Defined Benefit vs. Defined Contribution - the armwrestling continues!

[jlf]

Has there ever been any litigation to compel a DB plan to convert to a DC plan?

[david rigby]

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.

[IRC401]

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?

[jlf]

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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[MoJo]

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.

[Greg Judd]

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).]

[jlf]

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).]

[MWeddell]

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.

[IRC401]

<< 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.

[MoJo]

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....

[MWeddell]

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.

[John A]

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!

[jlf]

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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[david rigby]

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.

[jlf]

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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[david rigby]

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.

[jlf]

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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[david rigby]

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.)

[KJohnson]

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).]

[MoJo]

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....

[John A]

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?

[jlf]

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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[MoJo]

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.

[david rigby]

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).]

[jlf]

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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[Guest]

The DB plan IS PATERNALISM! Whats wrong with that. I assume that some db plan did jlf wrong and now he's out to make them all pay, and although it's pointless to argue, here goes.

The db plan is intended to protect the employee and his or her spouse from himself. Most employees (especially the older ones) lack the investment savey of jlf and would be clueless when it comes to investing. When 401(k) are put in labor heavy companys, the employees are generally too conservative and select against themself. The 401(k) is there for them to invest their own money and "play the market" if they want but the db plan is intended to be a safety net.

Most employers I deal with fight (bad choice of words) people like jlf all the time. They wonder why they should bother trying to give the employeess some security when a few constantly complain that they could do it better. If they felt that they could sleep at night, they would dump the db plan in a minute. Why not give them a 401(k) for a fraction of the cost if it makes them happy, give the people what they want.

Just because jfl is able to make big bucks in the market, he/she shouldn't assume that everyone is capable and willing to do so. If jlf can, than he/she should! But don't assume that its right for everyone. Many people would rather not have to watch the market or worry about outliving their personal savings.

Regarding "choice", just what kind of education do you wish to present the 55 year old sheetmetal worker with a high school education in order for him to make an informed and intellegent decision?

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

[MoJo]

jlf: If you believe employees should share in the excess earnings on db plan assets, would you then also believe they should share in the losses?

[Guest Roman]

I think jlf wants the government to have all employers convert their plans to a plan which would provide a 100% income replacement at retirement (with a cost of living provision) plus all the earnings, if any, of the trust assets. Hmm, interesting. Where do I sign?

[Lorraine Dorsa]

Thank you all for your opinions on DB and DC plans.

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[jlf]

Hey guys, don't you just love the www?

To mojo: Re: your post of 11-01. With the utmost respect, it is you, not I, who misses the point. "Irrational exhuberance" is totally irrelevant. The AIR (assumed investment return) I used in my statement of 10-20 is the same for both types of plans. The wealth building feature of my DC plan is the result of: 1. full and immediate vesting and 2. a level funding pattern. These points were made in my post of 10-20. You may wish to revisit it.

Your post of 11-02: Ans. Absolutely, that's part of being empowered.

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[jlf]

To Keith: Be careful about insulting those "hard hats"

Personally,I have many friends with "only" a HS diploma and friends without one that have managed very large sums of money for the last 30 years which includes this era of "irrational exhuberance". I feel they have done over the past three decades quite well. They have adopted a 60:40 ratio (approximately)between an S&P 500 type fund and investment grade bonds. I BET THAT IS THE WAY THE SHEETMETAL WORKER'S DB PLAN TRUSTEES INVEST.

As a HS teacher let me assure you that many, many of my former students never continued their formal education after HS but their desire to grow and learn before and after age 55 has always been present.

[MoJo]

jlf: It is the AIR that is irrelevant. We aren't dealing with hypothetical returns here. Real ones are what pays the bills in retirement.

If you accept the losses, then you've converted the db plan into a dc plan.... Hmmmm. Me, I'd rather have the guaranteed income (shelter from the downside) with a known limit on the upside.

[This message has been edited by MoJo (edited 11-02-1999).]

[jlf]

Doesn't your DB actuary use an AIR? The AIR is but one of many factors, hopefully realistic, that is used in the actuarial calculation to determine the contribution necessary to keep the DB plan fully funded. A realistic AIR is about 7-9%. I am astounded to hear you say that the AIR is irrelevant!

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[MoJo]

Of course its used in the actuarial calculation. However, actual results may vary (yeah, actually, they generally will vary). C'mon jlf - AIR is used for forward looking calculations. The wealth accumulation that you keep saying is making employers rich is the excess of reality over AIR.

