DC and DB Plans - Nothing is Risk Free

DC plans, like the 401(k) and DB pension plans, are like apples and oranges, both good for you but very different. With a DC plan, the employer and/or the employee contribute to the plan over time, and the benefit is the sum of those contributions and the earnings thereon—a lump sum. A DB plan provides a formula-based income stream at retirement based on years of service, compensation and occasionally age that can often be converted to a lump sum. Neither approach is risk free.

The risks inherent in DC plans are those accompanying the management of any pool of wealth. First, the assets must be maintained over time. Participants need to retain their accumulations in a DC plan or IRA over their working careers. Regulatory changes to facilitate this have been ongoing. However, as I have written before, this needs to be a voluntary decision.

DC money must be managed so that it retains its purchasing power as well as grows in value. This subjects the assets to market volatility. Strategies to manage that risk continue to be developed. Investment approaches such as the use of dollar cost averaging, rebalancing, diversification and age-based asset allocations reduce investment volatility risk, especially over time. Target date funds and managed accounts permit a participant to delegate investment management to experts. A risk-averse participant can invest in very conservative but low-yielding investments. DC plan participants can use some or all of their assets to purchase an annuity when they retire. Also, there is no limit to the amount DC plan participants can accumulate if they and/or their company want to set aside maximum amounts and they benefit from above average investment returns. Though rare, there are retired average wage workers with DC accumulations generating 100% replacement ratio retirement incomes.

DB plans have their own set of risks. Because DB plans are “back-loaded”, the final benefit is strongly determined by earnings in the final years of employment. Individuals who are involuntarily separated, who leave voluntarily, or who die before reaching retirement age lose a significant portion of what would have been their benefit had they worked for the company until retirement. For example, an employee who worked 13 years before leaving a company with a DB plan finished with a benefit worth just over $2,000 and was involuntarily cashed out.

DB plans are not portable and DB benefit accumulation starts over each time someone begins a new job. We know that most American workers change jobs many times over their working careers, not always voluntarily, and job change risk is significant for those hoping to accumulate a substantial DB benefit.

Another major risk is that the employer may decide to terminate the plan. When this happens the employee is left only with their accrued vested benefit. Again, because the DB benefit is more heavily weighted to reflect the years just prior to retirement, this accrued vested benefit is usually modest at best, except for the oldest employees. If the sponsoring employer becomes bankrupt, benefits may be reduced to the PBGC guaranty level.

Many DB plans limit payments to a fixed annual amount. Some remember as I do when the hyper-inflation of the late 70’s/early 80’s destroyed the purchasing power of those on fixed incomes. Finally the benefits generated by most DB plans are capped. The DB cap for the plan where I worked before joining PSCA was 45% of the average of the final five years of pay. This worked out to about 40% of the final years pay.

Both types of plans have risks for participants. The primary difference is that in a DC plan individuals can take action to manage those risks and react to changing conditions. In DB plans individuals are subject to risks over which they have no control.

David