Defined contribution vs defined benefit pensions

This article attempts to contrast the differences between defined contribution pension plans (DC) and defined benefit pension plans (DB).

The type of pension plan most people are familiar with is called a defined benefit pension plan or DB plan. The most common example is the Canada Pension Plan (CPP), to which contributions are made with the expectation of a known future payout. Many employers, however, now offer a defined contribution pension plan or DC plan, to which moneys are contributed and which is invested on behalf of the contributor. The final sum available to fund retirement then depends on the investment returns obtained.

Background
Traditional defined benefit pension plans have been in prolonged crisis, one whose roots were first exposed in the two recessions of 1980-82 and revealed more fully in the downturn of 1991. Those recessions most affected manufacturing companies with large workforces, first the steel industry, then companies such as IBM, extending now into the auto sector and the airline industry.

Such industries faced two challenges. The first was that, with restructuring, there was no longer a growing workforce to match the increasing number of retirees, whether long-timers or those who had taken early pensions. The solution would have been to raise contribution rates for new workers in what was treated much like a pay-as-you-go pension scheme (as, for many years, the Canada Pension Plan was). That structural problem was avoided, to some extent, by better rates of return offered by shifting the asset mix from bonds to equities. But that gravy train came to halt with the 2000-2002 bear market.

As pension burdens become increasingly problematic, companies are shifting to defined contribution pension plan. While DC plans provided startups in such industries as high-tech the flexibility to grow into mature companies without heavy upfront costs for pensions, they also exposed plan members to investment risk as well as longevity risk: inadequate retirement savings.

Increasingly, pension experts are examining a hybrid DC-DB plan with compulsory contributions.

How pension income is determined
Defined benefit pension plans provide a payment of a pre-determined amount based on factors such as years of service and salary.

Defined contribution pension plans payments are based on the contributions made and the investment return on the contributions.

Who makes the decisions?
In a DB plan, the sponsor decides on the required level of mandatory contributions, based on actuarial evaluations. Professional money managers handle the investments. In other words, plan members make no decisions and need no investment knowledge.

In a DC plan, members may have to decide themselves how much to contribute. In theory, they are supposed to calculate the savings rate required to reach a certain income replacement rate after X years of contributions, with Y% real (after inflation) salary growth, and anticipated investment returns of Z% per year. DC plan members also have to make investment decisions: (1) what asset allocation is best for them, and (2) what investment products to implement this allocation with. Members then have to maintain the savings discipline to make it happen, which could be a problem. They have have to stick with the plan during bear markets.

Investment and market timing risks
In a traditional DB pension plan, the plan sponsor bears the risk that the plan may not be sufficiently funded, and must top up any shortfall. The primary difference between a DB and DC pension plan is that, in the latter, the subscriber, not the sponsor, carries the investment and timing risks. Thus, DC plan contributors who invested heavily in equities during a market crash, may have suffered a substantial drop in the value of their pensions. Because of the potential for a large drop, some DC plan sponsors may limit the equity percentage that subscriber can hold.

If an individual member of a DC plan experiences a bad investment outcome, their retirement is underfunded, and that is their individual problem. The only solutions are to delay retirement or accept a lower pension. By contrast, if there are funding issues in a DB plan, "there is scope for spreading the adverse experience across time so that the consequences can be absorbed by different cohorts of plan members and employer contributors".

Longevity risk
In a DB plan, the pension must paid as long as the pensioner lives: the plan sponsor bears the longevity risk. In a DC plan, the member may be offered different options at retirement; unless an annuity is purchased, the retiree bears the longevity risk.

Insolvency risk
On the other hand, if a company declares bankruptcy and the DB plan is underfunded, pensioners may eventually get less than they were promised; this known as insolvency risk. There is no insolvency risk for DC plans, since the money belongs to the employees and these plans are by design always "fully funded".

Accrual risk
Another risk of DB plans for employees is called "accrual" risk. The idea is that because the pension formula is typically based on earnings and years of employment, which both increase over time, the "accrual pattern is nonlinear in dollar terms (and in present value), with much of the final benefit accruing in the final years". This means that if the formula changes just before a worker retires, the DB plan is terminated, or the employee looses their job, then accrued benefits can fall "far short of a worker’s expectations". Accrual risk does not apply to DC plans.

What happens if you leave your job?
In a traditional DB plan, shifting jobs can be disadvantageous: "under a pension plan that bases benefit payments on final average earnings, a member leaving one employer will receive termination benefits based on the member's then current earnings, not based on earnings at retirement. A member staying will receive benefits based on earnings at retirement". This is a manifestation of accrual risk. DC plans are more fair in that respect: you leave with whatever money is in your account (see leaving your DC plan before retirement for details). Therefore, DC plans make changing jobs easier.