[richard]

At the risk of entering this age-old debate, here goes:

Suffice it to say that the major difference between DB and DC plans is who bears the investment risk/reward --- company or employees.

Aside from that, one can make a DB plan behave like a DC plan, and vice versa.

Let's look at some examples.

1. Pattern of earning benefits over an employee's career:

A traditional DB plan backloads benefit accruals; in a traditional DC plan, allocations are more evenly spread over a career. Well, a cash balance DB plan evenly spreads benefit accruals over a career. Alternatively, a target benefit DC plan (or an age-based DC plan) has the same backloaded accrual pattern as in a DB plan. So, you can have an employee earn benefits in a DB plan much like in a DC plan, and vice versa.

2. Portability and vesting.

Clearly a DC plan pays benefits in lump sums, and often has more rapid vesting than DB plans. One of the complaints about DB plans is lack of portability. Well, an employer can provide the same more rapid vesting in a DB plan. Often, lumps sums (over $5,000) aren't offered in a DB plan. Well, an employer can provide lump sums without limit. So, both types of plans can have the same portability.

3. Spousal protection

Spouses in DB plans are protected by law, while spouses in some DC plans are not. So what. The DC plan can be designed with a similar (alright not exactly the same) protection as in a DB plan. Hence, similar spousal protection.

4. Risk of outliving one's DC account.

Certainly, with a DB annuity, there is no such risk. With a DC plan, there is such a risk. However, the employee can roll over his/her lump sum into an IRA and buy an annuity; hence, no risk of outliving the DC account. I've heard of large companies that sponsor both a DB and a DC plan addressing this problem by allowing the retiring individual to "transfer" his DC assets into the DB plan and "buy" the annuity through the DB plan.

5. Risk of inflation erosion.

Equity investments in a DC plan, in theory, protect the retiree against inflation. (And let's face it, even in a modest 3% inflation environment, there will be a 45% purchasing power erosion by the twentieth year.) I say in theory because during the inflationary 1970's, the equity markets did poorly. But, let's not get into that issue here.

Well a DB plan can provide automatic unlimited COLAs. Now why do corporate sponsors not do this. Partly because of the risk. But also because of the employee's lack of appreciation of the value of a COLA. A $1,000 per month annuity increasing at a 5% COLA is roughly equivalent in value to a $1,450 per month level annuity (for the actuaries in the audience, I assumed a twenty year certain payout and a 9% discount rate). Now, if you were a corporate plan sponsor, which do you think is more saleable to your employees?

(By the way, the inflation risk can be hedged by many techniques that Fortune 500 CFO and investment banks are well aware of, including equity-linked bonds, among others.)

So, it's not that DC plans are better able to protect against inflation risk, it's that private sector employees don't want DB plans that do. (Editorial -- public sector plan do have COLA protection. And their employees do appreciate it, because heaven help the government entity that tries to take away the COLA --- end of editorial.)

So, if DB and DC plans can be made largely equivalent except for the investment risk, then it is in fact the investment risk that is the key element. Who wants to bear this risk, and therefore gain the reward?

Now, there are two other differences (other than who bears investment risk) between DB and DC that I haven't mentioned yet (and I will here) that cannot be avoided by clever plan design.

One is government (PBGC) insurance. Clearly, the government cannot insure a DC plan; it's hard enough for them to insure DB plans (adverse selection, moral hazard, put option and political process are the key historical problems discussed in the literature). Of what "value" is PBGC insurance? That's debatable, and I'll let that remain for a further thread.

The other statutory difference is employee contributions. While an employer can (and often would like to) condition benefits on employee contributions, the employer cannot condition DB benefits on "deductible" employee contributions; only "nondeductible" employee contributions can be used. Of course, in a DC plan, these employer "benefits" (i.e., contributions) are conditioned on deductible employee contributions -- this is one of the key reasons that 401(k) plans are so popular.

(Editorial -- now, if we had a level playing field, we would allow deductible employee contributions to be in a DB plan -- end of editorial.)

So, if you've gotten this far, it all boils down to investment risk/reward. Who wants it? Who doesn't want it? Who gets it?

End of commentary. (I await your arrows!)

[Guest]

To Richard: Very well put. This debate has been raging for years and will continue to rage for years to come. Our own Pres. and many members of Congress are expressing similar desires as jfl when it comes to Soc. Sec.

