JOEL L. FRANK
Retirement Analyst
PO Box 148
Marlboro, New Jersey 07746-0148
732-536-9472
Email: rollover@optonline.net


MEMORANDUM

September 2006


Public Retirement Planning
“Defined Contribution” and “Defined Benefit” Plans



For more than 40 years the State of New York has administered a Defined Contribution (401(k) type) retirement plan (the Optional Retirement Program) as a primary retirement benefit for the administrative/professional staffs at the State and City Universities, (SUNY-CUNY). In fact this select group of employees is given a choice of plans with the other one being a Defined Benefit pension. The selection is made, not by the state, not by the unions but by the individual. This identical choice of plans should be offered to the entire public employee workforce in New York.

Any intelligent dialogue about solving the multi-billion dollar funding problem of public employee pensions in New York must include a discussion about offering a choice of plans, Defined Benefit or Defined Contribution.

The unions’ position goes something like: “Defined Contribution Plans have a number of attributes that limit their applicability to most state and local public employees, although they are suitable for higher education professionals. Defined Contribution plans place all of the investment risk on the individual. Hence, they are best for employees who can bear that risk because they have other assets and who are knowledgeable about investment alternatives.”

This assertion is utter nonsense and highly insulting to the hundreds of thousands of public employees who do not work for SUNY-CUNY. Prior to allowing the higher education employee to join the Defined Contribution Optional Retirement Program does the state require the employee to file a net worth statement and take a financial literacy test in order to evaluate his or her “knowledge about investment alternatives”? Of course not!

Prior to 1964 higher education employees in this State belonged to a State-administered Defined Benefit pension system just like all other public employees. As a group higher education personnel are more mobile than other career civil servants and, as will be shown in this Memorandum, the Defined Benefit system is hurtful to such employees. The Defined Contribution system, on the other hand, is ideal for the employee who has had several employers during a career of service or just one.

The Defined Contribution plan is not reserved for the higher education community because they have “other assets” and are “knowledgeable about investment alternatives”. Career mobility is the sole reason why higher education personnel are furnished with a choice of plans: Defined Contribution or Defined Benefit. When it comes to choosing the type of retirement plan one size does not fit all. The choice of plan is best left to the individual based on his or her personal circumstances and work pattern. The Defined Contribution approach may very well be “suitable” for the person that cleans the office of the Professor of Greek Mythology but “unsuitable” for the Professor. The State of Florida has come to this conclusion by offering a choice of plans to its entire public employee workforce. http://www.myfrs.com/content/index.html. New York should do the same.

Each type of plan has a different impact on a participant’s total compensation, career mobility, and retirement income.

The Defined Contribution Plan

This type of plan makes its pension commitments to participants in the form of monthly contributions that are a stated percentage of current salary. The employer’s contributions, along with those of the employee, are deposited each month to the individual retirement investment account of each participant, as are the investment earnings on the accumulating contributions. For the Defined Contribution plan illustrated in this Memorandum, contributions are 12% of salary, with 7% paid by the employer and 5% by the employee. (Under the assumptions used, this rate of contribution provides a retirement income of about the same amount as the Defined Benefit plan illustrated after a career of participation.)

During the working years, all funds contributed to a Defined Contribution plan accumulate with investment earnings, and at the time of retirement may be used to provide an annuity income based on the amount of the accumulation. Age, of course, has a material effect on life expectancy and therefore on the rate of monthly pay-out. The younger the age of retirement, the smaller the monthly income per $1,000 of accumulation, because the longer the number of years over which payments will be made.

The Defined Benefit Plan

This type of plan provides that if an employee stays with one employer until retirement, he or she will receive a monthly single-life income equal to a specified percentage of the average salary paid by the employer in the years just prior to retirement, e.g., 50% of final-5-year average salary at age 65, after a career of service. The monthly single-life income is therefore the same for all who have identical salary and service histories. The accumulation needed to pay the income is determined by the age, salary and service of the person.

