Encourage DB plans

[Guest ctobe]

I think the legislative push should be to get back to DB plans. I think retirees have lost out big on the shift from DB to DC

[Guest Dook]

Try telling that to the retirees whose future benefits were placed in the hands of Executive Life!

With the exception of union plans and a select group of closely held professional businesses, DB plans are dinosaurs. Participants don't understand them, fees are high, and benefit calculation errors are commonplace.

Businesses and workers have embraced 401(k) plans and at least over the past 4 years, have been amply rewarded with investment gains which should translate into retirement benefits far exceeding anything that a DB plan would provide.

[richard]

The DB vs. DC debate is lengthy, far from over, and often based on whether or not your business is being helped or hurt.

That being said, there is a lot of misinformation out there that has led to the popularity of DC plans. Also, the unwillingness of sponsors of DB plans (and their advisors) to accomodate the desires of employees has hurt DB plans. Finally, Congress and the IRS have (with their own biases and agenda) affected the mix.

For example:

Issue #1: Are DB plans are more expensive than DC plans?

Answer #1 - You can design an inexpensive DB plan (such as 0.2% of earnings per year of service) or an expensive DC plan (such as 10% of pay).

Issue #2 - DC plans have quicker vesting and more liberal eligibility than DB plans.

Answer #2 - That is based on plan design; not law.

Issue #3 - DC plans are more portable than DB plans.

Answer #3 - Both types of plans can be designed to allow immediate lump sums that can be rolled over (i.e., portable). That DB plans often do not do this (and hence are not portable) is by the choice of the plan sponsor.

Issue #4 - DC plans allow employees to get large investment gains.

Answer #4 - Of course, there can be investment losses. More importantly, the cost of a DB plan is also based on the investment performance of the fund. The same favorable investment performance that allows large employee retirement benefits in DC plans can be used to provide equally large retirement benefits in DB plans (if, and that's a big if, the employer uses the investment gains to provide these benefits.)

Issue #5 - employees prefer a lump sum to a deferred (or immediate annuity)

Answer #5 - That's a biggie. When a 65-year old (in "normal" health) is given the choice between an immediate life annuity of $1,000 per month and a lump sum of, say, $90,000, most would prefer the lump sum. Now, the actuarial value of that lump sum is, say $120,000. So, if you were an employer and your employees tell you they would prefer $90,000 vs. something "worth" $120,000, which would you provide? (Perhaps, as a matter of public policy, there is a need for some education!)

Issue #6 - Congress and the IRS does not provide a level playing field between DB and DC plans.

Answer #6 - (OK, this is my bias). This is one of the more critical reasons why DC plans have flourished. Congress applies 401(a)(26) only to DB plans. Congress only an employee to make tax-deductible contributions only to DC plans (i.e., 401k plans); employee contributions to DB plans are not deductible to the employee (even employee contrutions to health care plans are deductible under Section 125 Cafeteria Plans). DB plans have to offer annuities with their resulting complexity; some DC plans (profit sharing and 401k plans) do not.

DB plans have a critical distinction from DC plans -- namely shifting the investment and life expectance risk and reward to the employer. In fact, if you ignore the life expectancy risk, then the only difference should really be who bears the investment risk.

All other plan design factors can be found in DB or DC plans; sometimes though hybrid plans that make certain aspects of DB plans look like DC plans, and vice versa.

(For example, cash balance plans are a solution to many of these issues. Cash balance plans, for those not familiar, are defined benefit plans that look like defined contribution plans. So are "pension equity plans" which are the final pay version of cash balance plans. And target benefit and age wseighted DC plans are DC plans that attempt to reflect the way benefits are earned in a DB plan throughout an employee's career.)

Of course, other factors such an employee-choice and self-reliance, and changing nature of the employer-employee relationship, etc. are integral to this discussion.

However, how about someone else discussing these factors; you all have probably heard enough from me.

[Chester]

My concern about DC plans is that there will probably be many baby boomers retiring in the next 10-15 years who will have insufficient funds to live comfortably in retirement. It is foolhardy to continue to expect to have the kinds of returns in the stock market that we have been experiencing the past 4-5 years. In fact, the long-term average return on equities (based on a 70+ year history) is about a 10% annual yield. In addition, most employees are putting money into a DC plan without the faintest idea of whether or not their contribution rate will be sufficient to provide an adequate level of retirement income. In fact, I would venture to guess that for participants in a 401(k) plan, most participants only put in enough deferrals to get the maximum match from their employer. I also have qualms about the ability of most employees to be prudent investors. Most of the employees lack enough sophistication/training to make informed, intelligent investment decisions. I also take issue with the notion that DC plans cost less than DB plans--ADP/ACP tests, investment management fees, administration fees, etc. for a 401(k) plan can get pretty expensive compared to a plain, vanilla DB plan. We administer both DC and DB plans at our firm, so I have first hand knowledge of what I have been speaking about. DB plans have their proper place, just as DC plans do, but it is entirely erroneous to say that DB plans are dinosaurs, or that they do not serve their purpose any longer. The next great American crisis will be the insufficiency of retirement income that DC plans provide (because the stock market will not continue to provide 20-30% annual returns that people have become accustomed to).

