Question

The movement from defined benefit pensions (DB) to defined contribution pensions (DC) happened over the past decade.

1. What are the pros and cons of each (DB and DC pension design)?

2. If you are a small business operator with a DC pension plan for your workers, discuss the strategies you will employ to help overcome the limitations of that pension design.

Answer 1

There are two (main) types of pension plans.

In a defined benefit plan the employer/company is responsible for providing retirement benefits to its workers.

In a defined contribution plan the company might match employee contributions in the beginning but they have no further obligations from a benefits perspective.

Defined benefit plans are much more important from the level three perspective

Defined Benefit Plan Pros and Cons

Again, a DB plan is one in which the firm is responsible for providing fixed benefits to the employee. That's the defined benefit in the name, right…it's a promise to the employee.

This employee benefit is a future financial commitment for the firm. In other words it’s a liability which the firm is entirely responsible for.

From the perspective of the employee a DB plan is awesome. You know that you've got this pension that has a guaranteed future value. From the firm's perspective, however, it creates a lot of risk because the future liability is unknown. That said, there are potential benefits to the company. For example, if the plan generates a significant surplus these additional assets can support its stock price etc.

Defined Contribution Plan Pros and Cons

A DC plan is a bit more simple. Again this is a plan in which the firm's sole liability is in the beginning when they're obligated to match a certain dollar contribution of their employees into a retirement account. There's a few legal obligations at this stage (like presenting three plus investment options for the employee) but those are pretty limited and not likely to be tested.

Anyway, once the firm has matched that dollar contribution in the beginning, there is no investment risk for the company anymore and there's none of the costs associated with running a defined benefit pension plan either.

100% of risk gets shifted to the individual. Each person is now responsible for their investment results. You have to make sure that you have enough assets in retirement or like this guy from the Wild West you might be stuck trying to go rob a bank, right?

Pros and Cons:

Pros_DC: 1. Zero Investment risk

2. avoid cost of admin

Pros_DB: 1. Excess return can suppliment business income

2. Pension plan assets can support stock price

Cons_DC: 1. must comply with DC Law

Cons_DB: 1. have 100% market /investment risk

A defined contribution plan, on the other hand, does not promise a specific amount of benefit at retirement. In these plans, employees or their employer (or both) contribute to employees' individual accounts under the plan, sometimes at a set rate (such as 5 percent of salary annually). A 401(k) plan is one type of defined contribution plan. Other types of defined contribution plans include profit-sharing plans, money purchase plans, and employee stock ownership plans. Small businesses may choose to offer a defined benefit plan or any of these defined contribution plans. Many financial institutions and pension practitioners make available both defined benefit and defined contribution "prototype" plans that have been pre-approved by the IRS. When such a plan meets the requirements of the tax code it is said to be qualified and will receive four significant tax benefits. The income generated by the plan assets is not subject to income tax because the income is earned and managed within the framework of a tax-exempt trust. An employer is entitled to a current tax deduction for contributions to the plan. The plan participants (the employees or their beneficiaries) do not have to pay income tax on the amounts contributed on their behalf until the year the funds are distributed to them by the employer. Under the right circumstances, beneficiaries of qualified plan distributors are afforded special tax treatment. It is necessary to note that all retirement plans have important tax, business and other implications for employers and employees. SIMPLE: Savings Incentive Match Plan A SIMPLE IRA plan allows employees to contribute a percentage of their salary each paycheck and to have their employer match their contribution. Under SIMPLE IRA plans, employees can set aside up to $13,000 in 2019 (same as 2018) by payroll deduction. If the employee is 50 or older then they may contribute an additional $3,000 (same as 2018). Employers can either match employee contributions dollar for dollar - up to 3 percent of an employee's wage - or make a fixed contribution of two percent of pay for all eligible employees instead of a matching contribution. SIMPLE IRA plans are easy to set up by filling out a short form. Administrative costs are low and much of the paperwork is done by the financial institution that handles the SIMPLE IRA plan accounts. SEP: Simplified Employee Pension Plan A SEP plan allows employers to set up a type of individual retirement account - known as a SEP IRA - for themselves and their employees. Employers must contribute a uniform percentage of pay for each employee. Employer contributions are limited to whichever is less: 25 percent of an employee's annual salary or $56,000 in 2019 (up from $55,000 in 2018). SEP plans can be started by most employers, including those that are self-employed. SEP plans have low start-up and operating costs and can be established using a single quarter-page form. Businesses are not locked into making contributions every year. You can decide how much to put into a SEP IRA each year - offering you some flexibility when business conditions vary. 401(k) Plans 401(k) plans have become a widely accepted savings vehicle for small businesses and allow employees to contribute a portion of their own incomes toward their retirement. The employee contributions, not to exceed $19,000 in 2019 (up from $18,500 in 2018), reduce a participant's pay before income taxes, so that pre-tax dollars are invested. If the employee is 50 or older then they may contribute another $6,000 in 2019 (same as 2018). Employers may offer to match a certain percentage of the employee's contribution, increasing participation in the plan. While more complex, 401(k)plans offer higher contribution limits than SIMPLE IRA plans and IRAs, allowing employees to accumulate greater savings. Profit-Sharing Plans Employers also may make profit-sharing contributions to plans that are unrelated to any amounts an employee chooses to contribute. Profit-sharing Plans are well suited for businesses with uncertain or fluctuating profits. In addition to the flexibility in deciding the amounts of the contributions, a Profit-Sharing Plan can include options such as service requirements, vesting schedules and plan loans that are not available under SEP plans. Contributions may range from 0 to 25 percent of eligible employees' compensation, to a maximum of $56,000 in 2019 (up from $55,000 in 2018) per employee. The contribution in any one year cannot exceed 25 percent of the total compensation of the employees participating in the plan. Contributions need not be the same percentage for all employees. Key employees may actually get as much as 25 percent while others may get as little as three percent. A plan may combine these profit-sharing contributions with 401(k) contributions (and matching contributions).