To jfl: I certainly did not mean to insult any "hard hats". Most of them are very capable handling their own investments. My point was that you should not assume that all workers (blue or white collar) are willing to learn all the information necessary to make an educated decision about the proper retirement plan.

[MoJo]

Very well put, richard. The bottom line is a) a guaranteed, albeit limited payout, v. b) an uncertain, albeit unlimited balance. Over the last 15 years, (hindsight being 20/20) the dc plan was the place to be. In the prior 15 years, it wasn't. Who knows what the next 15 years will bring.

[david rigby]

There is point to re-emphasize with regard to the investments. If you have been hitting home runs over the last 15 years in a DC plan, you probably have a sizable account balance. However, what retirement income this account will provide depends on future earnings, not past earnings. This is very easily seen by pricing a single premium annuity from a commercial insurance company. It would be unwise to assume that future actual rates of return will be as generous as the last 15 years.

[This message has been edited by pax (edited 11-03-1999).]

[jlf]

Mojo- I am attempting to make the following point in my example of 10-20-99: The real rate of return matches the AIR for the 35 years; from age 30-65. You ask: Where is the wealth building component? In the DC plan it is in the funding pattern and in full and immediate vesting/ownership of the annuity contract/account. This contrasts with the DB plan where all employer funding is normally forfeited upon death prior to retirement. The forfeited amount is an actuarial gain or wealth builder for the plan. This is why most DB plans provide group life insurance.(non-contributory and/or contributory)

Even with this life insurance component the DC account balance remains greater. Reminder, my example assumes, at all times, the real rate of return equals the AIR.

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[This message has been edited by jlf (edited 11-03-1999).]

[Chester]

JLF, you have been obviously misinformed somewhere along the line, as your ignorance is clearly visible in your responses. For your information, it is false that most DB plans use group insurance to provide death benefits. Many DB plans provide a special death benefit to employees who die prior to retirement, and the employer pays for this benefit through contributions to the plan based on actuarial assumptions regarding mortality. As Mojo and countless others have already stipulated in previous posts, the main difference between DB and DC plans is that the employer bears the investment risk in DB plans, whereas the employee bears the risk in DC plans. The benefit in DB plans is guaranteed, while the benefit in DC plans is subject to the vagaries of the stock market, as well as the contributions made to the plan. JLF, it is true that the stock market has provided astounding returns during the past 15-20 years, but a closer inspection at investment returns over the past 60+ years would indicate the average annual return is somewhere around 8-9% (not the 20%+ returns that you and so many others have been blinded by). The point here is that once the stock market (and it will happen) starts returning to normalcy (some would say that 1999 may be the beginning of some normalcy) many employees in DC plans will find out that they will not have enough money to retire comfortably, or will discover after they have been retired that they retired too soon.Then you will have some real social engineering going on!

[jlf]

Dear Chester; I am not misinformed. The 50+ billion dollar DB System of the NJ Division of Pensions purchases its group policy from the Prudential Life Insurance Co. The coverage goes up to 3.5 times annual salary. Some DB plans fund this life insurance benefit internally through the plan. Please take a deep breath and acknowledge the point I am making: THE LIFE INSURANCE BENEFIT IS NEEDED(REGARDLESS OF THE UNDERWRITING VEHICLE) BECAUSE ANY EMPLOYER FUNDING OF THE DEFINED BENEFIT ON BEHALF OF AN EMPLOYEE IS NORMALLY FORFEITED UPON DEATH PRIOR TO RETIREMENT.

Now that you are more relaxed, I challenge you to find anywhere in this dialogue where I have assumed an investment return greater than 7-9%. You owe me an apology for winging it!!

[This message has been edited by jlf (edited 11-03-1999).]

[Chester]

JLF, you are the one who is winging it. You stated that a DB plan normally does not provide a death benefit, but that is clearly an incorrect statement. If you make an incorrect statement, then don't get annoyed if people try to correct you. If we agree to disagree, that is fine, but let's not be using generalizations or distortions of the facts.

