- Defined-contribution plans are inherently less efficient than defined-benefit plans, which are better managed and earn higher investment returns
- Defined-benefit plans can also take advantage of the law of averages
- To retain a qualified workforce, governments should offer compensation packages that are competitive with the private sector
This column by McCombs Accounting Professor Michael Granof originally appeared on Governing.com. It is republished here by permission of the author.
For an infographic that illustrates the differences between defined-benefit and defined-contribution retirement plans, scroll down to the end of the article.
Detroit's bankruptcy filing, following similar filings by Stockton and San Bernardino, Calif., and Central Falls, R.I., has brought renewed calls for public-pension restructuring. Probably the most frequently proposed reform is that state and local governments should switch from defined-benefit retirement plans to defined-contribution plans. Such a change, however, would be misguided.
Defined-contribution plans are, of course, the darlings of businesses. They let their sponsors avoid the uncertainties associated with defined-benefit plans. Once a company makes its annual contributions to its employees' accounts, it is off the hook forever for any further payment. As a consequence, the employers don't have to desecrate their balance sheets with pesky long-term liabilities or their income statements with expenses that are determined as much by changes in the stock market as they are by any actions of the employers themselves.
But almost any actuary will tell you that defined-contribution plans are inherently less efficient than defined-benefit plans. Indeed, some will say that the worst defined-benefit plan is more efficient than the best defined-contribution plan. In part, this is because defined-benefit plans tend to be better managed and earn higher investment returns. The primary advantage of defined-benefit over defined-contribution plans, however, is inherent in their nature: Defined-benefit plans can take advantage of the law of averages.
In a defined-contribution plan, the employer maintains a separate account for each employee. The employee is dependent upon the balance in that account for his or her retirement income. If an employee retires at age 65, then, if fortunate, he or she may live another 30 or more years. Therefore, upon retirement, the balance in that account -- and the pre-retirement contributions to attain that balance -- must be sufficient to provide an annuity for at least that number of years.
By contrast, in a defined-benefit plan, a single, common account is maintained for all eligible employees. If the employees retire at age 65, then on average they can be expected to live no more than about 20 years. Therefore, the balance per employee and the pre-retirement contributions can be far less.
It's true that many state and local governments' defined-benefit plans are fiscal debacles. The Center for Retirement Research at Boston College estimates that, collectively, state and local government plans are only 73 percent funded -- a shortfall of at least $1 trillion. But that is due more to imprudent policy decisions than to the nature of the plans. Simple, common-sense practices can restore them to fiscal health.
Most importantly, governments must consistently contribute to the plans the amounts that their actuaries calculate are necessary to sustain their long-term fiscal well-being. In the past, they have failed to do this, and particularly in years in which stock prices were high they have cut back on their contributions. They must acknowledge the law of fiscal gravity: What goes up also comes down.
In addition, governments can eliminate provisions that increase payments to retirees but otherwise make little economic sense. These include those that permit "spiking" (the practice by which employees work extensive overtime in their last year of employment to boost the basis on which their pensions are calculated) and that allow employees who retire at a young age to start collecting benefits well before they reach a normal retirement age.
Retirement benefits are but one element of a comprehensive compensation package. To be sure, retirement plans for government employees are typically more generous than those of private-sector workers. The Center for Retirement Research concludes, however, that, even taking account of benefits, private-sector workers enjoy on average a 4 percent compensation advantage over their state- and local-government counterparts.
To retain a qualified workforce, governments should offer their employees compensation packages that are competitive with the private sector. Simply moving from a more efficient to a less efficient pension plan is hardly consistent with that objective.
Infographic: Defined Benefit vs. Defined Contribution (click image for full size)