Defined Benefit Vs. Defined Contribution Retirement Plans

It is first helpful to consider the basic context and premise of both the defined benefit and the defined contribution retirement plan. Considering first the defined benefit plan, Clark and Pitts (1999) report that "Defined benefit plans promise a specific benefit at retirement..." (p. 18). Grande and Grande (2004) go on to expand this definition by noting that:

Often referred to as the traditional pension plan, a defined benefit plan provide a guaranteed retirement benefit for each participant. This retirement benefit is generally designed to replace up to 100% of the participants pre-retirement income when combined with social security benefits the participant will receive in retirement. The retirement benefit is stated in terms of specific dollar amount or percentage of pay to be paid annually during retirement (p. 14).

What this effectively demonstrates is that the defined benefit program is designed to provide the retiree with some degree of consistency in terms of the amount of money paid each month. Money for the defined benefit program is pooled into one account and can be paid annually or in monthly installments. In most cases employers exert complete control over these investments; making critical determinations about how the funds are to be invested over the lifetime of the account (Grande & Grande, 2004).

With the basic premise of defined benefit programs elucidated, it is now possible to consider the basic premise of defined contribution programs. Describing these retirement accounts, Clark and Pitts (1999) go on to note that, "defined contribution plans are based on contributions into individual accounts with benefits being determined by the value of the fund at the end of retirement" (p. 18). Seidner (2002) goes on to report that defined contribution plans mandate that the employee place so much money per month, or year, in a retirement account. The employer is then obligated to invest the contribution for the individual employee, with the intent that the end result will be more money than the initial contribution made by the employee. Although this benefit type carries with it the potential to reap the financial rewards of successful investment, it carries with it a high risk for inventors.

Benefits and Drawbacks of Defined Benefit Programs

Now that a rudimentary understanding of each of the benefits has been elucidated, it is important to examine each of these retirement accounts individually to provide a more integral understanding of these plans, their benefits and their risks. Schieber (2005) in his examination of defined benefit programs notes that recent media coverage of these programs have created considerable worry for investors. As organizations file for bankruptcy, unfunded defined benefit accounts are often left unsatisfied. According to Schieber defined benefit programs have been portrayed as highly unstable investments for employees. Despite this media hype however, Schieber contends that the defined benefit program is one of the most secure for retirees. Schieber asserts that defined benefit accounts provide employees with a precise method for planning their financial development through retirement.

Other authors support the assertions made by Schieber, insisting that defined benefit programs provide the best outcome for employees. Inglis (1997) contends that there is some evidence that suggests that organizations can effectively defend their decision to utilize these retirement benefits structures. In particular, Inglis reports that defined benefit (DB) have come under fire in recent years because they have been noted to produce less of a return on the investment than defined contribution (DC) plans. According to Inglis, this is simply not the case. In most instances, DB plans yield a higher rate of return per dollar because the money is invested by the organization. Under DC plans, the individual is given the authority to make investments with the money.

In addition to paying more benefits per dollar, Inglis argues that defined benefit programs also create a equity for the retirement of all employees in the organization. Specifically this author reports that, "In a DC plan, in which benefits are almost always available as lump sums, some participants are going to retire with more money than they will ever use and some will retire with less income than they need. DB plans, which often do not pay lump sum benefits at retirement, are more likely to make retirement income 'just right'" (p. 124). Here again, the issue of uniformity in paying benefits becomes an important factor for the success of these programs. With a defined benefit program in place, the individual has more control over his or her financial status at the time of retirement.

Finally, Inglis argues that the defined benefit program makes it easier for employee to manage their retirement. As reported by this author, the questions facing retirees are quite complex overall: "How much money do employees need for retirement? How should it be invested? How much should they use each year after retirement? When should they retire?" (p. 125). With a defined benefit program in place, the organization is charged with the responsibility of addressing these issues and providing a complete plan to facilitate the employee's successful retirement. "A defined benefit plan, by its very nature, goes much further toward helping employees answer those questions" (p. 125).

The arguments made by Schieber and Inglis clearly elucidate the fundamental benefit of defined benefit plans: these plans enable the individual to effectively plan for retirement, with full knowledge of what benefits will be provided. Although this situation clearly provides a solid basis for decision making when it comes to the employee's individual retirement decisions, scholars have noted that there are some problems engendered in this system. To illustrate the problems that are inherent in the system Doerpinghaus and Feldman (2001) assert that a closer examination of the structure of these programs must be considered. In particular these researchers report that, "defined benefit pension plans, pensions typically are calculated by an organizational formula based on annual compensation, age at retirement, and years of service. [...] Unlike employees in defined contribution plans, employees in defined benefit plans are typically penalized if they retire before they reach a specified age or complete a preset number of years of service" (p. 274). Thus, if the employee retires early, or is forced to retire early as the direct result of downsizing, he or she may see notably reduced benefits.

