THIS, DON'T WE?

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jlf: You miss the point entirely. DC plans *may* be wealth builders.... It depends on the markets, and on an individual's investment savvy. You are blinded by "irrational exhuberance" in the financial markets. It won't last.... DB plans provide a "guarantee" of a certain income level. It may not be the "guarantee" you want, but its the only guarantee the employer is willing to make. Keep in mind that retirement plans are discretionary. Only 42% of the American working population even has one.

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Correct MoJo.

Another point to jlf:

If a wage freeze to employees is "unthinkable" to the ER, then it won't be for the "loss of purchasing power" but because of the supply and demand within the labor market.

If the retired EEs on fixed income are "second class citizens" it is not because of ANY benefit program but because our society primarily values and recognizes individuals on what they are *currently* producing, not on their historical production. If this is the case, let's not blame the benefit program, or the employers or the government or the IRS or the unions, etc., let's recognize that it is an attitude of individuals who collectively make up a society.

Do you remember the Fifth Commandment, "Honor your father and your mother..."

[This message has been edited by pax (edited 11-01-1999).]

I'm a retirement actuary. Nothing about my comments is intended or should be construed as investment, tax, legal or accounting advice. Occasionally, but not all the time, it might be reasonable to interpret my comments as actuarial or consulting advice.

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Boy, You guys are ganging up on me! Why don't you respond to my "right to choose" point. Or, are you attempting to protect the employee from himself? Social engineering is alive, quite alive!

DB plans can only be defended when they start to SHARE, IN A MEANINGFUL WAY, THEIR EXCESS EARNINGS WITH THEIR FORMER EMPLOYEES.

A retirement benefit should only be a floor, not also a ceiling.

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