Befined Benefits vs Defined Contribution

Why Defined Benefit Plans Provide Retirement Security

All our public pension and Taft-Hartley funds are defined benefit (“DB”) funds, which guarantee a participant a pension for as long as he/she and his/her spouse are alive. The amount of the pension is generally based on a formula which takes into account a participant’s final average earnings, age at retirement and years of service.

The purpose of a defined benefit fund is to provide employees who retire with as much replacement income as possible for as long as they live. This places on the employer – and not the employee -- the burden of ensuring sufficient assets to pay this pension. The employer meets this obligation by making sufficient contributions to the fund. The fund then makes prudent investments of the fund’s assets and regardless of how well these investments perform, the obligation to fund the guaranteed pension benefits rests with the employer.

Why Defined Contribution Plans Put Our Members’ Retirement At Risk

Unfortunately many employers are trying to shift the burden of paying for retirement benefits onto their employees by shifting from defined benefit plans to defined contribution (“DC”) plans. In a defined contribution plan, an employer contributes each year a percentage of an employee’s salary into a 401(k)-type individual account and leaves it up to the employee the responsibility of investing these assets prudently. If an employees’ investments do not turn out well, or if the employee retires during a period of declining stock values, or if the employee outlives the value of his assets, then the employee is stuck without a core retirement income, and risks becoming a member of the elderly poor.

According to a leading benefits consulting firm, the returns achieved by DC plan participants have lagged defined benefit plan investments’ returns by 2% annually. (Click here for a detailed analysis of the performance problems of DC Plans). Lest anyone mistake this rate of underperformance for a small number, note that $100,000 invested at 10% for thirty years grows to $1,744,940, while the same amount invested at 8% for thirty years grows to only $1,006,266. The missing 2% compounds to nearly three-quarters of a million missing dollars for a hypothetical investor with a 30-year time horizon, roughly the average time between mid-career and mid-retirement for today’s long-lived individuals.[read the research]

Defined Benefit Plans Provide Supplemental Benefits, Defined Contribution Plans Don’t

Most defined benefit plans provide supplemental benefits, including early disability, cost of living adjustments, retiree health coverage, and death benefits. Most defined contribution plans provide no such benefits.

The Attack on Defined Benefit Pension Plans

Some employers are increasing their attack on the retirement security of our members by advocating and lobbying for the conversion of defined benefit pension plans to defined contribution pension plans. In the public sector this attack is led by the American Legislative Exchange Council (ALEC). 14 states have already adopted some form of compulsory or voluntary conversion to defined contribution plans. ALEC has promoted legislation in an additional 12 states to convert defined benefit plans to some form of defined contribution plans [click here for a list of “DC” states].

A core element of SEIU’s Capital Stewardship Program is to ensure our members’ wellbeing during their retirement by defending the defined benefit system and supporting the use of 401(k) plans and similar defined contribution plans only as a supplemental savings plan rather than as a replacement for a defined benefit pension plan.

States with Defined Contribution (“DC”) Pension Plans and Proposals

• Full DC Conversion Option
• MIchigan (mandatory for new employees)
• Florida
• Montana
• North Dakota
• Ohio
• South Carolina
• Washington

DC Limited to a small group of employees

• Louisiana (Teachers)
• Virginia (Political Appointees)
• Vermont (exempt employees [elected, appointed, at-the-pleasure, judicial], some municipalities)

Supplemental DC/ Hybrid Plan

• Arizona (repealed Limited Optional DC plan, and introduced supplemental DC in 2001)
• Colorado
• Utah
• Wisconsin

States whose legislatures introduced bills proposing some kind of defined contribution reform to their pension system (not passed):

• California
• Georgia
• Iowa
• Kansas
• Maine
• Maryland
• New Hampshire
• New York
• Oklahoma
• Tennessee
• Texas
• Vermont (expansion to all state employees and teachers)

Why Defined Contribution (“DC”) Plans Perform Worse Than Defined Benefit (“DB”) Plans

While proponents of DC conversion typically depict their proposals as a means to increase the retirement income available to working families, in fact the money invested in Defined Contribution plans routinely under-performs the investments of Defined Benefit plans to the tune of 2% a year. Such across-the-board shortfalls can’t be solely attributed to the investment decisions made by individuals; instead, the underperformance points to serious flaws in the structure of Defined Contribution plans. Several of these flaws are described below.

