Question

Discuss the principle reasons that organizations have moved to defined contributions plans from defined benefit plans, and the specific impact to employees.

Analyze how organizations might enhance the benefits of defined contribution plans to make them more attractive to employees without causing the organization unwanted issues, including fiscal challenges, since that was an original intention of moving from the defined benefit program.

Answer 1

Defined Benefit Plan :

Employers guarantee a specific retirement benefit amount for each participant of a defined benefit plan, which can be based on the employee's salary, years of service or a number of other factors. Employees have little control over the funds until they are received in retirement. The employer bears the investment risk of ensuring the defined benefit amount is able to be paid to the retired employee. Due to this risk, defined benefit plans require complex actuarial projections and insurance for guarantees, making the costs of administration very high. This has made defined benefit plans all but obsolete.

Defined contribution plan :

Defined contribution plans are funded primarily by the employee, called the participant, with the employer matching contributions to a certain amount. The most common type of defined contribution plan, which many people are familiar with, is a 401(k) plan. A participant may elect to defer a portion of his gross salary via a pretax payroll deduction to the plan, and the company matches according to its summary plan description, or SPD. The contributions can be invested, at the participant's direction, in select mutual funds, money market funds, annuities or stock offered by the plan. As the employer no longer has any obligation on the account's performance after the funds are deposited, these plans require little work and are low risk to the employer. The employee must direct contributions and investments to grow the assets adequate for retirement.

Principle reasons that organizations moved to from defined benefit plan to defined Contribution plan :

Defined benefit (DB) pension plans have fallen out of favor. Despite superior performance in providing retirement income, employers are turning away from DB vehicles and toward the use of defined contribution (DC) plans such as 401(k)s and 403(b)s as the sole savings/retirement vehicle for their employees.

This change in sentiment derives from a number of perceived disadvantages of DB plans:

• High employer costs.
• Volatility and unpredictability of cash contributions and accounting expenses.
• Administrative burdens attributable to complexity of applicable law and regulations.
• Responsibility for uncertain obligations.
• Appeal of an immediate, portable benefit for a mobile workforce.
• The Conversion Process

A systematic approach to the conversion process does not guarantee that everyone will be happy with the outcome. It will, however, produce the best possible solution for the money spent. The key elements in the evaluation are:

1. Effects on plan sponsor. The primary effect will be the cost of the new program (including the cost of the DB plan after it is frozen), but the new program may affect retention and hiring if the organization has had a philosophy of long service in exchange for retirement benefits.
2. Effects on participants.Inevitably, some will win and some will lose. DB and DC plans deliver benefits differently. The DB plan channels most of the contributions to those who eventually will retire from the organization, while the DC spreads the money, with relatively more going to young employees and those who have short careers.
3. Effects on the DC plan.The organization might decide to provide additional contributions within the DC plan to a grandfathered group of participants who are particularly vulnerable to the transition. While maintaining two DC programs, nondiscrimination testing might be needed.
4. Effects on the DB plan. Unless the organization decides to continue the DB plan indefinitely, it will be frozen and will need to be maintained and funded until the time at which it is terminated and all benefit obligations satisfied through the purchase of annuities or payment of lump sums. Until then, the organization will need to administer the plan and decide on an investment strategy that is appropriate for a frozen plan.
The budget. The main reason that DB to DC-only transitions fail to reach a successful conclusion is a failure to define an acceptable budget number. The budget has long-term and short-term aspects. In most cases the DB plan must be continued for some time because participants are accruing benefits or because the plan is not well enough funded to be terminated. During this time, the plan sponsor normally will be supporting DB and DC plans with commensurately higher costs. Ultimately, the DB plan will terminate and the only cost will be the DC plan. The target budget will guide the design of the replacement DC plan and quantify how far the sponsor can go in providing additional benefits to participants who are adversely affected by the transition.

As of year-end 2011, most DB plans were underfunded and cannot be terminated. Furthermore, the additional contributions needed to make the plan sufficient for termination are likely to be too high. Consequently, as noted above, the DB plan will need to be maintained for some time, at least until it is completely frozen and the underfunding has been reduced or eliminated.