CHAMPAIGN, Ill. - What a difference a word can make to the security of a person's golden years.
For tens of millions of Americans depending on their company pension to retire comfortably, the difference between a "defined benefit plan" and a "defined contribution plan" can be security versus risk, according to a pension law expert at the University of Illinois at Urbana-Champaign.
Seniors covered by a defined benefit plan receive a regular pension check payable until they die, Richard L. Kaplan, a professor at the College of Law, explains in the spring 2004 issue of the Arizona Law Review.
"If that person leaves a surviving spouse, the survivor will receive a portion of the plan's regular payout - generally half - until that person passes on as well," Kaplan wrote. "This feature addresses what retirees say is their single most important concern, the certainty of lifetime income."
On the other hand, a defined contribution plan requires an employer to contribute a certain amount to an employee's individual retirement account, usually based on a formula of the employee's salary and length of service. When an employee retires, this pension benefit comes in a lump sum rather than a monthly stipend. "There is no minimum monthly benefit level, and no guarantee that a retiree (or his surviving spouse) might not outlive the lump sum," Kaplan said.
What's more, employees with identical work records and salary histories can have radically different pension benefits under a defined contribution plan. This is because employees themselves are able to choose how their contributions will be invested, subject to certain conditions set forth in the plan.
Although a defined benefit plan is superior by nearly every measure to a defined contribution plan for employees, the number of participants in benefit plans has declined precipitously, while the number of participants in contribution plans has risen steadily.
Kaplan is worried about these trends, and in his article he examined some of the root causes of this shift. One factor is that defined benefit plans are more expensive for employers. Such plans must be insured through premiums to the federal Pension Benefit Guaranty Corporation, which give retirees further security, but add to the cost to employers.
A broader trend has been the structural shift of American jobs from the unionized manufacturing sector to service and technology companies. Unions have long favored defined pension plans, as have many traditional manufacturing companies.
The absence of unions in the service and high-tech sectors, together with the pressure on all companies to boost bottom-line results, have led to fewer companies offering defined benefit plans for employees.
"The combined effect of these favors is unmistakable," Kaplan wrote. "More pension risk is being borne by employees."
Starting in the 1980s, many companies began offering salary reduction arrangements sanctioned under Section 401(k) of the Internal Revenue Code, sometimes as a substitute for a company pension plan.
While advertising and media publicity "indicates that 401(k) plans are more attractive than ever," Kaplan wrote, the reality is that these plans require employees to be financially savvy and disciplined to properly manage their accounts.
Do employees really want such power over their future, and can they wisely use it to safeguard their retirement? Unfortunately, Kaplan pointed out, many Enron Corp. employees were all too happy to receive Enron stock in their 401(k) plans when the stock was rising.
The subsequent collapse and bankruptcy of the company wiped out the retirement accounts of thousands of employees, revealing the downside of over-concentration of funds in a single company.
"The risks of nondiversification in 401(k) plans are real and carry the potential for enormous financial pain," according to the Illinois law professor. "These risks should be avoided in the future, and an outright ban on employer stock by Congress in such plans is the simplest and most effective way of doing so."
Beyond the need to reform 401(k) plans, Kaplan asserted that the push away from defined benefit plans, in the name of individual choice, ignores the reality that most Americans are not well versed in financial matters. They are easily swayed by advertising and by offers of speculative stocks or other risky investments that may imperil their retirement years.
"Even the Bush Administration indicated at the National Summit on Retirement Savings that more should be done to encourage defined benefit plans," Kaplan wrote.