Defined Benefit vs. Defined Contribution Retirement Plans: Why 401k Plans are Not Your Father’s Oldmobile

Wednesday, February 6, 2013 at 1pm
By John Friedman

Making the rounds the past 24 hours is a piece by Atrios in USA Today called “401Ks are a Disaster.”

Here are the first two paragraphs:

We need an across the board increase in Social Security retirement benefits of 20% or more. We need it to happen right now, even if that means raising taxes on high incomes or removing the salary cap in Social Security taxes.

Over the past few decades, employees fortunate enough to have employer-based retirement benefits have been shifted from defined benefit plans to defined contribution plans. We are now seeing the results of that grand experiment, and they are frightening. Recent and near-retirees, the first major cohort of the 401(k) era, do not have nearly enough in retirement savings to even come close to maintaining their current lifestyles.

No doubt these notions about higher Social Security benefits strike a lot of people out there as sheer lunacy, while striking many others as a very good idea indeed. I leave it to you to decide, Rorschach Test-like, which side (or sides?) of that spectrum you find yourself on today.

Here I instead want to emphasize the defined benefit vs defined contribution shift — the DB-to-DC shift mentioned in the second paragraph of the piece. Do you know what Atrios is talking about there? If you have any sort of historian in you, or you are simply a curious person — or, more practically, if you have a 401K plan or other similar retirement plan — then it’s a good idea to understand what changing that trailing B in DB to a C is all about.

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So what is this DB-to-DC shift all about?

A defined benefit retirement plan is one in which the retirement benefit at the end is knowable at the onset — a plan in which the benefit you receive when you retire is defined. Those definitions usually take the form of an equation something along the lines of this:

If you work for this company for at least five years, then, once you leave our employ and you’ve turned 65 and continuing on from there until you die, for every year you worked for us we will pay you 2% of the average of the annual compensation you received from us during your last three years with us, but in no event we will pay you more than 80% of that average.

So if you work for this particular company from the age of 35 to 65, and if you averaged $100k annual compensation during the last three years of your employment there, then the company would pay you $5k a month for the rest of your life (because 30 years worked times 2% benefit per each year worked equals 60%, and 60% of $100k average annual compensation equals $60k per year, which, with 12 months each year, equals $5k per month).

Gee whiz . . . you start with $5k a month for the rest of your life from your DB, throw in a nice dollop of Social Security and some savings, and, why, you might even be saving money in retirement! Most people end up spending their money down, but you’d be adding to your savings instead. Sounds nice, eh?

I’ve seen it, and I venture to say that all financial planners have probably seen people who grew more wealthy during their retirements. For normal folks, that usually means that they have a defined benefit retirement plan in their life, and, quite happily, it also turns out that their defined benefit is more than sufficient to make the retirees’ ends meet (forgive me if this last phrase conjures up unintended consequences in your mind . . . ).

But . . . there’s a problem. You can think of that sort of picturesque retirement picture as your father’s Oldsmobile, in that both are no longer being made and both are becoming rarer and rarer sights with the passing of every day. These days government and union workers and some employees of old-line, slow-moving corporations are about the only folks who have anything at all like those beautiful defined benefit plans of yesteryear.

So that’s what DBs — defined benefit plans — are all about. You can think of them as good ol’ fashioned pension plans

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In their stead we now have DCs — defined contribution plans.

With defined contribution plans the only thing that’s defined is what goes in, i.e.,the amount you, on your own, decide to contribute to the plan. And from then on, it’s anyone’s guess about how much of a benefit you might then see when you are in your elder years, because it all depends on how the money you contribute to the plan is then stored — in the stock market, in the bond market, etc. — plus how much it costs you to do the storing.

401k plans, 403b plans, 457 plans, IRAs, SEP IRAs, SIMPLEs, Roth IRAs, Individual 401k plans, and an alphabet soup of others are all defined contribution plans.

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Happily, even today, and in spite of the huge fall-off in DB plans across the land, more folks participate in defined benefit retirement plans than do in defined contribution retirement plans. Why?

It’s because just about all of us participate in Social Security (pols and certain government employees, excepted, together with a slice of certain sorts of felons) (and please, no jokes from the peanut gallery about what some would see as three-of-a-kind). And what does Social Security do? That’s right: it pays you a monthly check based on how much you made during your working life. Sounds like that equation up above, doesn’t it? Sounds like a defined benefit plan, yes?

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It was almost not to be, for when George W. Bush talked about private accounts and privatizing social security, what he was really talking about was SS going the DB-to-DC route — about SS doing the B-2-C dosey-doe. In other words, he wanted to take Social Security from a defined benefit plan to a defined contribution plan and, in doing so, relieve our most ever-present Uncle of some very long-term, very large financial obligations.

That idea had some people very, very happy, primary among them the people who were in the 401k business, which is a very nice business to be in indeed — a business in which your end-users had essentially zero pricing information (with some slight improvement on this since Bush’s time) and who also tend to be largely inattentive to their best financial interests (probably no change there since Bush’s time . . . !). Those same folks would argue that Social Security has a paltry return for each dollar a participant invests in the program, and that everyone should have their choice about how to invest for retirement. Ya know: freedom, sha na na na.

And it had some other people very unhappy, primary among them the people who know what a lifesaver (both literally and figuratively) Social Security has been and continues to be. Also against Bush’s idea were the people who believe that an effective approach to securing all of our retirements was to pool our risks — those who believe that an approach resting on the idea that we are all in this together usually works better than one based on the idea that you’re on your own. 

Indeed, many of those same people would argue that Social Security is the most successful government program in the history of America, and perhaps all of humankind for all time (not doing so well is Medicare, which, because it rides for the most part upon the super-fast cost-escalator that is our terrifically inefficient medical-care delivery system, currently badly lacks long-term financial wherewithal).

These days, the rumblings of Social Security privatization are few and far between. So, too, is any argument, as Atrios makes, that Social Security benefits should be increased. Rather, the talk now is of decreasing the benefits, if slightly — though over time the slowing-the-rate-of-increase sorts of changes currently envisioned might well amount to something quite substantial.

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So there you have it: a quick explanation of the DB-to-DC shift.

It’s amazing how the shift that the second letter of that abbreviation takes, towards the Z-end of the alphabet — as small a shift as it can take — has made such a huge world of difference, for everyone you see, every day and every where, in this loverly ol’ land of ours.

 

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