Education Programs Fail to Deliver

The educational programs available to Defined Contribution plan participants generally don’t provide them with the tools necessary to select an investment strategy that maximizes returns at an appropriate level of risk. Most educational programs are provided by the plan administrators themselves, who are therefore in a position to encourage participants to buy their products. Many DC education programs emphasize fund selection without a prior clarification of the key concepts (mean-variance analysis, asset allocation, the “efficient frontier”) that guide the investment professionals employed by Defined Benefit pension funds. Moreover, even when the educational program is well designed, the overwhelming majority of participants simply do not have the time, energy, or expertise necessary to make investment decisions in as well-informed a manner as the full-time, dedicated, and well-educated professionals who manage Defined Benefit plan investments.

Costs Are Too High

Despite the fact that investment fees, commissions, and other costs can be controlled and minimized, DC plan participants typically pay much higher costs than other investors. Mutual funds, which make up the majority of investment choices typically offered in DC plans, charge fees that can be twice as high as otherwise comparable institutional funds.[2] These higher costs result in part from an emphasis on the recent short term performance of individual funds. This emphasis in turn leads participants to invest too heavily in actively managed funds that charge much higher fees than passively managed, index funds. However, high costs also stem from the “bundling” of administration and record keeping and investment management: through such bundling, the investment company administering the DC plan performs for “free” the bookkeeping tasks that would otherwise fall to the pension fund. These companies effectively subsidize the sponsor’s cost of administration through the excessive fees charged to participants by its actively managed funds. Such arrangements clearly present a conflict of interest between plan sponsors and participants, and one that invisibly reduces the participant’s likely retirement income.

Participants Take on Too Much or Too Little Risk

When DC plans first began to spread in the 1980’s and early 1990’s, plan sponsors and administrators had a very difficult time convincing participants to invest in relatively risky securities (equities in particular). Whereas Defined Benefit funds usually put 50 to 60 % of their assets in equities, as recently as 1990 DC plan participants invested only 45% of their assets in stocks. Many participants continue to have the vast bulk of their DC assets in low-risk, low-return instruments such as Guaranteed Investment Contracts. More recently, with the long bull market of the 1990’s, DC account holders dramatically increased their allocations to equities: equities now constitute over 70% of aggregate DC holdings, and some participants have 100% of their investments in the stock markets. Thus, having long undershot the reasonable 50-60% allocations of the Defined Benefit plans, by the late 1990’s DC participants became overly-exposed to this riskier asset class just as the markets prepared to go south.

Participants Take on Too Much Active Risk

In addition to the failures of educational programs and the conflict of interest between plan sponsors and participants, the common focus on recent short-term fund performance encourages participants to put most of their money in actively managed funds. The risk that an active investment manager will fail to meet average returns, called “active risk,” ought to be compensated by better-than-average earnings, but typically is not. Only a very small number of such funds actually beat average market returns on a consistent, long term basis: indeed, it is impossible for all active managers to “beat the market” simultaneously, and therefore the returns to individual managers are very widely dispersed (some years well above average, some years well below). Conversely, Defined Benefit pension funds invest heavily in passively managed accounts indexed to market averages. Such index based investment vehicles not only produce reliable returns at low risk, they also minimize the various fees, commissions, and other costs that eat into returns.

Taken together, these defects help explain why DC plans consistently underperform DB plans. An individual’s DC plan can greatly underperform the typical DB plan, even more than the aggregate underperformance cited above. For these reasons, conversions of Defined Benefit retirement plans to Defined Contribution pose a serious threat to the retirement security of working families.