Copyright © 2008, The McGraw-Hill Companies, Inc.
Defined Benefit versus Defined Contribution Plans
There are advantages and disadvantages to each type of plan, whether we are looking at
things from the employer’s or employee’s perspective.
Defined benefit plans offer an employee a guaranteed level of income, and it is up
to the employer to make sure that the funds are available to support that income. The
employee does not have to worry about where the funding will come from, or how money
set aside to provide retirement plans will be invested. The employer bears the cost of funding
the plan, and, if the investment returns earned by the plan’s assets fall short of expectations,
is responsible for making up the difference. Furthermore, to ensure that the employer will
be able to meet its pension obligations, these plans are regulated, and the employer must
meet requirements for funding, managing, and financially reporting the results of this type
of plan. (Unfortunately, despite these regulatory efforts, pension plans do occasionally fail
to meet their promised obligations.) For an employer, complying with these regulations can
be a significant burden of both cost and effort.
While defined contribution plans are also subject to regulation, the employer’s issues
of adequate funding and investment results largely—though not completely—disappear.
Since the plan does not guarantee any particular income to its retirees, the employer does
not have to worry about maintaining adequate funding levels or investment returns. The
investment decisions are made by the employee, and if the investment returns disappoint,
that is not, in general, the employer’s problem.^1 These reasons provide a very strong incen-
tive for employers to switch over to defined contribution plans, and that has certainly been
the trend over the last few decades. Employers generally prefer the fewer risks and fewer
headaches that DC plans offer.
Defined contribution plans offer advantages to the employee as well, however. The
employee has control over how her funds are invested, and as we have seen mathemati-
cally, small amounts of money invested well can produce astonishingly large returns in the
long run. An employee who makes good investment decisions has the potential to build
up a large nest egg in a defined contribution plan. (Though conversely, if her investment
choices do not work out so well, the end result will not work out so well either.)
Portability is a major advantage to the employee of defined contribution plans. The
benefits offered with defined benefit plans are almost always based on years of service.
For someone who works for many years for the same employer, this works out well, but
for someone who changes jobs several times over the course of his career it doesn’t. If you
work for 10 years at one employer, 8 at another, 12 at another, and then 15 at yet another
you may have a vested defined benefit at each company, but each of these will be compara-
tively small since it is based on your years of service. And in the modern working world,
even this track record may be remarkably stable.
Defined benefit plans work best for someone who can accumulate a large benefit by the
combination of accumulating many years of service with an increasing salary on which
the benefit will be based. In Example 7.1.6, Dave was vested in a $4,185.60 per year ben-
efit, but that benefit will never get any bigger, even if he is many, many years away from
retirement. In distinction, when you leave an employer with a defined contribution plan,
the vested funds in your plan can be rolled over into the new employer’s plan, or into a
personal retirement account. Unlike a vested defined benefit, a vested defined contribution
balance can continue to grow over time.
This portability of plans can be a disadvantage to employers. A skilled and experienced
worker at a company with a DB plan is likely to want to stay working for that company,
if for no other reason than to keep building on his pension benefit. Without those “golden
handcuffs,” this employee would be easier to lure away to work for a competitor.7.1 Basic Principles of Retirement Planning 311(^1) Since the employer does decide what sorts of investments will be available in the plan, there can still be some
risk of the employer being held responsible for bad investment results. For example, if the investment options are
very limited or if employees are required to invest their money in company stock, the employer can still be liable
for bad investment performance. However, as long as there is a wide enough range of investment options, the
employer is not usually responsible for investment performance, and most employers make sure that their plans
offer enough choices so that this issue is avoided.