From defined benefit to defined contribution plans: Formulas for retirement success

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By Lance M. Burma | 26 December 2012

The promise of a secure retirement is a valued employee benefit. However, current circumstances—including an extended period of market volatility and business uncertainty—are causing people to wonder how secure they actually will be in the future.

These concerns are not without foundation. In recent months, the stark choices faced by severely underfunded public pension plans, aka defined benefit (DB) plans, have been plastered across the news. Also, in recent years, many private companies have frozen their DB plans or changed to 401(k)-type defined contribution (DC) plans. The 2012 labor dispute with NFL referees was largely related to just such a proposal.

Unfortunately, the shift from DB to DC plans may simply be masking a future crisis in the making.

In this environment, it’s a good idea to review the basic premises, including the fundamental formulas that underpin retirement planning for American workers. Only by knowing how these plans work—and where the risks are—can today’s employees understand their retirement benefits and plans effectively for the future.

A very simple formula

Starting with the basics, all retirement plans are based on a very simple formula:

C + I = B

C stands for contributions made. I represents investment earnings—in other words, the market returns generated by investing the contributions. And B is the benefits paid out to the retiree.

As we all know, future investment earnings are unknown—particularly when investing in riskier assets such as stocks. Professional investors rely on stocks (also known as equities) for growth. But the particular risk of stocks is volatility. They go up anddown. As a result, even the most experienced professionals have difficulty in predicting the market.

Because investment earnings are unknown, either the contributions or the benefits can be fixed, or “defined.” And therein lies the critical difference between DB and DC plans.

DB plans: A promise for the future

C + I = B 

For DB plans, the benefitis fixed. It’s a promise made by the employer, whether a government or a private entity, of an amount to be paid in the future. Because the investment earnings can only be estimated, the contributions to a DB plan, which generally come from the employer, are variable.

To fund the promised benefit, the employer makes contributions to the retirement plan. If the markets do well, then a larger portion of the benefit will be paid for from investment earnings. This lowers the cost for the employer. But when investment returns are lower, then the employer has to contribute more—sometimes on very short notice.

The employer is therefore taking the investment risk. Some employers would prefer not to have this risk and that’s one of the reasons why some employers have switched to DC plans.

DC plans: Everyman as CFO

C+ I = B 

In a DC plan, the contributionsare fixed, which makes the benefits variable.

Under these plans, the employer generally makes an annual contribution that is a specific dollar amount or percentage of each employee’s salary. Employees often contribute as well.

In the DC world, it’s the largely untrained participants who must make the investment decisions that will significantly affect their retirement benefits. The challenge for employee benefits consultants is to provide plan sponsors with solutions that help employees make good choices or, even better, help them mimic some of the risk mitigation that employees enjoy under DB plans.

For example, many plan sponsors today are adopting investment options that automatically and dynamically adjust investment allocations. Target date funds and model portfolios are simple examples of these funds, but Milliman’s InvestMap product is a much more advanced solution. InvestMap uses the participant’s age and risk tolerance to dynamically reallocate participant investments year by year, without additional action required by the participant. Think of it as a target date fund customized for each participant’s age and risk tolerance.

These types of strategies incorporate the expertise of professional investment managers and passes that through to the participants, so they don’t have to try to figure it all out on their own.

Of course, the other way to increase B (that is, benefits) is to increase contributions. Employees can max out their personal contributions at 100% of annual salary or $50,000, whichever is less.

Solutions for a more secure future

There’s no question that DB plans have lower risk for employees than DC plans. For participants who stay at a job long enough to vest in the employer’s plan, DB plans produce a predictable benefit that is generally paid for life. Compare that to a DC plan, which is unpredictable, and requires work and investment management skills. However, in today’s workforce, few employees get to choose. The trend over the last few decades is definitely in the direction of DC.

The good news for DC participants is how the industry is focusing on making it easier for them to achieve their goals. As mentioned above, investment products are increasingly focused on helping participants make easy choices and incorporating automatic adjustments along the way. This new wave of solutions is truly innovative and has the potential to significantly reduce risk for the average employee.