Why Did Employers Switch from Traditional Defined Benefit Pensions to Defined Contribution Pensions?
Your friend is correct: the switch from traditional defined benefit (DB) to defined contribution (DC) pensions in many cases is due to the high costs and management burden of DB plans. The shift occurred in significant part because changes in accounting standards in 1993 made it more challenging and expensive for employers to fund these plans.
Evolution of Pension Funding Rules
Began in 1993, the Financial Accounting Standards Board (FASB) implemented new rules that caused companies to increase their funding requirements for DB plans. Under the old rules, companies generally funded their pension plans based on a simplified formula, which did not adequately account for the long-term nature of pension obligations. The new rules required a more accurate calculation, including updated actuarial valuations and funding requirements, leading to increased contributions.
The Complexity of Funding DB Plans
Let us explore the complexity of managing DB plans through an example. Suppose you promise an employee $1,000 a month starting at age 65, and they are currently 25 years old. If you expect a 5% annual return over 40 years, the current contribution required is approximately $1. If the same employee is 60 and the payouts must start in 5 years, the required contribution jumps to about $8.50 now. However, if the expected 5% return is not realized, the plan must still pay the promised benefit. This shortfall must be met by higher contributions, which can then accumulate to a surplus if the plan performs better than expected.
Actuaries must constantly evaluate numerous factors, such as mortality rates, investment performance, and future market trends, to ensure the plan remains adequately funded. This ongoing assessment can lead to large, unexpected contributions requiring significant financial resources. Moreover, these contributions often occur without the company foreseeing such high expenses, which can impact their financial stability and investor confidence.
The Shift to Defined Contribution Plans
Defined contribution (DC) plans, such as 401(k)s, offer a more straightforward and predictable cost model. In a DC plan, employees contribute a fixed percentage of their income, and the investment risk is borne by the employee. Employers are not responsible for further contributions, and the plan’s performance is based on the individual’s investment choices. This shift thus reduces the financial burden on the employer, making it a more appealing option.
However, the move to DC plans also means that employees must take on the responsibility of managing their retirement savings. This shift represents a significant cultural change in the workplace, as employees are now tasked with making informed investment decisions to secure their financial futures.
Cost Comparison: DB vs. DC Plans
The cost of running pension plans falls primarily on the employer. In contrast, with a 401(k) or similar DC plan, the expenses are shifted to the employee. In a DB plan, the company must contribute to ensure promised benefits, whereas in a DC plan, contributions are based on employee contributions, and the employer's role is limited.
Was the DB Model Actually Beneficial?
The traditional DB pension model was historically accessible to a limited number of workers, primarily those employed by large corporations such as automakers, steel companies, and tire manufacturers. These plans often required long-term employment (e.g., 20 years) for a worker to qualify for pension benefits. As such, the DB model was not an option for most workers, which limited its overall impact.
Moreover, the financial burden of DB plans has contributed to the bankruptcy of several companies, particularly in the auto industry during the 2007-2009 Great Recession. The insolvency of these companies underscores the challenges and risks associated with relying on DB pension plans.
Conclusion
The shift from traditional defined benefit pensions to defined contribution plans is driven by practical considerations, including the high costs and uncertainties associated with funding DB plans. While defined contribution plans might present challenges for employees, they offer a more manageable and predictable financial structure for employers.