Are defined Benefit plans still a good option?

Traditional defined benefit pension plans have taken a backseat--in perception if not in reality--to their defined contribution counterparts for the better part of the past two decades. The defined contribution revolution started with the passage of the Revenue Act of 1978, which added Section 401(k) to the Internal Revenue Code.

When the regulations were issued in 1981, employers added matching 401(k) plans to their portfolio of benefits, which increased the ability of individuals to save on a tax-sheltered basis. And defined contribution plans were much easier for employees to understand (and appreciate) than defined benefit plans.

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So, despite the fact that defined contribution plans placed greater responsibility for retirement planning and savings on their backs, employees reacted positively to them.

Little wonder, then, that employers gradually moved from defined benefit plans in favor of defined contribution plans, a trend that has led some to ask: Are defined benefit plans still a good option?

The answer is yes, though defined benefit plans face some serious challenges these days as contribution requirements escalate sharply and the plans remain something of a mystery to the average employee.

Defined benefit plans are an important element of an overall retirement strategy that meets business, human resource and employee needs. A well-designed and well-communicated defined benefit plan creates substantial value for both employer and employee, and can be a source of competitive advantage for the employer.

EMPLOYEE PREFERENCES

One factor that fueled the move from defined benefit plans was the belief of many employers that employees preferred defined contribution plans. Recent research from the Society of Actuaries and AARP shows this is more myth than fact.

The Society of Actuaries indicates that employees with defined benefit plans prefer them over defined contribution plans, while the AARP research shows that disappointing losses in 401(k) plans are forcing more senior employees to postpone retirement, thus, 401(k) plans that once were attractive have exposed their down side thanks to the recent bear market.

This research is consistent with the experiences of employees who have moved from defined benefit plans to defined contribution plans. When given a choice between the old defined benefit plan and the new defined contribution plan--or a hybrid plan, such as a cash balance plan--employees often choose the old plan.

A substantial portion of the work force frequently views traditional defined benefit programs as competitive with or even superior to hybrid or defined contribution plan designs, especially if the employer clearly communicates the defined benefit plan's benefits.

Employee preference for defined contribution plans or traditional defined benefit plans is often driven by their demographic profile. Employees at different ages and stages of life benefit much more from one plan type than the other.

For young employees who won't stay long with an employer, defined contribution plans (or cash balance plans) are generally better than traditional defined benefit plans. For employees who remain at a job longer, the reverse is generally true--a defined benefit plan can build value over time.

Since most employers have a diverse group of employees, it makes sense to offer different plan types to ensure that all employees' needs are met. Relying on just one type of plan can mean that many employees will receive inadequate retirement benefits.

DEFINED BENEFIT ISSUES

Despite the significant value creation of defined benefit plans, the following are some issues that need to be considered.

* Volatile contribution requirements. Volatility results from employers making just the minimum required contribution and investing in equities. But plan sponsors can help stabilize contributions by either making higher contributions that create a cushion for contribution requirements or investing primarily in fixed income securities.

However, while higher contributions divert cash to the pension plan that is not available for other employer purposes, those contributions may lower the long-term cost of the plan if its assets experience a higher tax-adjusted return than the marginal use of cash within the organization (or if the return is higher than the marginal cost of borrowing for the employer).

Fixed income investments are likely to lower the long-term return of plan assets, thus raising the cost, but generally lessening volatility.

* Volatile expense levels. There are many accounting methods for smoothing volatile expense, but potential accounting changes may reduce or eliminate this flexibility. Should this happen, the alternatives would probably be changes in investment policy to match assets with liabilities or living with volatile expense levels.

* Unfunded liabilities. These can be minimized by better funding policies, plan design and investment policies. Employers that fund the absolute minimum should not be surprised when unfunded liabilities develop.

* Pension plans cost too much. Many executives had thought that there was no cost to defined benefit plans, but we know better today. Providing a secure retirement income is an expensive proposition, whether it is done by the individual or through a pension plan. But what must be recognized is that the cost can be up to 50 percent less in a defined benefit plan. Those who believe that defined contribution plans cost less may fail to recognize that they also deliver much less retirement income.

