A pension plan, which is also referred to as a Defined Benefit (DB) plan, is a retirement plan whereby employees are entitled to a certain amount of money that is kept aside by the employer to cater for a set payout once the employee retires. Defined benefit plans are of two types: traditional pensions and cash balance plans. The pension is dependent on the number of years that one was on the job and the average salary of the last few years before retirement. The cash balance credits the employees’ account with a certain percentage of their salary every year. A cash balance plan is portable, in that it can be transferred into IRA in case one switches employers while the traditional pension is not transferable. Defined Contribution (DC) plans, on the other hand, specifies the amount that an employee will receive for their retirement as soon as he or she joins it. This study will, therefore, be an argumentative essay against the replacement of defined benefit plans with defined contribution plans and later conclude.
Arguments against the Replacement of Pension Checks with Direct Contribution
Employees who are under defined benefit pension do not manage the plan. They normally hire an investment company that is responsible for ensuring that the employees receive their regular payments on retirement and also ensures that they can be able to approximate the amount of funds that they will be receiving as the pension benefits. The employee therefore has no direct involvement in the investments that pertains the plan, (Poterba et al, 2007). The hired company must be an investment company with the capability of making accurate forecasts and with the required knowledge on how to manage the pension plans. The costs associated with hiring the investment company are less compared to the costs that would have been otherwise associated with wrong decision making, failure to receive timely pension payments or failure to adhere to the state laws. The management burden is therefore lifted off the employee at a considerably low cost, unlike in the defined direct plan where the employee is directly involved, (John, 2005).
The amount of money that the retiree receives as pension funds under the defined contribution plan is expressed as a certain dollar amount or a percentage of the employees’ salary. In most cases, the amount is invested in annuities or mutual funds, hence earning little interest. This also calls for more attention in the management of the chosen mutual funds and annuities. The government might lose a lot of money through financial crisis, and at the same time be required to pay out the given figure that it promised its employees. The fact that the amount of funds that will be paid on retirement is quoted as soon as the employee gets employed exposes the government to higher risks in case the figure becomes an impossible amount to disburse. The ongoing debate on the replacement of defined benefit plans with defined contribution plans in the public sector should therefore be replaced with strategies on how to make the current defined benefits program more effective, (Olsen, et al, 2013).
Defined Benefit Plans Can “Assume Away” Risks since Governments Are Long-Lived
The advocates of the replacement claim that continuing to pay pension benefits under the defined benefit plan is risky for the government. There is an incorrect claim that the government will not be able to support the plan in some years to come. However, the affordability of the plan cannot be questioned, since the fact that governments are long lived makes the probability of the risk of underperformance to be in a reducing manner as the years go by. The main problem with the accounting of public pensions is the rate of return that is assumed on investments. This is due to the need to include the risks associated with such investments in the calculations. The assumed rate of return ranges typically from 7.5% to 8%.
It is possible for the pension funds to achieve 8% average returns, but even if they fail to attain, they guarantee the retirees a payment of their pension. This guarantee is not free but has to be incorporated to the costs of the pension plan. Economists have ensured that risk mitigation is taken care of through discounting the future pension liabilities using a risk-adjusted rate of return, which ranges from 3 to 5 percent, unlike the expected rate of 8 percent, (Estreicher & Gold, 2007). However, with the public defined benefits, the economists need not include the calculations as mentioned above because the governments are long-lived and they are multi-generated entities. The risk of underperforming therefore approaches zero in the long run. This means that governments can be able to afford defined benefits plan, in the long run, raising no need of replacing them with defined contribution benefits, (Estreicher & Gold 2007).
DB Plans Replacement Is Cost Inefficient
Some U.S. states have considered a replacement of the defined benefit plan with the defined contribution plan in the recent years. Most states have however concluded that it would cost considerably more to shift to the DC program. Two states that had converted to DC had to partially convert back DB due to the low income that they were producing for their retirees. DC plans are expensive to manage, and it would be better to have a large well-managed DB plan through making the necessary changes to the tax laws. Research has shown that for an efficient $10 billion defined benefit plan to be converted to individual defined contribution plan, accounts that are worth the same value as the initial DB plan would lead to an increase in the cost of the plan by 77%, (Choi, et al, 2004). It would also need an increase on the required contribution rates. The replacement would also lead to a drop of the final benefit accrued from investment returns from 75% to 45%. Replacing the current defined benefit plans would increase the costs of the resultant defined contribution plan, but the ongoing cost of the new defined benefit plan would drop from 77% to 26%, (Olsen et al., 2013). In addition to the increase in the costs of the DC plan that would be used to replace the DB plan, the government, which is the sponsor of the DB plan, would still have to act as the transition sponsor hence being exposed to more risks. It would face an increase in financial risks for many decades for the defined benefit plan that would be parallel with its resultant defined contribution plan. However, the risk will be at a reducing rate as the years go by. Over the first few decades, the government could decide to bear higher costs for the closed pension plan instead of the high risks. This could be realized through partially de-risking the terminated pension plan’s investment portfolio, which would lead to an increase in the costs of running the termination by 38% for the first few decades after the replacement. If costs motivate those advocating for the replacement of the DB plan with the DC, then they should be made to understand that the replacement will increase the costs of delivering the new pension benefit, (Olsen et al., 2013).
