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Defined Benefit vs Defined Contribution Plans

In 2018, the military transitioned into a new type of retirement plan, called the Blended Retirement System (BRS). As it did, the military became one of the last major employers to move away from a traditional pension plan towards a defined-contribution plan.

The military’s transition to the BRS did not move exclusively to a defined contribution plan. BRS is more like the hybrid plans that have become more popular amongst government sector recently.

This article will discuss:

  • The purpose of a pension
  • The difference between defined-benefit plans (DB plans) and defined contribution plans (DC plans)
  • Factors that have forced the shift from DB plans to DC plans
  • How this shift will impact today’s workforce, especially younger employees

Let’s start with the purpose of a pension plan.

Purpose of a pension plan (DB benefits)

The purpose of a pension program is straightforward. A pension plan program used to be an employer’s attempt to provide a financial reward to its eligible employees for the value they provide to the employer.

Historically, the employee’s years of employment and the employee’s salary helped determine their pension. As the employee accrued more years of service, their specified monthly benefit would increase.

Of course, the exact dollar amount of the defined benefit pension depended on a few factors.

defined benefit plan is also known as pension

Who was the employer?

Employer could be a company, non-profit organization, the U.S. Government, or a state/local government agency.

If the employer was a civilian company, then the pension costs came at the expense of shareholder earnings. If the employer was a governmental entity, then taxpayers would foot the bill.

What is the financial reward for service?

The traditional defined benefit is defined by the Department of Labor as “promising a specific monthly benefit at retirement.” Your grandfather probably received this type of defined benefit program, along with his gold watch.

But how much did your grandfather receive? That would depend on a specific formula used by the pension administrator.

How are DB pensions calculated?

Generally speaking, there are three ways to calculate a DB pension:

Final pay formulas. Pension payments calculated as a percentage of the employee’s final pay. Usually the most expensive option. The military used final pay formulas for members who came onto active duty before September 8, 1980.

Career average formulas. This could be calculated as a percentage of pay for every year the employee participated in the plan. Or it could be an average annual salary over the period of plan participation. The military’s ‘High-3′ plan, which averaged the highest 36 months of the retiree’s basic pay,’ is a type of career average formula.

Flat-benefit formula. Simply a flat dollar amount for each year participating in the plan.

But as retirees began to live longer, the costs of their participation in DB plans started to rise. As a result, more pension plans started offering a lump-sum payment as an alternative.

What is a lump sum payment?

The lump-sum distribution consists of a one-time payment to the retiree in exchange for the forfeiture of their monthly payment. Calculated based on complex actuarial projections, the lump sum payment represents the net present value of the lifetime stream of payments to the retiree.

ERISA, the retirement law that protects workers’ pensions, does not require lump sum payments. If an employer offers the retiree a lump sum payment in exchange for a reduction or elimination of their monthly pension payment, it’s a good deal for the business owner, not the employee.

The military’s first failed experiment, known as the REDUX plan, proved this point. In exchange for a $30,000 payment (never adjusted for inflation), the service member would receive a lower starting pension at retirement. The servicemember also received a lower inflation adjustment throughout retirement.

As time went on, more and more people started declining the REDUX plan, as the deal got worse every year.

But even if an employee did not take the lump sum distribution, there was still the matter of survivor benefits.

How do survivor benefits work?

Usually, survivor benefits were guaranteed as part of an employee’s pension. In fact, ERISA requires that defined benefit pension survivor benefits be at least 50% of the retiree’s DB plan.

Companies would offer a variety of options for survivor benefits. Generally, they would look like:

  • Single life expectancy (no survivor benefit)
  • Joint and 50% survivor benefit
  • Joint and 75% survivor benefit
  • Joint and 100% survivor benefit

The companies would use actuaries to ensure that the expected lifetime payouts were equal. But generally, the highest monthly benefit would go to the employee who selected a single life option, while the 100% survivor benefits would receive the lowest promised benefit.

According to ERISA, any option that is less favorable to a surviving spouse than the 50% option must be accompanied by a notarized spouse’s signature. This measure was intended to protect spouses who did not work outside the home, and would be left destitute in the case of the retiree’s death.

But a lot has changed in recent years. Most households are dual-income households. Most notably, most companies made the switch from DB plans to DC plans.

Before we explore that trend, let’s look at the key difference between the two.