The Defined Benefit plan in the illustrations that follow provides that for each year of participation the plan will pay a retirement income at age 65 equal to 1.5% of the average salary paid the employee during the final five years of participation in the plan. This formula therefore promises that after 35 years with one employer the participant will receive a retirement income equal to 52.5% of final-5-year average salary.

Pension Contributions as Deferred Compensation

It is revealing to compare the two plans in terms of how much they add to a participant’s total compensation each year. Under the Defined Contribution plan illustrated, employer contributions of 7% of salary are credited to the participant’s retirement account each month along with the participant’s own contributions of 5%. Each month the employer is therefore adding 7% of salary as deferred compensation to each person’s account.

A Defined Benefit plan is more difficult to pin down in terms of how much it adds to a person’s compensation each year. Although employer costs are often expressed as a percentage of salary, e.g., “7% of covered payroll,” this over-all percentage is rarely indicative of the value of pension benefits earned by any individual in the plan. Instead, the cost of the defined benefit earned by a year’s work depends on a person’s age, salary, and years of participation in the plan. If the plan is contributory, participants contribute a stated percentage (5% in the illustration), just as in Defined Contribution plans. But the employer’s share of the cost varies substantially from person to person, adding little or nothing to a younger person’s compensation, and adding a great deal with advancing age and long-term participation in the plan. This is shown in Table I, which illustrates the contribution pattern required to keep each type of plan fully funded for a person who enters at age 30 and stays with one employer until age 65.

Assumptions

All of the Tables are based on the following assumptions:
· Salary is $8,000 a year at age 30, increasing by 4% a year to an average of $28,107 a year between ages 60 and 65.
· The Defined Benefit plan provides that a person who enters at age 30 and stays with one employer until age 65 will receive a retirement income of 52.5% of the final-5-year average salary, or $14,756 a year for life.
· The level contribution rate for the Defined Contribution plan (12% of salary) was selected because under the stated assumptions it too will provide a single life annuity of approximately the same amount at age 65.
· Both plans provide full and immediate vesting and the full accumulation value is assumed to be payable to the participant’s family if he or she dies before retirement.
· Employee contributions are 5% of salary for both plans.
· The investment return is 5% for both plans.

Table I

Contributions as Per Cent of Salary



Employee’s Employee Employer Contribution Employer Contribution
Attained Age Contributions Defined Contribution Defined Benefit
Either Plan Plan
Approach
________________________________________________________________________

30 5% 7% -2.18%
35 5 7 -0.99
40 5 7 1.02
45 5 7 3.86
50 5 7 7.83
55 5 7 13.38
60 5 7 21.06
64 5 7 29.27

Under the Defined Benefit plan illustrated, the younger employee’s own 5% contributions are more than enough, with anticipated interest earnings, to cover the full cost of the defined benefits earned at the younger ages, and to cover most of the cost until nearly age 50. Thereafter, for a participant who remains at one employer throughout a career, the employer’s share of the cost rises rapidly with advancing age and long service, because each year’s pension commitment includes not only (a) the cost of the current year’s 1.5% benefit, based on the most recent five years’ average salary, but also (b) the additional cost of updating all previously earned benefits to the latest 5-year average salary. This results in deferring most of the employer’s pension commitment for an individual to the final years of long service, as shown. For example, in the Table I illustration about 85% of the employer’s cost under the Defined Benefit plan is deferred until after the 25th year of participation, between the participant’s age 55 and 65.

This deferral has the unfortunate effect of making a disproportionate part of a person’s lifetime compensation contingent on age and fealty to one employer. Deferred funding also works to the disadvantage of those who participate at the younger ages but leave the work force during the middle years, say to raise a family. They take little or no deferred compensation with them when they leave, and their re-entry problems, if they later return to work, are exacerbated by the high pension costs at the older ages. A Defined Benefit plan also has worrisome implications for an employer’s budgeting and salary administration, especially during periods of salary inflation. For example, under the Defined Benefit plan illustrated, each salary increase of $1,000 at age 60 carries with it a pension cost of approximately $5,800 between ages 60 and 65.