Despite Making Changes, States Are Maintaining the DB Pension Plan
A recent study at Boston College by the Centre for Retirement Research focused on states and their pension plans, in the quest to find out whether there have been replacements of the DB with the DC plans. This was done after the country experienced the financial crisis in 2009. The study confirmed that three-quarters of the states’ pension plans had made changes since then. However, these changes did not involve a complete replacement of the DB plan with the DC pension plan. It is only a quarter of the changes that were affecting the current employees while the other changes affected future workers, (Raines, 2012). The changes that affected the current employees were a rise in workers’ contribution and a change in the Cost of Living Adjustment (COLA). These are permissible changes that cannot be compared to the changes such as pension reductions which are the potential results of a complete replacement with defined contribution plan, (Raines, 2012). The changes that affected future employees were diverse depending on the state, with the most common ones being making changes on the benefit multiplier. An increase in the length of service required for one to claim the pension benefits and an increase in the number of years used in the final average salary calculation, (Mitchell et al., 2017).The changes were made as a way of strengthening the stability of the pension plans, in the long run. It is worth noting that most states did not replace their DB with the DC plan since they understood that the DB plan provides the best retirement benefits for the retirees and also that a replacement attracts more costs. Cities that had embraced a defined contribution plan are moving back to the defined benefit plan. For instance, the city of Palm Beach, FL moved back to defined benefit plan in 2016, (Mitchell et al., 2017). This was after a recognition of the value of sticking with the defined benefit plan.
Workers face high penalties in case they want to take an earlier retirement under the defined benefit plan. These costs would be less if the workers were under the defined contribution plan. However, the number of people who request for early retirements is very low. In fact, most workers would continue even after they attain the retirement age as a way of pilling up more funds, if it was possible. With a consideration of the increase in transferring and operational costs associated with the replacement of the direct benefit program with the direct contribution plan, it is worth noting that the transfer costs are higher than the costs associated with early retirement requests, (Bassett, et al, 2008). This claim also represents a smaller percentage of the people, since most of them prefer retiring on time and not before, (Zelinsky, 2004).
The fact that early retirements attract a penalty should not be considered as a disadvantage, this is due to the fact that the defined benefit program offers higher returns than the defined contribution plan. An early retirement benefit under DB even after the subtraction of the penalty would still be larger than an early retirement under the defined contribution plan, (Choi, et al, 2004). The DB plan therefore remains to be the best pension plan that has shown an evident potential of taking care of the retirees needs.
In conclusion, this study agrees with the fact that defined benefit plans are more beneficial that defined contribution plans and should not be replaced. This is because a replacement will only attract more costs and risks. The claim of the high penalties associated with the defined benefit plan in case of a request for an earlier retirement only favors the little number of people that would wish to get earlier retirement. Statistics have shown that the most substantial number of people work until their retirement age, and would therefore not need to face the penalties associated with early retirement under the defined benefit plan.
Bassett, W. F., Fleming, M. J., & Rodrigues, A. P. (2008). How workers use 401 (k) plans: The participation, contribution, and withdrawal decisions. National Tax Journal, 263-289.
Besley, T. J., & Prat, A. (2011). Pension fund governance and the choice between defined benefit and defined contribution plans.
Broadbent, J., Palumbo, M., & Woodman, E. (2006). The shift from defined benefit to defined contribution pension plans–implications for asset allocation and risk management. Reserve Bank of Australia, Board of Governors of the Federal Reserve System and Bank of Canada, 1-54.
Choi, J. J., Laibson, D., & Madrian, B. C. (2004). Plan design and 401 (k) savings outcomes (No. w10486). National Bureau of Economic Research.
Choi, J. J., Laibson, D., Madrian, B. C., & Metrick, A. (2002). Defined contribution pensions: Plan rules, participant choices, and the path of least resistance. Tax policy and the economy, 16, 67-113.
Estreicher, S., & Gold, L. (2007). The Shift from Defined Benefit Plans to Defined Contribution Plans. Lewis & Clark L. Rev., 11, 331.
John, J. K. V. (2005). U.S. Patent No. 6,963,852. Washington, DC: U.S. Patent and Trademark Office.
McClendon, J. K. (2007). The death knell of traditional defined benefit plans: Avoiding a race to the 401 (k) bottom. Temp. L. Rev., 80, 809.
Mitchell, O., Hammond, P., & P, S. (2017). Pension Research Council. Pension Research Council. Retrieved from https://pensionresearchcouncil.wharton.upenn.edu/
Munnell, A. H., Haverstick, K., & Soto, M. (2007). Why have defined benefit plans survived in the public sector?
Olsen, K., & VanDerhei, J. (2013). Defined contribution plan dominance grows across sectors and employer sizes, while mega defined benefit plans remain strong: where we are and where we are going.
Poterba, J., Rauh, J., Venti, S., & Wise, D. (2007). Defined contribution plans, defined benefit plans, and the accumulation of retirement wealth. Journal of public economics, 91(10), 2062-2086.
Rajnes, D. (2012). An evolving pension system: Trends in defined benefit and defined contribution plans.
Zelinsky, E. A. (2004). The defined contribution paradigm.Yale Law Journal, 451-534.