Unfortunately, Doerpinghaus and Feldman report that this is not the only inequality associated with the defined benefit process. According to these authors, the decision of the employee to leave the workforce is often predicated on the amount of retirement benefit that will be received. In the defined benefit program, the amount of retirement benefits paid is directly linked to the salary of the individual. The higher the salary, the higher the pension paid each month. As reported by Doerpinghaus and Feldman, this reality creates a situation in which "employees with higher salaries will earn higher pensions as well, thereby allowing better-paid employees to exit the workforce before their lower-paid colleagues" (p. 275). For the human resource manager this could have a notable impact on employee morale in the organization. Individuals paid lower wages may not feel as if they will be able to retire at the time that is right for them. This can create considerable tension between the employee and the organization.

Adding to the negative attitudes that have developed with respect to defined benefit programs. Feinberg (2004) reports that executives and managers in most organizations no long support these retirement plans. "Only 10% of corporate executives would offer a traditional defined benefit plan if they were allowed to create their companies' retirement programs from scratch... By contrast, some 83% of would offer a defined contribution plan" (p. 46). This decision has been reinforced by recent court cases which effectively demonstrate the inequities in these programs. IBM faced discrimination charges as a result of accusations that its defined benefit program favored older workers. With so much controversy in place, organizations worry that they will suffer from legal challenges to their defined benefit retirement programs.

Benefits and Drawbacks of Defined Contribution Programs

The push away from defined benefit programs and toward defined contribution programs suggests that defined contribution programs provide notable benefits and fewer drawbacks. While this would appear to indeed be the case, the current research that has been produced on defined contribution plans suggests that there are considerable pitfalls that must be considered when evaluating these programs as well. As such, it is important to address the benefits and drawbacks that can be garnered from the utilization of defined contribution plans.

As noted earlier, defined contribution plans allow the individual employee to choose how much money he or she wishes to invest each month. This defined contribution is then placed in a separate account that is invested, principally in the stock market. Although current research suggests that defined benefit accounts afford a better return on investment, historical analyses of defined contribution accounts suggest that the payout for defined contribution accounts is much higher than that of defined benefit accounts (Power, 1987). In addition, research demonstrates that because the defined contribution account is not contingent upon the individual's age or number of years of service to the organization, payouts for these accounts can be much higher at an earlier stage in the individual's career (Inglis, 1997). Despite these benefits however, defined contribution programs have their fair share of problems.

Examining the extent of the problems that can arise in the context of defined contribution programs, Seidner (2002) reports that because the funds are invested in the stock market by the individual employee, downturns in the stock market can have a devastating impact on retirement savings. "The recent downturn in the US economy has caused many individuals who have invested in the stock market through employer-sponsored defined-contribution plans to suffer extreme financial losses" (p. 84). This author goes on to note that after September 11, many employees began questioning quality of life issues. This coupled with downturns in the economy has created a situation in which employees that want to retire cannot. Although recent improvements in the stock market have been noted, the reality is that many individuals have already lost a substantial portion of their investment. This makes it even more difficult for them to acquire the money needed for retirement.

Even though substantial problems have been identified when it comes to defined contribution plans, the reality is that these plans are growing in popularity. According to Murray (1999) defined contribution plans are not only popular in the Untied States, they are popular across the globe as well. Because employees no longer spend most of the lives at one specific job, the defined contribution program allows them to take there accumulated savings with them when the switch jobs. In doing so, employees do not have to worry about seeing their retirement benefits cut because they have not contributed a specific number of years to the organization. In this context it is evident that the defined contribution program makes the most sense for the modern workforce.

In addition to the fact that defined benefit accounts provide the employee with some degree of security when changing jobs, researchers also note that these programs have notable benefits for the organization. For instance, Murray goes on to report that the specific investments used in the defined contribution program enables the organization to place the risk of investment on the employee. Specifically, Murray notes that:

...With defined benefit plans, the employer has to invest company funds to make sure the employee is paid a certain amount at retirement. With defined contribution plans, employers usually just provide employees with ongoing sums of money--typically paycheck-to-paycheck--and the amount each employee receives upon retirement is largely dependent on how he or she invests the money (p. 30).

In this context, the organization has fewer obligations to fulfill with respect to its pension plan should the possibility of bankruptcy develop.

Finally, Brewer, Geller and Smilowtiz (2003) in their examination of the benefits of defined contribution programs to the organization note that the administrative fees typically associated with the administration of pension accounts are notably reduced for the organization utilizing defined contribution accounts. A review of the administrative costs associated with defined benefit accounts demonstrates that over the long-term, these programs have substantial costs for the organization. However, because the defined contribution accounts are largely managed by the employee, these accounts afford less costs to the organization over the life of the investment. Further, if an employee leaves the organization, the costs of program administration are passed on to the next employer.