Defined contributions plans

Let’s look at how defined contribution plans differ from DB plans. Unlike a DB plan, a defined contribution plan does not promise a specific amount of retirement benefits. DC plans have to meet certain requirements to be ERISA compliant.

Some of these requirements include:

  • Vesting timelines for employer’s contributions
  • Fiduciary plan responsibilities
  • Employees must be given certain information to make their own investment decisions within the plan
a 401k is a type of defined contribution plan

ERISA enforcement falls under the supervision of the Department of Labor. The Department of Labor determines whether a pension plan complies with federal law.  

If a pension plan is deemed to be non-compliant with ERISA, that doesn’t mean that it’s illegal.  It just means that companies won’t get the tax benefits that they otherwise would. This is important, as I’ll explain next.

Why the shift?

Back in the day, when our grandparents were working for companies that gave away gold Rolexes at retirement, you were guaranteed two things:  the gold watch, and a pension. In order to guarantee the pension, the company would set aside a certain amount of money, in accordance with ERISA guidelines.

Companies did this because back in the day, you would:

  • Work really really hard with the same company for a very long time and retire in your 60s.
  • Then die. Usually in your 60s.

About a generation and a half ago, private sector companies realized a couple of things:

  • People were living longer and longer.
  • Paying traditional pensions for 20 or 30 years was much more expensive than paying a pension for 5-10 years.
  • Since longer pensions were more expensive, companies had to set aside more money to guarantee future benefits. This had a direct impact on their bottom line.
  • It was cheaper to just give people a bag of cash (in the form of a 401(k) or pension buyout) in exchange for the right to not have to pay them money for the rest of their life.

By being able to transition their workforce from a defined benefit program to a defined contribution scheme, most companies were able to keep their ERISA tax benefits. At the same time, they reduced or eliminated their pension obligations. This directly improved company profits.

Look at the automotive industry bailout. The move from defined benefit to defined contribution was largely executed by the IBMs and GEs of the world decades earlier. Big Tech companies like Microsoft and Apple completely avoided setting up pension funds altogether.

Conversely, the Big Three were saddled with billions of dollars in pension obligations. These almost crippled the entire automotive industry. Not only did corporate America recognize this trend, but so did the rest of the U.S. Government.

In 1987, the US Government replaced the Civil Service Retirement System (CSRS), with the Federal Employees Retirement System (FERS) for employees in government positions. Both systems had elements of defined benefit (pension) and defined contribution (Thrift Savings Plan).

However, it was clear that FERS was more focused on the employee’s responsibility to manage their own retirement funds.  We’ll talk about that next.

The impact to the employee

That’s great for the company, being able to save money and all. What about the employee?  That’s where things get a little dicey.

Regardless of your employer, think of funding your retirement as a measure of risk. Let’s define that risk as the ability to have money available to fund a certain retirement income.  

Under a defined benefit scheme, it was the company’s responsibility to fund that income. All your grandfather had to do was set his budget to that income, and your grandparents were set.

Your grandparents didn’t have to know how the company did it. But as long as the company existed, your grandfather kept getting the same pension and could actually budget to it, because it was guaranteed by the company. If the company failed, the Pension Benefit Guaranty Corporation would step in with some protection.

The company, on the other hand, had to set aside enough money to make sure they could keep pumping out those retirement checks.

Under a defined contribution plan, that changes.  The company no longer has to set aside that money for pensions.  However, if you want that same cash flow, you do.  Now, you have to:

  • Pay a lot closer attention to your cash flow needs
  • Manage the actual cash flow in your retirement from your accumulated savings
  • Wisely invest your money, over the course of your life and in your retirement, so that you have enough to support your cash flow needs

In other words, while your grandfather didn’t have to worry about where his pension came from, YOU DO!  Moving from a defined benefit plan to a defined contribution plan means shifting the investment risks from the company to the employee. 

You can think of this as a 0-100 scale. In blended programs, like the government FERS program, the risk is somewhere in between, since there are defined benefit and defined contribution elements.

What’s the shift (in broad terms) for the military’s pension plan?

In a broad brush aspect, this retirement system reform is the government’s attempt to shift some (not all, at least not right now), of that retirement risk from the military to servicemembers and their families. It might sound like a good deal.

In certain circumstances, it is a good deal especially in situations where people with less than 20 years walk away with zero defined benefit pension.

However, in the case of people who end up with a military retirement, the BRS means giving up a part of that security in exchange for having to manage more of your future.