Introduction
Employer sponsored retirement plans are broadly classified into two categories; defined benefit pension scheme (DB) and defined contribution plans (DC). As the name suggests, in a defined benefit pension scheme, a defined pension is paid to employees every month/quarter after the retirement till the end of life. On the other hand, in a defined contribution plan, employees and employers contribute and invest funds over time to build a retirement fund. Both the schemes are different from the perspective of who bears the risk, growth opportunities of funds and administration and distribution of funds (JCT, 2002). Defined benefit plans are used by most of the government and public sector companies across the world. However, in recent years, the popularity of defined contribution plans has gone up substantially. Both defined benefit and defined contribution are sound methods of providing income upon retirement. Which out of the two pension plans is better depends on individual circumstances. This paper will discuss the two plans in greater detail, analyzing the benefits and pitfalls of the plans under different circumstances.
Philosophy
The basic philosophy behind any type of retirement option is to build retirement fund for the employees so that they can maintain the current lifestyle and are monetarily covered for any emergency situation post retirement. This can be achieved through savings during the work life. However, empirical evidences suggest that people tend to save less if they are not guided through a structured savings process (Dvorak, 2012). This was the primary reason for retirement benefit models such as defined benefits and defined contribution to evolve.
Defined benefit provides members with lifetime retirement income from the date of retirement till death. In defined benefit, the monthly income is guaranteed (Holzmann, and Palmer, 2006). On the other hand, the philosophy behind defined contribution plan is to help individuals in accumulating retirement savings during their active work life that they can use after retirement. As a philosophy, both the retirement options are sound with the potential to cover post retirement outlays. Traditionally, almost all the organizations used defined benefit as de facto retirement option for the employees. Still defined benefit is offered as the main retirement plan in all public sector and government organizations across the world. However, in recent years, an increasing number of employers are offering defined contribution as the main retirement option to their employees. In the UK, the number of participants in the defined contribution plan has gone up from one million in 2006 to eight million in 2014 (Ezra, 2015). Similarly, in the USA, more than 90% private sectors companies offer defined contribution as their only retirement savings option. Even companies like General Motors whose defined benefit plans were one of the best in the industry have stopped offering new defined benefit plans to the employees.
Contributions
In a defined benefit plan, members and employers contribute a percentage of salary to a retirement fund, which is then used by the employers to pay monthly pensions to the retirees. Companies that offer defined benefit plan are obligated to contribute a defined amount to a retirement pension fund every month. This pension fund is then managed by a professional investment management company (Ezra, Collier and Smith, 2009). In many cases, employers only need to contribute to the members’ lifetime pension funds. However, in many modern defined benefit plans, both employers and employees contribute a set percentage of members’ salary to the members’ lifetime pension funds as part of defined benefit scheme. For instance, in India, the central government employees contribute 12.5% of their salary to their retirement pension funds, which is then matched by every amount by the central government (Holzmann, and Palmer, 2006).
In a defined contribution plan, individuals and employers contribute a set percentage of individuals’ salary. Unlike defined benefit in which money is deposited in a central pension fund account of the employer, in defined contribution scheme, money is deposited in a personal account created in the employee’s name (Ezra, Collier and Smith, 2009). In defined contribution scheme, the percentage contribution made by the employer and the employee is often variable. However, there is a cap on the maximum contribution that can be made towards a defined contribution account. In the USA, 401K is the most common form of defined contribution retirement scheme in which employees can contribute up to $18,000 per year with an option to contribute additional $6,000 as catchup amount (Dvorak, 2012). Employer, on the other hand, matches a percentage of the employee’s contribution to the 401K.
In terms of contribution mechanism, defined benefit plan is better for employees, because the investment risk of the pension fund is totally borne by the employer or the government. On the other hand, defined contribution plans are good from the perspective of employers, because employers only bear the obligation to pay the monthly percentage in the defined contribution account. The investment risk is totally borne by the employees, while employers are not at all responsible for the same. Government organizations typically use defined benefit because the basic philosophy behind the retirement plan in a government organization is to ensure that the employees are able to continue their current lifestyle even after retirement (Dvorak, 2012). On the other hand, private organizations often use the defined contribution method as a means to attract employees, because it is an alternative to salary hike or other forms of benefits. However, private companies do not want to undertake too much financial liabilities on their balance sheet. Therefore, defined contribution is the most popular retirement option among private companies (Shearer, 2004).
Investment Decisions
In a typically defined benefit scheme, the pension fund is managed by the employer. Employers often hire wealth management professionals to manage growth and risks of the pension fund. Since the whole pension fund is managed as a single contribution fund in a defined benefit option, the cost of management of such fund is lower (Holzmann, and Palmer, 2006).
In a typical defined contribution plan, individuals manage their own funds. In many cases, employers offer employees with a wealth management service of their defined contribution account. For instance, Apple offers wealth management solutions for individual 401K account of its employees with a minimal service charge of $50 per year (Ezra, 2015). However, as defined contribution accounts are managed individually, the overall cost of managing such firms is much higher than that of defined benefit funds.
Income at Retirement
In a typical defined benefit plan, the income after retirement is based on the final years of salary and the total number of years served. Once employees start receiving monthly pension after retirement, they receive it throughout their remaining life. Defined benefit plans are well-defined and therefore, it is easy for employees to estimate the amount they will get as pension per month well in advance as there is no market uncertainty influencing the pension scheme (Ezra, Collier and Smith, 2009).
Defined contribution, on the other hand, is also well-defined. The amount of contribution from the employers and employees is well chalked out. However, since retirement accounts are managed individually by the employees and the growth of these retirement accounts is highly influenced by the market conditions, the final value of the retirement accounts is not easily estimable. Therefore, in case of defined contribution, retirement income is not known until the actual retirement happens even through the contribution made by employees and employers to the retirement funds throughout the period of employment is well-defined (Ezra, Collier and Smith, 2009). Even after retirement, individuals need to manage their own funds, which is an expensive affair.
Additional Benefits
Defined benefit plans offer additional benefits to the employees such as inflation protection, early retirement benefits, disability benefits and survivor benefits. In most of the cases in the USA, the retirement pension is paid to a joint account in case of a married member so that the surviving spouse can continue to get 50% of the retirement income even after the death of the primary member (Dvorak, 2012).
Defined contribution plan, on the other hand, does not offer any of the benefits discussed above. However, individuals get the option to buy all those facilities in exchange for a price. After retirement, individuals continue to manage their retirement funds. Although they have the option to opt for an annuity, which will convert their retirement fund into a regular monthly income, many individuals do not opt for the same often ending up to spend most of their accumulated funds well before their death (Shearer, 2004).
Conclusion
It is difficult to conclude which out of the two pension schemes is a better option. However, the above discussion makes it clear that from the perspective of employees, defined benefit is a better retirement scheme as it provides a secure and risk free retirement pension per month irrespective of market performance. Defined contribution is a risky option for employees as they need to assume the risk associated with their own retirement funds. From the perspective of employers, defined contribution is a better option as the total liability of managing the retirement funds is passed on from the employer to the employee in this case. Employers do not need to bother about managing huge pension funds and market movements. From the philosophical viewpoint, government organizations should continue to provide defined benefit option as they are more concerned about the welfare of their citizens rather than the organizational profitability. On the other hand, private organizations will continue to offer defined contribution as they do not want to assume additional liabilities associated with retirement benefits.
Bibliography
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Ezra, D., Collie, B. and Smith, M. (2009). The retirement plan solution. Hoboken, N.J.: Wiley.
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