Hybrid Programs-The Best of Both Worlds?

A critical review of the information presented in this investigation clearly suggests that the defined contribution retirement account is preferred over the defined benefit retirement program. While this does indeed appear to be the case-as the defined contribution account has more benefits for both the worker and the organization-the reality is that neither of the programs is a panacea for meeting all of the needs of retiring employees. With this in mind, it is not surprising to find that many organizations are now choosing to develop hybrid programs for retirement savings that attempt to capture the best of both retirement plans. Given that these programs have become more widely used in recent years, there is a clear impetus to examine hybrid programs and determine the benefits and drawbacks that can be acquired through the use of these programs.

One author examining the specific context of hybrid retirement plans that have been used by the organization notes the myriad of plans that have been formulated in recent years: "Cash balance and pension equity plans...are classified as defined benefit plans but have many defined contribution plan characteristics, whereas age-weighted profit-sharing, new comparability, and target benefit plans are classified as defined contribution plans but have some defined benefit plan characteristics." This author goes on to note that, "Floor-offset plans consist of two separate but associated plans rather than a single plan design with both defined benefit and defined contribution plan characteristics" (Hybrid retirement..., 1996, p. 35). What this effectively demonstrates is that there are a host of models that can be used by the organization in order to create a hybrid retirement plan for employees.

The myriad of hybrid programs that have been developed in recent years makes has promoted substantial investigations into the overall benefits that can be garnered from these plans. As reported by Korn (2002) the most notable advantage of hybrid plans is that they offer considerable cost savings to the organization. However, Korn does report that for many organizations, cost issues have fallen by the wayside when it comes to providing retirement programs for employees: "the shift toward hybrid plans in the marketplace is less about cutting costs and more about redistributing retirement dollars from long-term to short-term workers" (p. 52). Korn asserts that interest in the well being of employees at the time of retirement has fueled interest in the development of a number of specific hybrid plans. The two most popular are the cash balance plan and the pension equity plan:

Cash Balance Plan: "In a cash balance plan, an employee might receive an allocation (the pay credit) equal to 4% of pay each year; the employee's account also will be credited with interest at, say, 5%, compounded annually. The interest credit might be variable, perhaps tied to yields on long-term Treasury bonds. [...] Each year, an employee's account balance grows, with all contributions made by the employer in most situations. After the employee is vested in the plan (often after five years), the amount becomes portable" (p. 54).

Pension Equity Plan: The pension equity plan "pays a benefit based on an employee's final pay, often the five last years. Each year, a participant is credited with a percentage that will be applied against final average earnings. Generally, the percentage increases with age or service" (p. 54). Pension equity plans favor top performers in the organization and allow the organization to better control the investments of the individual employee.

Despite the fact that steps have been taken to improve the current problems associated with defined benefit and defined contribution retirement plans, the reality of these new hybrid plans is that they have not been widely proven to be effective for eliminating all of the problems associated with more traditional plans. In fact as Korn notes many of the new hybrid programs have not been evaluated by the US Treasury Department. Korn reports that the government has taken a "wait and see" approach to evaluating hybrid plans. With this mind, as the number of employers using these plans increases, the government will take this as a sign of their increasing viability. For investors this reality should raise some flags. Even though hybrid programs attempt to offer the best of both defined benefit and defined contribution programs, there is no substantial evidence to suggest that these programs work without fail.

Summary of the Research

Summarizing the information that has been provided in this investigation, it becomes clear the organizations face daunting challenges when it comes to developing pension plans for employees. Fifty years ago defined benefit plans were seen as the best method for ensuring the well being of the employee at retirement. Under defined benefit programs the employee is given a specified amount each month after retirement. This combined with Social Security benefits should provide the employee with the financial resources necessary to remain financially stable after retirement. In addition to providing a steady stream of benefits each month, defined contribution plans also rewarded employees that remained with the organization over a long period of time-i.e. 30 to 50 years. Because defined benefit programs are directly related to the salary and years of service of the individual employee, the longer the employee remained with the organization, the more retirement benefits he or she could accrue.

Clearly, the specific context of the labor market 50 years ago made these specific parameters for developing a pension program quite viable. However, in the last 25 years, the specific labor force patterns that served as the impetus for the creation of defined benefit programs have also served as the impetus for the decline of these programs. The labor force has changed, focusing more on the career development of the individual, granting the individual employee considerable freedom in job selection. This process has lead to the creation of a situation in which employees do remain dedicated to one organization for their entire career trajectory. In an effort to address this issue, organizations began developing defined contribution accountsthat allowed the individual to invest in retirement without the threat of losing his or her investment when a job change occurred.

