Pension Plans Defined Benefit vs Defined Contribution

The distinction between defined benefit versus defined contribution pension plans comes from the actuarial liability implied by each scheme.

In a defined benefit plan, the final pension available to a qualifying plan member is set by the plan sponsors. An employee, as a plan member, will qualify for the plan after completing a mandatory period of employment. The rules of the pension plan will then determine the formula that will be used for the calculation of the pension; that will accrue to the plan member over the period of employment. This actuarial formula is a multiple of the annual salaries received by the plan member during their term of employment.

The majority of defined benefit plans are called “Final Salary” plans. A “Final Salary” plan will pay a pension; that is a multiple of the salary that the plan member receives in their final year of employment. The structure of a defined benefit plan has an inbuilt incentive for the employee to remain in employment with same company plan sponsor after a certain period of time. This incentive becomes stronger each year that the employee stays with the same company. Furthermore, the incentive becomes even stronger if the employee’s salary increases over time. Inflation, which leads to a rise in salary, also reinforces this pecuniary incentive.

The actuarial working profile of an employee implies that an inflection point may be reached.  At this point it makes no sense to move jobs from a pension perspective, and under a defined benefit regime. A potential employer must provide significant pensions and salary incentives to entice employees away from their current defined benefit scheme.

In a defined benefit plan the company pension plan sponsor may elect to make real or notional contributions to the employee pension plan. If real contributions are made, this money may be invested directly by the company, or by an external asset manager.

Small companies that lack the resources to be pension fund managers hire asset management companies to manage the pension fund. As the workforce matures towards retirement, it will have an actuarial profile that follows the financial liability of the final pensions. If companies have not made real financial contributions to their pension schemes, it is possible for them to have a deficit in the pension plan. This is known as an unfunded deficit.

Unfunded deficits may be realized in financial terms. In other words, this is when the company has to start paying out pensions without having any assets set aside to fund them. This deficit must then be funded out of current income as it is drawn down by retiring employees. A company that then cannot meet its current defined pension liabilities is therefore insolvent.

The pension plan members must then join the line of creditors during insolvency proceedings. When this occurs the defined benefit may not be fully paid. A defined benefit is therefore no guarantee of payment, even though it is a legal contract. A defined benefit pension fund deficit can also occur in a situation in which the company has funded the pension plan. A deficit in a funded plan occurs when the performance of the assets in the plan do meet the actuarial requirements of the defined benefit liability.

In a defined contribution scheme, the employer and employee must make a contribution to the employee’s pension plan. The contributions will then go into a pension fund; that is either managed by the company, or an external pension manager. The pension manager is given guidelines covering the assets that will make up the investment portfolio and parameters that must be adhered to. At the maturity of individual pension plans within the whole fund, the pension manager will liquidate the investments for the individual employees to receive their pro-rated pensions. The final pension therefore depends upon the value of the assets; and hence the performance of the financial markets, as well as the skill of the fund manager.

Comparing and contrasting the two forms of pension plan, the implied risks and financial liabilities become clear.

A pension fund deficit can occur under a defined benefit scheme; however it cannot occur under a defined contribution scheme. A deficit in a defined contribution scheme can only come from deliberate malfeasance. A defined benefit pension plan member may therefore believe that they are in a better position than a defined contribution plan member. However, this may not be the case if the defined benefit plan sponsor has not been making real contributions to the pension fund. Furthermore, if the defined benefit plan pension manager has been managing the assets of the fund poorly, then a deficit can also occur even when the plan has been funded. There are no guarantees in either defined benefit or defined contribution plans, even though the defined benefit plan may appear to have them.

Neither defined benefit, nor defined contribution can therefore provide guarantee of the value of a pension. There is more clarity in the defined contribution system, because it clearly provides a reference point against which a pension value can be calculated over the life of the pension plan.

In practice, companies with defined benefit plans have not funded their pension schemes with real financial contributions. Instead, the funds have been used for commercial activity. In some cases the revenues derived from this commercial activity have been insufficient to meet the requirements of the defined pension benefits. Many private companies now face insolvency and litigation from their defined benefit pension plan members. The public sector is also burdened with defined benefit pension liabilities, which it is now struggling to fund out of tax revenues.

To meet current defined benefit pension liabilities, many public and private sector plan sponsors have borrowed from the capital markets. The proceeds of the borrowing are then used to meet outgoing cash payments to retired pension plan members. To avoid reaching this situation, some plan sponsors have borrowed in anticipation of reaching this deficit point in the future. In both circumstances, the financial liability for the pension is not however transferred legally to the lenders. The plan sponsor has two liabilities, one to the lender and the other to the pension plan members. Plan sponsors with weak balance sheets and weak cash flows, therefore increase the risk of insolvency further; by going into debt to fund their pension liabilities.

The “Credit Crunch” of 2008 exposed the shortcomings of both the defined benefit and defined contribution systems.

The defined benefit plans were exposed; as weak company financial performance was unable to mitigate the liability of the unfunded defined benefit pension deficits. Even where the deficits were funded, poor pension fund performance created a deficit that could not be funded from company current income.

The defined contribution plans were exposed; by weak performance of the assets in the pension funds. There was however clarity in the exposure of the defined contribution schemes. Pension plan members had been poorly rewarded by their defined contribution pension plans, however they had no legal recourse for poor performance of the fund manager.

Ultimately, the issue of pensions has become political. So large is the public and private sector liability in the defined benefit system, that policy makers cannot go back to taxpayers and demand that they bailout the insolvent pension funds. The best that the politicians can do is to legislate for mandatory defined contribution schemes going forward. The politicians can bring clarity to the system, however they can never remove the uncertainty that pension plan members do not desire. The debate of defined benefit versus defined contribution has therefore been resolved as an issue of clarity.