* Pension Benefit Guaranty Corporation premiums. Let's keep this cost in perspective. If the plan is well-funded, the annual cost is only $19 per person. Higher variable premiums can be avoided by funding the plan well.

* Lack of portability. Complete portability implies that people are indifferent to whether they stay with an employer or leave. That is usually the way a defined contribution plan works once a participant is vested. Defined benefit plans have less portability.

* No early access to funds. Research shows that less than 40 percent of early distributions from qualified plans are rolled over to other retirement vehicles. Defined benefit plans that retain funds until retirement are accomplishing their goal much better than plans with early distribution.

* Complex administration. Some plans are difficult to administer, but this is often a result of complex design chosen by the plan sponsor. Straightforward plan design can simplify administration and enhance employee appreciation.

* Lack of understanding and appreciation. The typical defined contribution plan provides quarterly print statements and online access to account balances so employees can view and reallocate their account balances daily. The typical defined benefit plan gives an annual estimate of the benefit payable at age 65. Is it any wonder that most employees know more about their defined contribution plan? Defined benefit plans need to evolve to the Internet age with frequent access to benefit accruals and projections.

DECISION FACTORS

It's easy to understand why defined contribution plans have become very popular and widely accepted since their creation some two decades ago. Employers like them because of the lack of volatility in cost, the perceived low cost relative to defined benefit pension plans and the lack of complex administration. In addition, the employer has no potential for unfunded liabilities and no balance sheet impact.

Employees usually like defined contribution plans because they are very visible, easier to understand than traditional pension plans and portable. In addition, they typically give employees control over investments.

So what makes a defined benefit plan a good choice from the employee perspective?

Defined benefit plans deliver more consistent benefits to employees and provide a source of steady retirement income with virtually no risk to the employee. The benefit level does not depend on the individual's investment abilities. Participants who lack the time, knowledge, skill or simply the luck to be good investors are not disadvantaged in a defined benefit plan. Perhaps most important, defined benefit plans pool the longevity risk, allowing the retiree to spend the income without fear of outliving his or her assets.

Employers should consider the following factors when considering whether to offer or keep their defined benefit plan:

* Industry practice: Companies in some industries are more likely to offer defined benefit plan, so offering one becomes a matter of remaining competitive for talent.

* Company size: Defined benefit plans are prevalent among the largest companies (10,000 or more employees) and quite common among midsize companies. Again, offering a defined benefit plan may be necessary to compete effectively for talent.

* Employee age and tenure: Defined contribution plans tend to appeal to younger, shorter-service employees, while older, longer-service employees find greater value in defined benefit plans. That's why it's important to consider the composition of your work force.

* Attraction and retention issues: Because they encourage longer service, defined benefit plans can help lower turnover and its associated business costs.

* Work force management issues: Market performance and employee investment ability play a major role in capital accumulation through a defined contribution plan. The unfortunate result is that employees sometimes cannot afford to retire--and that can lead to work force management issues for the employer.

The defined benefit vs. defined contribution debate really is not an either/or proposition. It's important to keep in mind that defined benefit plans are most effective when they complement a defined contribution plan. The combination of the two helps a diverse group of employees attain financial security.

In today's competitive labor market, most--if not all--employers need a competitive 401(k) or comparable plan. But relying on a defined contribution plan as the sole retirement vehicle will be expensive and inefficient for employers who want to encourage lower turnover, facilitate retirement of older workers and create value for their employees.

Employers who balance the two well will see lower overall employment costs and a more productive work force.

CHANGES ARE NEEDED

Defined benefit pension plans can create value and help Americans attain an economically secure retirement. And while they are highly desirable, the deferred nature of the benefit, the employer risks associated with the plans and the complex regulations and funding requirements have contributed to the steady decline of worker participation in these plans.

To guard against this decline, employers can develop a well-designed and well-communicated defined benefit plan that helps more employees understand the plan and achieve a financially secure retirement.

BY DONALD E. FUERST, FSA, AND RUSSELL S. PROCTOR, FSA

Donald E. Fuerst, FSA, and Russell S. Proctor, FSA, are senior retirement consultants with Mercer Human Resource Consulting. They can be reached at [e-mail] and [e-mail].