They say in fashion, given enough time, old styles become popular again. Today’s headlines appear to claim the defined benefit (aka pension) plan as the “new” style for employers to consider. But defined benefit (DB) plans have been around for a very long time. Most people are familiar with a defined contribution (aka 401(k)) plan as the “current” style.
So what fashion statement is the proper one for you or your clients? Let’s take a tongue-in-cheek look at the five major differences between a DB and a DC plan as if they were fashion movements. It’s a fun way to discuss with employers what style (plan design) might fit them best based on their own preferences and circumstances.
1. Benefit Determination
DB Plans: The plan document “defines a benefit” which the employee receives monthly in retirement. It’s based on a formula generally using a combination of an employee’s length of service, an accrual percentage rate or a fixed dollar amount, and a compensation average.
To illustrate, let’s use a benefit accrual equal to 2% of average compensation multiplied by accumulated years of service. An employee retiring with 30 years of service and averaging $80,000 would receive lifetime payments of $4,000 per month (2% x 30 x 80,000/12).
DC Plans: The plan document “defines a contribution” which is placed in individual accounts set up for each employee. The contributions can be funded by employees through payroll deduction or by employers through matching or non-elective (aka profit sharing) contributions. Employees generally choose how to invest their individual accounts from among options provided by the employer.
To illustrate, an employee elects to defer 6% of her pay into the plan and her employer matches those deferrals dollar for dollar up to 5% of compensation. If she makes $80,000, her individual account for the year will have $4,800 (80,000 x 6%) in deferral contributions and $4,000 (80,000 x 5%) in matching contributions.
Fashion Tip: Think of the DB plan as the little black dress; stable and reliable. In contrast, a DC plan is like the latest fashion trend: it may be a hit or bust depending upon contribution amounts and investment earnings. In addition, DB plans have more perceived value for employees who intend on staying at one employer for a long time. A DC plan generally works better for employees who may have many jobs in their career.
2. Retirement Income Responsibility
DB Plans: The employer is responsible for ensuring sufficient funds are available to pay all retirement benefits. Employers sponsoring DB plans hire an actuary to calculate the amount of assets needed to ensure benefits can be timely paid. Factors include likely retirement ages and mortality assumptions. In addition, most private employers must pay premiums to the Pension Benefit Guaranty Corporation (PBGC) – a government entity established by ERISA – to insure private sector DB plans.
DC Plans: The employee is responsible for ensuring sufficient funds are available for financial security in retirement. The contributions made to the individual accounts experience market gains and losses from investments picked by the employees. If the employee selects funds that have significant investment losses prior to retirement, there will be fewer funds available as a source of income in retirement.
Fashion Tip: Retirement income responsibility is similar to raising a teenager. Sponsoring a DB plan is like being a parent to a teenage boy. It is your responsibility to fill his closet with nice clothes or he will wear the same hoodie and shorts for every occasion. Sponsoring a DC plan is like being a parent to a teenage girl. She is responsible for filling her own closet with all fashion needs. Whether the transfer of responsibility from employer (DB plan) to employee (DC plan) is a good thing depends upon whether you are the employer or employee.
3. Employer Contributions
DB Plans: As the employer is responsible for paying the retirement benefits, required annual contributions may be needed to ensure sufficient funds are available for paying the benefits. An actuary generally determines the amount of required contributions, and it may fluctuate each year based on investment performance and other factors.
DC Plans: There is no requirement that the employer contribute at all to a DC plan. A DC plan may be established which just allows employees to make contributions through payroll deduction. On the other hand, the employer may wish to provide a matching or non-elective contribution. These contributions may be fixed in the plan document or discretionary.
Fashion Tip: Employer funding is like deciding between custom tailored clothes or buying off the rack. Like custom tailoring, you must spend more for a DB plan, but you know what you are getting. DC plans are like buying off the rack clothes. The fit is good, prices are better, you can get rid of it easily, but it may not last as long. DB plans generally work better for businesses with a steady revenue stream due to the required contributions. DC plans work better for businesses with fluctuating or uncertain revenue streams due to the discretionary nature of contributions.
4. Distribution Options
DB Plans: The retirement benefit is usually paid as a monthly benefit for the employee’s life and possibly for the employee’s spouse’s life, if married. Some DB plans, especially cash balance plans, allow employees to take the retirement benefit as a lump-sum distribution. In addition, DB plans may offer employees the ability to receive a distribution while still working if the employee is over the age of 59 ½.
DC Plans: The retirement benefit is usually paid as a lump-sum distribution. Although not required, some DC plans allow installment payments or payments for the employee’s life. In addition, many DC plans allow employees to access their individual account while still employed. In-service distributions are generally permitted upon the attainment of age 59 ½, occurrence of a hardship, or other unique circumstances.
Fashion Tip: Evaluating the distribution options is like choosing between the big, puffy ski jacket or dressing in layers. The DB plan is a big, puffy jacket. The retirement benefits may work well, but if conditions change while you are still employed, you likely have to wait until you are no longer working to receive any benefit. In contrast, the DC plan is like dressing in layers. You are saving for the future, but if conditions change while employed, you possibly have an in-service distribution option available to access funds – similar to taking off a layer or two.
5. Administration Complexity and Cost
DB Plans: There can be many costs and expenses associated with a DB plan:
- Hiring an actuary to determine funding and contribution amounts.
- Paying required contributions timely to avoid penalties and interest.
- Calculating and paying PBGC premiums timely to avoid penalties.
- Performing annual discrimination testing and filing a Form 5500, which likely includes hiring a third party administrator (TPA) to handle.
DC Plans: An employer controls the level of complexity in DC plans, which in turn controls the level of administration and costs. Although an actuary is not required, an employer should still assess other potential hires and expenses:
- Hiring a recordkeeper to maintain individual accounts for the employees.
- Timely paying of either fixed or discretionary contributions.
- Hiring a financial advisor or consultant to assist in selecting the available investment options.
- Performing annual discrimination testing and filing a Form 5500, which likely includes hiring a third party administrator (TPA) to handle.
Fashion Tip: The difference in administering a DB or DC plan is like shopping at a fashion boutique instead of online. Like a fashion boutique, a DB plan involves more assistance and can be costly. But you will also be in the latest looks at all times. A DC plan is like shopping online. You choose how much you are going to spend and what you think is “in” right now. Some items may hit the mark and others may be a bust.
Which Fashion Style Is Best For You?
DB plans used to be the predominant fashion design. However, over time DC plans have become the popular choice for many. According to the Investment Company Institute, among all private-sector workers having access to a retirement plan in 2021, 15% had access to a DB plan, 65% had access to a DC plan, and some had access to both.
Just to be clear, an employer is not limited to choosing between a DB or DC plan. There may be situations where you can utilize both plans to maximize benefits for both the employer and employees.
Is it time to re-visit these DB plan features to see if it is the right style for a given employer? Or do DC plans continue to be the best style for most? More importantly, is it time yet for me to dust off my flannel shirt and overalls from the 90s?
About The Author
Brian Furgala is Senior Director, Retirement Services Strategy for PenChecks Trust, a leader in outsourced retirement plan distribution processing and Automatic Rollover/Missing Participant IRAs and related services. His broad experience as an ERISA attorney and senior executive for several leading retirement plan service providers gives him a unique perspective on the industry.
The views expressed in this article are those of the author and do not necessarily represent the views of PenChecks Trust®, its subsidiaries or affiliates.
0 Comments