[jlf]

Chester: THE DEATH BENEFIT PRIOR TO RETIREMENT COMES FROM LIFE INSURANCE (funded inside or outside of the plan.) The death benefit DOES NOT come from the DEFINED BENEFIT PLAN'S INVESTED ASSETS THAT ARE DEDICATED TO PROVIDE THE DEFINED BENEFIT. YOU KNOW THIS IS EXACTLY THE POINT I AM MAKING!! Chester, have you found the post where I assumed a return OF 20% AS YOU FALSELY ACCUSED ME OF?

[This message has been edited by jlf (edited 11-06-1999).]

[Wessex]

I had determined not to participate in any thread initiated by jlf as he appears to extrapolate his specific personal experiences with employer-sponsored retirement plans (which he obviously deems violations of something) to the general and makes ad hominem arguments in response to logical responses to his posts. (I know, I know, I am now making an ad hominem argument too. Sorry jlf.)

The basic discussion here as to the pros and cons of defined benefit or defined contribution plans, including some of the points made by jlf is very interesting, but it would have been much better if jlf had posed the issue as such a discussion rather than often ranting, by both tone and frequently stupid, in-your-face use of capitals.

With respect to jlf's last post, because the plan specified by jlf funds death benefits by insurance (note this is the NJ Division Pension Plan and jlf profiles himeslf as a NJ teacher -- perhaps a participant?) does not mean that even a minority of other DB plans do the same. In more than a decade of (I like to think sophisticated) employee benefits practice I have not encountered any plan (other than than the less-than-minuscule number of 412 plans) that funded death benefits with an insurance contract.

Jlf, again, I'm sorry for my ad hominem arguments too, particularly as I am usually quite sympathetic to the employee's point of view. I am now back to my position of not responding to jlf's posts for so long as they seem to me as I have previously characterized them.

I am also well aware that no one cares at all whether I participate in the boards or not. Long live rational, diverse discussion on these message boards!

[This message has been edited by Wessex (edited 11-03-1999).]

[MoJo]

jlf: In my 17 years of experience in the business (first setting up db plans, then tearing them down, and now setting them up again) I have yet to see a db plan that funds a death benefit through insurance. A public db systems does not make an industry. Public plans are very different animals from the typical. In addition, I've never seen a db plan NOT provide a death benefit. I think the QPSA rules may have something to do with that. And yes, you can fund the death benefit from the assets of the plan, because typically the death benefit is based on the benefit accrued (not on participant current comp).

[jlf]

Mojo, When the death benefit comes from plan assets I assume the proceeds is considered qualified money and, therefore, eligible for rollover treatment. Is my assumption correct? (Note my lack of caps. I hope my passion is not waning.)

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[This message has been edited by jlf (edited 11-04-1999).]

[MoJo]

Depending on the type of payout, and the beneficiary, yes, the benfit would be rolloverable. Keep in mind that in a death benefit situation, the only beneficiary that has a rollover opportunity is a surviving spouse, and if the benefit is annuitized, its not rolloverable. Even if the death benefit is funded by plan purchased insurance, the distribution would be from the plan, and therefore rolloverable.

[Guest Dan Cassidy]

Interesting discussion.

First Comment - Most of the issues with DB plans being not portable, having small death benefits, etc. are mostly designed based considerations. Historically, DB have been designed a certain way. That doesn't mean they can not be changed and designed in a more modern way to acheive other results.

Second Comment - No one has mentioned the flexibility built into DB plans. Several areas like minimum/maximum funding give the employer a way to manage their cash flow in a more strategic manner. Also, early retirement window benefits are very easily integrated into a DB plan. Try doing that with a 401(k)/profit sharing plan.

Third Comment - No one really talks about the cost shifting that has happened as we move more into DC plans and away from DB plans. Employees pick up a much larger share of plan expenses in new DC plans with daily vals, quarterly statements, telephone access by paying mutual fund companies' retail expense loads. While DB have traditionally been administered institutionally. I feel that this silent transfer of expenses have been quietly ignored.

Would love to hear any feedback. Let the debate continue.

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[This message has been edited by Dan Cassidy (edited 11-05-1999).]

[jlf]

MoJo, Re: your post of 11-4-99.

If the surviving spouse elects not to rollover the death benefit is it includible in the spouse's gross income?

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[MoJo]

Typically, in my experience, the death benefit from a db plan is paid in an annuity, and hence isn't rolloverable.... I suppose, although this isn't my area of expertise that an insured death benefit would be excudible from income. Anybody have the answer here? By the way, jlf, nice try, but the income tax consequences of the death benefit are irrelevant to the main topic of this thread.