As defined in this investigation, the defined contribution pension system allows the individual employee to place a predetermined amount of money in an account each month. This money is then invested by the individual, for the purposes of generating more wealth. While the defined benefit system is weighted to ensure that the individual receives the maximum amount of benefits as he or she nears retirement, the defined contribution plan allows for a more linear development of pension benefits. Further, because the defined contribution system allows for the individual to invest the money and is not directly tied to the individual's years of service to the organization, no monies will be lost if the individual makes the critical decision to change career paths.

Even though the defined contribution retirement plan appears to be a panacea for a modern workforce, the reality is that this pension program is not without its problems. Most importantly researchers have noted that because the defined contribution plan relies on the stock market for individual investment, changes or downturns in the stock market can have a detrimental impact on the ability of the individual to retire. Thus, even after years of investing, the risk associated with the defined contribution plan can leave the individual employee with nothing for retirement. Even though this situation removes the burden of the system from the shoulders of the organization, it does bring to light the importance of institution some type of control over employee retirement accounts.

Although it seem reasonable to argue that the benefits of the defined contribution program appear to have outweighed the benefits of the defined benefit programs, the reality is that organizations are still not satisfied with the current system of providing pension benefits. This is witnessed by the fact that organizations are now experimenting with the development of new hybrid models of providing pension benefits. The new hybrid models attempt to provide employees with all of the benefits of defined benefit and defined contribution plans, without any of the drawbacks. While it is clear that these programs have surged in popularity in recent years, the current research suggests that the true effectiveness of these programs has not been widely substantiated. The programs are often quite complex, forcing even the US government to wait and see what happens with these initiatives. Thus, further research on these programs is clearly needed if organizations and human resource managers are to make the best decisions in developing new pension benefit programs.

Recommendations for the HR Manager

Based on the data uncovered in this investigation, it is now possible to offer some recommendations for the development of pension programs for employees. While the data in this investigation clearly demonstrates that the defined contribution retirement plan is the preferred choice for most employers, researchers have noted that more than 40 million workers in the United States are currently enrolled in defined benefit programs (Feinberg, 2004). What this seems to suggest is that these programs have some viability for the modern worker. As such, the human resource managers in the organization need to take into consideration the specific environment of the labor force in the organization.

Using this as a springboard for the development of retirement programs, it is recommended that human resource managers first assess the basic composition of the organization's labor force. Once this assessment has been made, human resource managers need to consider employee needs. If this investigation demonstrates that most employees only remain with the organization for a short duration of time or that employees desire greater control over their retirement programs, a defined contribution plan should be considered as the best method for ensuring the well being of individual employees. However, if the organization finds that most employees have a tendency to remain with the organization for long periods of time and prefer more security in their retirement benefits, the HR manager may find that the defined benefit program is the right choice.

Although an assessment of employee needs in the organization may yield a clear picture of the characteristics that define the labor force, the reality is that the information garnered may not provide a definitive solution for the organization. In this instance, the question of whether or not to employ one of the hybrid models is raised. While it is evident that hybrid models may provide a clear method for reconciling all of employee retirement needs, the lack of empirical data on hybrid programs seems to suggest that organizations employing these programs may encounter more problems than they resolve. Thus, while it is important for human resource managers to acquire a solid balance for all employees when it comes to providing retirement benefits, managers need to consider what is currently known and not known about these hybrid programs. Without clear evidence to support a particular hybrid program, the human resource manager should stay the course and utilize either the defined benefit or the defined contribution program.

Even though there is a clear impetus for HR managers to carefully consider the specific retirement benefit program selected, this does not mean that the organization cannot develop a new program over the course of time. As new information and research on hybrid pension programs becomes available, HR managers need to consider this information in light of employee and organizational needs. What this effectively demonstrates is that the HR manager must consistently strive to understand the benefits available to employees and how best utilize these benefits for organizational development. Further, this situation clearly elucidates the need for HR managers to keep abreast of changes in the field and incorporate these changes in an effort to improve operations in the organization.

Conclusion

The initial hypothesis of this investigation was that through examination of both defined benefit and defined contribution retirement plans, it would be possible to identify which program was best suited to the modern organization. While this research definitively demonstrates that the defined contribution plan has more utility for the modern workforce, it is evident that this program is not without its drawbacks. With this in mind, it is easy to understand why organizations have chosen to develop hybrid pension plans that will enable employees to reap the benefits of both defined benefit and defined contribution plans. However, at the present time, hybrid plans have not proven to be effective outside of the realm of theory. Unfortunately, it may take several more years before the true efficacy of hybrid programs is known. With this in mind, it seems feasible to argue that human resource managers should develop an implement a program-either a defined benefit or a defined contribution plan-that best suits the needs of employees. As more is learned about hybrid programs this can be effectively integrated into HR policy and practice.

References

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