Death Benefit Prior to Retirement

It is also interesting to compare the amount that accumulates on behalf of each participant during the working years. Under Defined Contribution plans the accumulated funds are payable to the participant’s beneficiary if the participant dies prior to retirement. Under the Defined Benefit system, any employer funding on behalf of an employee is forfeited upon death prior to retirement. The funds revert to the pension plan and help pay the employer’s pension costs for other participants. But Table II shows the combined amounts of accumulated employer and employee contributions at 5-year intervals, and assumes that under both plans the full amount would be payable to the beneficiary or estate of a participant who remains at one employer until the ages shown and then dies.

Table II

Accumulated Death Benefit Prior to Retirement

(Assuming participant remains at one employer until death at age shown)

Age Defined Contribution Plan Defined Benefit Plan
Attained
at Time of Death

30 $ 953 $ 223
35 7,166 1,951
40 16,476 5,621
45 30,066 12,846
50 49,521 26,495
55 76,964 51,545
60 115,225 96,572
64 156,115 156,523


Retirement Income and Career Mobility

The effect of career mobility on the end product of each plan also bears examining. A person who moves among several employers having identical Defined Contribution plans will reach retirement with the same level of retirement income that would have been produced staying at one of the employer’s for an entire career. On the other hand, a person who moves among several employers having identical Defined Benefit plans will reach retirement with substantially less retirement income than by staying at one of these employers for an entire career.

Consider Jack and Jill. Jack is covered from age 30 to age 65 by the 12% Defined Contribution plan illustrated. He will receive $14,718 a year at age 65, or about 52.4 percent of his final-5-year average salary whether he remains at one employer throughout his career or moves among several employers having identical plans.

Jill is covered by the Defined Benefit plan illustrated, and if she stays at one employer from age 30 to age 65 she will receive a retirement income of $14,756 a year, or 52.5% of final-5-year average salary. But if, for example, she changes employers at age 40 and again at age 50, remaining at the third employer until age 65, her retirement income will be $10,246, even though all three institutions have identical Defined Benefit plans and provide full and immediate vesting. This occurs because when she leaves an employer the defined benefits earned at that employer are related to the participant’s 5-year average salary just before leaving, not to the 5-year average salary just before retirement.

The “cold storage vesting” of Defined Benefit plans provides no way for vested benefits to increase between termination of employment and retirement. The calculation is shown below.

Table III

Average Salary
Last 5 years Years
at Each of Yearly Income
Employer x Service x 1.5% = at age 65

Employer 1 $10,543 x 10 x .015 = $ 1,581
Employer 2 15,606 x 10 x .015 = 2,341
Employer 3 28,107 x 15 x .015 = 6,324
Total $ 10,246

Advantages of Each Plan

The main advantage of a Defined Benefit plan is that it assures retiring employees with equal periods of service at a given employer a consistent ratio of retirement income to final average salary. And this ratio (although not the amount of retirement income) is predictable if it can be assumed that the employee will stay with a given employer until retirement.

A major advantage of the Defined Contribution plan is that it adds a consistent and visible percentage of salary to each employee’s total compensation at the time the compensation is earned. If one person’s salary is more than another’s, the deferred compensation is greater by the same percentage, not warped out of proportion by age or length of service. This pattern of funding, unlike a pattern that defers most of the employer’s commitment to the final years of long service, helps keep the pension plan a neutral factor when the person is deciding about joining or leaving an employer (also when the employer is making the decision). Shouldn’t the individual have a full measure of benefits whether staying at one employer or moving among several?

