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Choosing between Defined Benefit Plans & Defined Contribution Plans. Jon Forman Alfred P. Murrah Professor of Law University of Oklahoma August 15, 2005. Overview. Background Types of Plans Comparisons between Defined Benefit and Defined Contribution Plans. Background. Social Security

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Choosing between defined benefit plans defined contribution plans l.jpg

Choosing betweenDefined Benefit Plans &Defined Contribution Plans

Jon Forman

Alfred P. Murrah Professor of Law

University of Oklahoma

August 15, 2005


Overview l.jpg
Overview

  • Background

  • Types of Plans

  • Comparisons between Defined Benefit and Defined Contribution Plans


Background l.jpg
Background

  • Social Security

  • Poverty Levels

  • Aging of America


How much does social security pay l.jpg
How Much Does Social Security Pay?

www.ssa.gov/OACT/COLA/colaeffect.html


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How do Social Security benefits compare to earnings?

Retired worker age 65, 2005

National Academy of Social Insurance,

Social Security Finances: A Primer (2005)


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American Academy of Actuaries (2005), available at <http://www.actuary.org/pdf/socialsecurity/medicare_socsec_briefing_april05.pdf>.


2005 poverty levels l.jpg
2005 Poverty Levels <http://www.actuary.org/pdf/socialsecurity/medicare_socsec_briefing_april05.pdf>.

  • Single individuals – $9,570 ($798/month)

  • Married couples – $12,830 ($1,070/month)

http://aspe.hhs.gov/poverty/05poverty.shtml


Aging of america l.jpg
Aging of America <http://www.actuary.org/pdf/socialsecurity/medicare_socsec_briefing_april05.pdf>.

  • Americans are living longer but retiring earlier

  • Life expectancy for a male born in 1940 was just 61.4 years

    • today it is 73.9 years

  • Also, a man reaching age 65 in 1940 could expect to live another 11.9 years

    • but a man reaching 65 in the year 2000 could expect to live another 15.9 years


Aging of america9 l.jpg
Aging of America <http://www.actuary.org/pdf/socialsecurity/medicare_socsec_briefing_april05.pdf>.

  • Increasing percentage of Americans will survive to old age.

    • For example, although just 54 percent of men born in 1875 survived from age 21 to age 65 in 1940

    • Almost 83 percent of men born in 1985 are expected to survive from age 21 to age 65 in 2050

  • A graying of America


Aging of america10 l.jpg
Aging of America <http://www.actuary.org/pdf/socialsecurity/medicare_socsec_briefing_april05.pdf>.

  • Trend toward earlier and earlier retirement

  • Average age at which workers begin receiving their Social Security retirement benefits fell

    • from 68.7 years old in 1940 to 63.6 years old in 2002

  • Labor force participation rates for the elderly have also dropped


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Bureau of Labor Statistics, Labor Force Statistics from the Current Population Survey: Civilian Labor Force Participation Rate (2004),

available at <http://data.bls.gov/labjava/outside.jsp?survey=ln>.


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Three Basic Types of Plans Current Population Survey: Civilian Labor Force Participation Rate (2004),

  • Defined benefit plans

  • Defined contribution plans

  • Also, hybrid plans


What is a defined benefit plan l.jpg
What is a Defined Benefit Plan? Current Population Survey: Civilian Labor Force Participation Rate (2004),

  • Employer promises employees a specific benefit at retirement

  • To provide that benefit, the employer makes payments into a trust fund and makes withdrawals from the trust fund

  • Employer contributions are based on actuarial valuations


Defined benefit plan l.jpg
Defined Benefit Plan Current Population Survey: Civilian Labor Force Participation Rate (2004),

  • Employer bears all of the investment risks and responsibilities

  • Typical plan provides each worker with a specific annual retirement benefit that is tied to the worker’s final average pay and number of years of service


Defined benefit plan15 l.jpg
Defined Benefit Plan Current Population Survey: Civilian Labor Force Participation Rate (2004),

  • For example, a plan might provide that a worker’s annual retirement benefit is equal to 2% times years of service, times final average pay

  • B = 2% × yos × fap

  • Final-average-pay formula


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Defined Benefit Plan Current Population Survey: Civilian Labor Force Participation Rate (2004),

  • Worker with 30 years of service would receive 60 percent of her pre-retirement earnings

  • Worker earning $50,000 would get $30,000-a-year pension

    • B = $30,000 = 60% × $50,000 = 60% × fap = 2 percent × 30 yos × $50,000 fap


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Defined Benefit Plan Current Population Survey: Civilian Labor Force Participation Rate (2004),Effect of inflation on real value of retirement income


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Defined Benefit Plan Current Population Survey: Civilian Labor Force Participation Rate (2004),

  • Benefits are “backloaded”

  • Disproportionately favor older workers


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Only 3 ways to fix an underfunded Defined Benefit Plan Current Population Survey: Civilian Labor Force Participation Rate (2004),

  • Raise Contributions

  • Cut Benefits

  • Increase Investment Returns


What is a defined contribution plan l.jpg
What is a Defined Contribution Plan? Current Population Survey: Civilian Labor Force Participation Rate (2004),

  • Individual account plan

  • Employer typically contributes a specified percentage of the worker’s pay to an individual investment account for the worker

  • Owned by employee

  • Benefits based on contributions and investment earnings


Defined contribution plan l.jpg
Defined Contribution Plan Current Population Survey: Civilian Labor Force Participation Rate (2004),