[Guest Dook]

Sure as a benefits professional you can make many arguments to support the use of DB plans. Some of these arguments are paternalistic (i.e. investment risk, lump sum vs. annuity payout). I personally like plans that do not allow any payouts until age 60 (even to terminated participants) and which only allow annuity type payouts (talk about paternalistic!) But this is not what the majority of workers wants. What they want are 401(k)s.

They want to know what their account balance is 24 hours a day. They want to be able to access that information via the internet. They want to be able to initiate investment transfers, deferral changes, loans, distributions etc. on any day. This may be the fastest and easiest way to end up with a zero account balance after two years of retirement, but that's what they want!

Employers that want to attract and retain high quality workers feel they must offer a 401(k). The only time I have heard an employer say they must offer a DB plan is when they are obligated to do so by a union.

You can legislatively make DBs more attractive to employers, but the average worker does not now want them or understand them.

DB plans; participants don't understand them, fees are high (including PBGC premiums, and document compliance fees), and benefit calculation errors are commonplace.

[Guest Franklin Evans]

Please don't take this wrong. I am still boiling about the Americans for Tax Reform propoganda; but you are all avoiding the main point. Plan sponsors have two reasons for having a qualified plan: retaining valuable employees; and maximizing their tax deductible contributions.

It is clear that the most abuse in pensions has been in DB plans. It is easier to pad the pockets of the executives with a benefit formula than with a flat contribution percentage credited to an individual account; especially when the executive is usually over 45 years old. Do the math. The executives' first desire is to hear from the actuary how 75% of the annual contribution is going to fund the top 10% of the benefits.

That being said, it is easy to see why DC plans are more likely to be chosen for employee morale and retention. They are at least superficially non-discriminatory in that "everyone" gets the same amount from the contribution. For many reasons they are also a better choice for the plan sponsor, especially when no industry is immune from a major down turn, and discretionary contributions are important to fiscal planning.

I'm 43. I'd much prefer to have a DB plan. How many laymen out there know enough about qualified plans to be able to make such a statement?

[LCARUSI]

What I am hearing from the supporters of DB Plans is that employees need a DB Plan to provide retirement security.

Your typical employee today who makes frequent job changes will get peanuts from all the DB Plans he or she might participate in over the course of his or her career - even if he or she is fully vested in each benefit. Either the lumpsum cashouts will be minmal or the frozen terminated vested benefits will ultimately add up to an insufficient benefit.

The employee would be better off participating in a series of 401(k) Plans and maintaining all those balances until retirement.

[richard]

You know, it's interesting when talking to business owners and senior management about why they have (or do not have) retirement plans. Franklin Evans' observation of why sponsors have plans (to keep valuable employees and to maximize tax deductions) is accurate. The paternalistic "provide for the orderly retirement of our workforce" is limited to fewer and fewer companies.

Which of the two objectives is paramount depends on the business owner. Often (particularly with the smallest companies), maximizing tax deductions is the only objective. In this case, if the tax laws do not allow sufficient favoritism to the owner, he/she will simply not have a plan. Therefore, the employees will be left out. The only way around this would be some sort of mandatory pension plan for all employers (remember "Minimum Universal Pension" a/k/a MUPs in the mid 1980's).

As far as the other objective, attracting and retaining employees is important if the owner cares about attracting and retaining employees. If owners believe employees are interchangeable (ask management of large companies over the last 10 years what they think), why bother to provide benefits?

By the way, while there can be significant abuse using DB plans, you can get a lot of abuse with DC plans. In some cases, even more than with DB plans -- consider age weighted profit sharing plans. It's just that it is easier to hide abuse in DB plans. (Or if "fair benefits" are the company's goal, they can use either DB plans or DC plans.)

[joel]

My DB plan compels me to annuitize. Yet if I should die after reaching eligibility to retire my beneficiary has the option to receive my reserve funds in a lump sum. In the absence of full investment return participation the "guaranteed pension" that you cannot outlive is GUARANTEED to be erroded by INFLATION. This erosion is simply a very cruel "retirement tax" levied on DB pensioners. Excess earnings should not be used as a cash cow for the plan sponsor. Excess earnings belong to the pensioners. It is part of their deferred income.

[joel]

I venture to say that until Congress requires full earnings participation for DB plans, DC plans will be the plan of choice among employees. If this should happen watch and see how many DB plans fold in favor of DC plans. Why should an employer continue its DB plan when it can no longer eat off the retirees plate?