The Defined Contribution plan also has budgeting advantages for the employer. Pension costs are a constant percentage of salary each year. And the employer’s pension obligation for each person is fully and permanently funded at the time the obligation is incurred, not left as an open liability tied to whatever salary levels the future brings.

someone has a lot of free time

Are you enjoying having a discussion with yourself?
You start off with an error of fact. Although section 401(k) was added to the IRC in the mid-1970s, no 401(k) plans were actually adopted until 1980 or so. Originally they were called "salary reduction plans".
Thrift plans were very common among governmental plans in the early 1970s.

vebaguru:
Are the other statements true, in particular the part about defined benefits plans accruing much of the employer's liabilities between the hypothetical participant's ages of 55 and 65?
Also, the part about comparing defined contribution plan totals with 3 different defined benefit plan totals?
Don Levit

This is Joel's pattern, which is why very few get sucked into his "discussions".

Please read my post again, I used the term "401(k) type". I use "401(k) type" because it has become the most popular type of DC plan and most observers would recognize it. Specifically the Plan at hand use to come under section 403(b) but was changed a couple of years ago to section 401(a)

No, on the contrary it took many hours to finish it. I trust I haven't wasted my time in answering you.

Pax: about now you must feel as foolish as vebaguru.

My post was meant to be humorous. Obviously it failed.

Just out of curiousity, did you prepare this for a publication? Or just because you had nothing better to do?

Are you still attempting to be humorous or should I believe you have "a lot of free time"

Don-
Yes, it is true that the lion's share of accruals in a defined benefit plan are within the final few years.

As originally envisioned by Congress, funding of retirement benefits was to be a "3-legged stool" consisting of: (1) Social Security Benefits, (2) An employer-provided pension benefit, and (3) personal savings. Replacement of a defined benefit or fixed contribution DC plan with a 401(k) or similar plan seeks to cut off the second leg and strengthen the third leg of the stool. IMHO, it is not in our best interest as a society to make that change.
A 401(k) plan is an employee savings plan, and employer matches are nothing more than an incentive for employees to save. They cannot substitute for an employer-provided retirement benefit. An elective profit sharing contribution is simply what it is: a sharing of profits with employees based on their achieving certain goals.
DC v DB (or hybrid) for the second leg of the stool is best decided for each employee group based on the funding available and demographics of the group. All groups need all 3 types of benefits. The best thing about 401(k), 403(b) and 457 plans is that they facilitate employee savings. The worst feature of such plans is that they allow employers to pretend that they are doing their part when all they have done is encourage employee savings.

Vebaguru: Please note that in my posted Memorandum both employees may contribute to a voluntary salary reduction plan. The question, however, is which is the superior primary plan, one in which the employER funds the lion's share of the benefit. The answer to this question is best left to the individual. The Optional Retirement Program of the State and City Universities of NY gives this choice to the individual while similarly situated employees in New Jersey are mandated into the DC plan.

Vebaguru:

Except for your first sentence I fail to see how your remarks are responsive to Don Levit's second question: "Also, the part about comparing defined contribution plan totals with 3 different defined benefit plan totals"?

Joel

Joel:
I understand that the typical employee works for each employer about 5 years before moving on.
If that is true, the "typical" employee would seem to benefit much more from a defined contribution plan, than a defined benefit plan.
The defined benefit plan seems to be front-end loaded. With only 5 years at each employer, the employee has little or no chance of accessing the perceived benefits.
It is similar to retiree health benefits that usually do not vest; the benefits are more perceived, rather than real.
Don Levit

This myth persists.
While it can be common for an employee to have 5 jobs in his/her twenties, it is flawed logic (not to mention foolishly ignoring simple observations) to assume that pattern will continue in his/her thirties, forties, fifties, etc. Do you know anyone who has had 4-5 jobs in his/her fifties? I don't.

It is flawed logic to say a DB plan is not beneficial. It is flawed logic to say every employee is savvy enough to do their own investing, or wants to.
Enough!

Don, assuming you are referring to my Memorandum the relevant part states:

"Retirement Income and Career Mobility

The effect of career mobility on the end product of each plan also bears examining. A person who moves among several employers having identical Defined Contribution plans will reach retirement with the same level of retirement income that would have been produced staying at one of the employer’s for an entire career. On the other hand, a person who moves among several employers having identical Defined Benefit plans will reach retirement with substantially less retirement income than by staying at one of these employers for an entire career.