  • For example, employer might contribute 10% of annual pay

  • Under such a plan, a worker who earned $30,000 in a given year would have $3,000 contributed to her account

    • $3,000 = 10% × $30,000

  • Benefit at retirement based on contributions, plus investment earnings


Defined contribution plan22 l.jpg
Defined Contribution Plan Current Population Survey: Civilian Labor Force Participation Rate (2004),

  • Money purchase pension plans

  • 401(k) and 403(b) plans

    • allow workers to choose between receiving cash currently or deferring taxation by placing the money in a retirement account

  • Profit-sharing plans & stock bonus plans


What is a hybrid plan l.jpg
What is a Hybrid Plan? Current Population Survey: Civilian Labor Force Participation Rate (2004),

  • “Hybrid” plans mix features of defined benefit and defined contribution plans

    • For example, a cash balance plan is a defined benefit plan that looks like a defined contribution plan

    • Cash balance plans accumulate, with interest, a hypothetical account balance for each participant


Hybrid plan l.jpg
Hybrid Plan Current Population Survey: Civilian Labor Force Participation Rate (2004),

  • For example, a simple cash balance plan might

    • allocate 10% of salary to each worker’s account each year

    • and credit the account with 7% interest on the balance in the account

  • Under such a plan, a worker who earned $30,000 in a given year would get an annual cash balance credit of $3,000

    • $3,000 = 10% × $30,000

  • Plus an interest credit of 7% of the balance in her hypothetical account as of the beginning of the year


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Hybrid Plan Current Population Survey: Civilian Labor Force Participation Rate (2004),

  • Another common approach is to offer a combination of defined benefit and defined contribution plans

  • For example, many companies with traditional defined benefit plans have recently added 401(k) plans


Comparisons l.jpg

Defined Benefit Plans Current Population Survey: Civilian Labor Force Participation Rate (2004),

Benefits determined by set formula (e.g., 2% × years of service × final average pay)

Funding flexibility

Defined Contribution Plans

Benefits determined by contributions and investment earnings (e.g., 10% × annual pay)

Possible discretion in funding

Comparisons


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Defined Benefit Plans Current Population Survey: Civilian Labor Force Participation Rate (2004),

Reward older and long service employees (backloaded)

Financial penalties for working past normal retirement age

Defined Contribution Plans

Significant accruals at younger ages

No disincentives for working past normal retirement age

Comparisons, cont.


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Comparisons, cont. Current Population Survey: Civilian Labor Force Participation Rate (2004),

Based on Ron Gebhardtsbauer, testimony before the Senate Committee on Health, Education, Labor, and Pensions (September 21, 1999)


Comparisons cont29 l.jpg

Defined Benefit Plans Current Population Survey: Civilian Labor Force Participation Rate (2004),

Long vesting period (e.g., 5 years)

Employer bears the investment risk

Employee has no investment discretion

High rates of return

Defined Contribution Plans

Often a short vesting period (e.g., 1 year)

Employee bears the investment risk

Employee has investment discretion

Lower rates of return

Comparisons, cont.


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Defined Benefit Plans Current Population Survey: Civilian Labor Force Participation Rate (2004),

Often not portable

Require actuarial valuation

Relatively low employee understanding and appreciation

Defined Contribution Plans

Portable

Does not require actuarial valuation

Relatively high employee understanding and appreciation

Comparisons, cont.


Comparisons cont31 l.jpg

Defined Benefit Plans Current Population Survey: Civilian Labor Force Participation Rate (2004),

Unfunded liability exposure

Provide benefits targeted to income replacement level

Defined Contribution Plans

No unfunded liability exposure

Do not provide benefits targeted to income replacement level

Comparisons, cont.


Comparisons cont32 l.jpg

Defined Benefit Plans Current Population Survey: Civilian Labor Force Participation Rate (2004),

Usual form of benefit payment is monthly income (annuity)

Employees cannot borrow

Defined Contribution Plans

Usual form of benefit payment is lump-sum distribution

Employees may be able to borrow

Comparisons, cont.


Possible transitions from a defined benefit plan to a new plan l.jpg
Possible Transitions from a Defined Benefit Plan to a New Plan

  • Keep the traditional DB plan and add a supplemental DC or hybrid plan

  • Offer both a DB plan and a new plan

  • Close entry to the DB plan and add a new plan


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Possible Transitions, cont. Plan

  • Close entry to the DB Plan, add a new plan, and shift unvested employees to the new plan

  • Freeze the DB Plan at current salary levels and add a new plan

  • Terminate the current DB plan and replace it with a new plan


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Goals for a Pension Plan Plan

  • First, ensure that every employee earns a meaningful retirement benefit

    • and that long-time employees are guaranteed an adequate income throughout their retirement years

  • Second, have a minimum of work disincentives for employees coming in and out of service

  • Third, be affordable and well-financed


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Selected Sources Plan

  • Jonathan Barry Forman, Public Pensions: Choosing Between Defined Benefit and Defined Contribution Plans, 1999 (1) Law Review of Michigan State University Detroit College of Law 187-213 (2000).

  • Jonathan Barry Forman, Making Pensions Work, in New York University Review of Employee Benefits and Compensation, Chapter 5, pp. 5-1 to 5-60 (Alvin D. Lurie ed., 2004).

    • Both at http://www.law.ou.edu/profs/forman.shtml


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