[This message has been edited by joel (edited 11-25-98).]

[david rigby]

by the way Dook, your first comment about Executive Life does not hold water as a criticism of DB plans. That problem was an investment choice (by plan sponsors), which could also have been made by individuals in a DB plan or an IRA.

One of the major problems is that many observers (including members of Congress) think narrowly, and construct laws and regulations that favor DC plans, thus effectively removing (or minimizing) choice by sponsors and participants.

[Guest ESOPwizard]

I don't like DB plans because they are basically worthless

for employees younger than 50 and so expensive for employees

older than 50 that employers have an incentive to find (a

legal) way to get rid of older employees. Furhtermore, if

a company collapses, employees lose their pensions (not their

insured accrued benefits, but the benefits they expected to

accrue had they been able to work until retirement age).

DB plans may have made sense in the 1950s when it was

common for someone to spend 30+ years with one employer,

but they don't make sense in the 90s (unless you own

the company and are over 50).

[Chester]

I'm not sure what point ESOPwizard was trying to make with the plan termination argument, because DC plans also terminate, and employees lose the future contributions they were expecting to earn in that situation. I think it's highly erroneous to say that DB plans are worthless, because the optimum situation for a plan sponsor is to have both a DB and a DC plan. The overwhelming majority of large plan sponsors have both a DB and a DC plan, which appeals to both the highly mobile employee as well as the long-term career employee. The DB plan provides a base level of retirement income to the employees and the DC plan serves as a supplement to the DB plan. I have a feeling some of the people who have posted messages here are ignorant of the benefits of DB plans, and probably primarily are involved in the administration of DC plans. An employer is best served if they sponsor both a DB and a DC plan, and those pension professionals who only peddle DC plans to their clients are really doing a disservice to clients. The argument that DB plans are too expensive is highly fallacious, as a DB plan can be designed to be inexpensive and to serve many different purposes. The devil is in the details of the plan design, and that is where an experienced and knowledgeable defined benefit expert can come in handy (such as an enrolled actuary whose forte is designing defined benefit plans).

[richard]

Chester's comment is quite accurate. Unfortunately, small companies cannot afford to have both types of plans, and mid-sized companies often don't think these issues through.

Joel's dissatisfaction with DB plans is unfortunate. In a DB plan, the employer guarantees a benefit amount (calculated by formula based on your service and salary). When an employee terminates employment or retires, he/she IS ENTITLED TO A SPECIFIC BENEFIT AMOUNT, paid monthly or perhaps in a lump sum.

The employer is taking on the risk of insufficient assets (cause often by poor investment performance). In that case, the employer must INCREASE CONTRIBUTIONS AND MAKE UP THE DIFFERENCE.

Conversely, if there is good investment performance, the employer can either decrease contributions OR increase benefits.

Sounds fair, since the employer is taking on the investment risk.

(If you employees would like to have the investment risk and reward, that's called a DC plan. But remember, investments go down as well as go up!)

[Guest Franklin Evans]

Richard's brief comparison of DB and DC is what I was waiting to see, being too lazy to do so myself. I must admit to empathy for the emotional comments being made; I'm now over 4 years removed from day-to-day admin, but I remember well the depth of feelings for one type of plan or another.

That being said, the objective stance to take is really to blame it all on Congress. The laws of the land, but especially tax laws, have never been designed properly or even taken much account of side effects in industry or to citizens as individuals or groups.

I've done everything an admin-type can do for nearly every type of qualified plan, except build one from scratch and sign a Schedule B. I've seen them separately, together and in succession to each other. I believe I can safely say that there are no generalizations possible in plan design or the appropriateness of type of plan. It _depends_ on the employer's attitudes, its industry's stability and potential for growth (or decline!), and only time can tell whether the asset management is good or bad, the employee population will prove the actuary's assumptions about mortality and turnover, or even whether the employer will simply disappear thru merger, takeover or bankruptcy to be replaced by a possibly completely different set of attitudes.

I must respectfully point out that any consultant who pushes his/her "favorite" type of plan or bad-mouths the other type is likely to fail to serve the best interests of a good half of the clients.

[joel]

The DB/DC debate will never be complete without the input of the TIAA-CREF organization. They published a MEMORANDUM more than 25 years ago on the advantages and disadvantages of each approach. This report is as valuable today as it was then. Maybe our moderator can contact TIAA-CREF and get their approval to publish it on this

Board. It was published in 1971 or '72.

[Guest Franklin Evans]

Re: TIAA-CREF "Memorandum" comparing DB and DC plans. Thanks to Joel for the suggestion. I will look into it at the first opportunity.

[joel]

Dear Franklin,

I have a hard copy of the TIAA-CREF MEMORANDUM. Should I mail it to you?

JOEL