Consider Jack and Jill. Jack is covered from age 30 to age 65 by the 12% Defined Contribution plan illustrated. He will receive $14,718 a year at age 65, or about 52.4 percent of his final-5-year average salary whether he remains at one employer throughout his career or moves among several employers having identical plans.

Jill is covered by the Defined Benefit plan illustrated, and if she stays at one employer from age 30 to age 65 she will receive a retirement income of $14,756 a year, or 52.5% of final-5-year average salary. But if, for example, she changes employers at age 40 and again at age 50, remaining at the third employer until age 65, her retirement income will be $10,246, even though all three institutions have identical Defined Benefit plans and provide full and immediate vesting. This occurs because when she leaves an employer the defined benefits earned at that employer are related to the participant’s 5-year average salary just before leaving, not to the 5-year average salary just before retirement.

The “cold storage vesting” of Defined Benefit plans provides no way for vested benefits to increase between termination of employment and retirement. "

Don, I trust you see the DB participant, Jill, has THREE different employERS with identical DB plans over a 35 year career. Jill, therefore, is entiled to three DB pensions starting at age 65. The total, however, is 69 percent of the single DB pension she would have earned if she had only one of the ERS for her entire 35 year career.

Joel

Pax:
You are correct that the employee changing jobs every 5 years could be a myth.
But, even if the employee changes jobs every 10 years, how would the DB plan balance stack up against the DC plan balance, making this assumption, and assuming the same returns?
Don Levit

Joel:
Thanks for your reply. We apparently posted our responses about the same time.
I wonder if Pax would agree with your figures.
By the way, are cash balance plans a way to help correct the apparent disparities between DB plans and DC plans?
Don Levit

Don,

I am not qualified to respond to your question in a meaningful manner.

Joel

Vebaguru: You answered Don's first question but not the second. Do you intend to answer his second question?

Joel

Don Levit asked Vebaguru: "Also, the part about comparing defined contribution plan totals with 3 different defined benefit plan totals"?

Pax: While we await Vebaguru's answer would you like to respond to this fundamental question?

Joel

Pax:

You knew very well that Don Levit misinterpreted the number of jobs that Jill had in her career but rather than correcting him you insulted him. You insulted him because you want to divert people away from the points made in my Memorandum.

Jill indeed has the inferior plan IF she had three jobs in her 35 year career with each employer having identical Defined Benefit plans.

Moreover, if "it is flawed logic to say every employee is savvy enough to do their own investing, or wants to"; (an assertion that has not been uttered in this thread) is not the "logical" solution to offer a choice of plans, Defined Benefit or Defined Contribution with the employee making the decision?

Vebaguru: Just so you know, 401(k) plans just celebrated their 25th birthday. Would you care at this time to respond in a constructive way to my Memorandum or at least acknowledge that it was YOU, not I, that made "an error of fact" ?

I just read your thread for the first time in several weeks. I am amazed that you are still trying to get people to discuss this topic.
You acknowledge that 401(k) plans began in 1981 rather than the "early 1970s" and then insist that I made the error?
What is a 401(k)-type plan? An individual account profit sharing plan? Those go back a long time before the early 1970s. A 403(b) annuity plan? Those have been in the IRC since 1954. Which 401(k) type plan goes back to the early 1970s?

The first sentence in my Memorandum reads: "For more than 40 years the State of New York has administered a Defined Contribution (401(k) type) retirement plan (the Optional Retirement Program) as a primary retirement benefit for the administrative/professional staffs at the State and City Universities, (SUNY-CUNY)."

In a subsequent quote I said: "Please read my post again, I used the term "401(k) type". I use "401(k) type" because it has become the most popular type of DC plan and most observers would recognize it. Specifically the Plan at hand use to come under section 403(b) but was changed a couple of years ago to section 401(a)"

Now that I have asserted for the second time that the DC Plan at hand first came under section 403(b) and more recently section 401(a) would you now like to reply in a thoughtful way to my Memorandum?

Peace and hope,
Joel L. Frank