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Defined Benefit vs. Defined Contribution Debate

There are two types of pension plans -- defined benefit (DB) and defined contribution (DC). Historically, public sector plans have been predominately DB plans. However, in recent years, some public sector jurisdictions have imposed DC plans on their employees, and there have been unsuccessful efforts to convert to DC, or hybrid DB/DC plans, in other public sector jurisdictions.

Why Some Jurisdictions Have Considered DC Plans

• Employee Choice

  DC plan proponents claim that these plans offer employee control over their own investment choices. While this may be true, a major concern with DC plans is whether all employees have the ability to invest their funds wisely. Employees in DC plans bear all of the investment risk and poor investment choices will likely result in inadequate retirement savings. Proponents of DC plans also claim that these plans allow employees to engage in social investing. However, not all DC plans include "socially responsible" investment options.
  
  

• Portability

  DC plan proponents point out that these plans offer portability and that portability is crucial these days because job tenure has decreased over the years. However, numerous studies of job tenure dispute this argument and even show that job tenure has increased over the years, particularly for public-sector employees.
  
  

• Cost Control

  The motivation behind most DC proposals is controlling employer costs. Although concern over underfunding is often cited, on average, state and local DB plans are over 85% funded and future DB plans are not difficult to budget. Additionally, employers often face high costs when converting from DB to DC coverage such as funding both the old DB and new DC plans simultaneously.
  
  

• Cost Shifting

  Although the financial service industry claims that DC plans save money, they are actually more expensive to administer than DB plans. The difference is that employees pay much of the costs (investment, actuarial, and administrative fees) of DC plans, while these costs are paid by the employers in DB plans. A good example of cost differences was provided in a report issued by the Director of the Illinois Municipal Retirement Fund (IMRF). This concluded that the combination investment management and administrative costs of DC plans are four times as high as those same expenses in DB plans.
  
  

The Public Policy Question

• DB plans are better public policy. The basic purpose of a retirement system is to provide a secure and predictable level of income for former employees after retirement. DB plans do this. Under DC plans, individuals who were unable to make substantial contributions, fare poorly in investing their funds, or
  
  
• who outlive their retirement benefit may use more social services and need governmental financial assistance in their retirement years, offsetting any perceived "savings" to taxpayers. Conversely, such employees may be forced to stay employed longer at a higher salary, preventing upward movement of young, lower paid workers.
  
  
• DC plans allow terminating employees to access their savings prior to retirement and most allow lump sum payments upon retirement. If these distributions are poorly invested, or spent, the individual could be left without adequate retirement income.
  
  

Alternatives to Switching to a DC Plan

• Portability issues can be addressed within a DB plan by shortening vesting periods, implementing reciprocity agreements, allowing buybacks for prior and related service, including a money purchase component to a DC plan, in the DB plan (hybrid plans) and/or indexing benefits to active employees pay raises or inflation for vested employees who take a discontinued service annuity.
  
  

Arguments That Apply to Public Sector Plans

• A DB plan is the most effective means of providing retirement income to long-service employees. Public sector workers tend to stay with the same employer for longer periods of time than do private sector workers, often for their entire career. The limited possibility of earning high wages in the public sector is somewhat offset by retirement economic stability.
  
  
• Because many public sector employees are not covered by Social Security, a DB plan may be the only retirement coverage available to them that guarantees a lifetime benefit with automatic cost of living increases. DC plans do not guarantee a specific benefit and are unable to provide cost of living increases.
  
  
• Increasing federal regulation of DB plans has encouraged many private sector employees to switch to DC plans. However, most of these regulations do not apply to public sector plans.
  
  
• Employers with DB plans can offer early retirement incentives when downsizing or privatization of the workforce is desired. Early retirement incentives cannot be provided under a DC plan.
  
  

Is There Ever A Case for Defined Contribution Plans?

There are advantages to adding a DC plan as a supplement to a DB plan. Employees who have the resources can choose to augment their retirement package by contributing to the DC plan. However, standing alone, DC plans do not provide retirement security. Plan sponsors and legislators may look to DC plans as a quick fix to funding their employees’ retirement. We should be cautious not to let a decent retirement plan slip away for the benefit of non-career employees, or for the benefit of those simply attempting to reduce spending on public employee benefits.

For more detailed information on the defined benefit/defined contribution debate, contact the Department of Research and Collective Bargaining Services at 202/429-1215.

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