Back to Basics – Defined Benefit vs. Defined Contribution Pension

PensionIntroduction

As the military transitions into a new pension system, it’s important to take a step back and look at the concept behind this move.  This article will not go into specific details on the new vs. old plan, but will speak generally in terms of the shift from defined benefit to defined contribution.  Although the US Government is looking to make adjustments, such as raising the cap on government contributions from 5% to 6%, this does not change the broader discussion.  Let’s focus this discussion on the difference between a defined benefit plan and a defined contribution plan, and its impact on your life.

Purpose of a pension

Before we get too far, let’s first start with the purpose of a pension program, and how it works in the civilian world.  A pension program is an employer’s attempt to ensure some semblance of financial reward to its employees for the value they provide to the employer.  This sentence is purposefully vague, because it doesn’t:

  • Define what the employer is. Employer could be a company, non-profit organization, the U.S. Government, or a state/local government agency.
  • Define the financial reward. This could be any number of things, to include a lump of cash, guaranteed income for a certain period of time (or for life), the right to invest in securities (or securities themselves), or any combination.
  • Define the employee or the required value contribution. The employee could be anyone, everyone, or people who meet certain criteria (length of service, achieving certain positions, etc.)

A pension does not guarantee a certain quality of life, nor is it supposed to establish any expectations than what’s clearly articulated:  a certain incentive to meet a certain set of conditions.

Difference between defined benefit and defined contribution

Since pensions are not limited to the U.S. government (although they seem like it nowadays), let’s look at the difference between defined benefit and defined contribution plans.  For non-government entities, there are legal definitions of each term, under the Employee Retirement Income Security Act of 1974 (ERISA), which provides certain tax benefits to employers for providing pension plans that meet the requirements.  According to ERISA, below are the definitions of a defined benefit plan and a defined contribution plan:

  • A defined benefit plan promises a specified monthly benefit at retirement
  • A defined contribution plan, on the other hand, does not promise a specific amount of benefits at retirement.

That seems pretty simple, but let me explain why that’s relevant.  ERISA enforcement falls under the supervision of the Department of Labor, which makes determinations on whether a pension plan complies with the law.  If a pension plan is deemed to be non-compliant with ERISA, that doesn’t mean that it’s illegal.  It just means that companies won’t get the tax benefits that they otherwise would.  This is important, as I’ll explain next.

Why the shift?

Back in the day, when our grandparents were working for companies that gave away gold Rolexes at retirement, you were guaranteed two things:  the gold watch, and a pension.   In order to guarantee the pension, the company would set aside a certain amount of money, in accordance with ERISA guidelines.  Companies did this because back in the day, you would:

  • Work really really hard with the same company for a very long time and retire in your 60s.
  • Then die. Usually in your 60s.

About a generation and a half ago, companies realized a couple of things:

  • People were living longer and longer.
  • Paying a pension for 20 or 30 years was much more expensive than paying a pension for 5-10 years.
  • Since longer pensions were more expensive, companies had to set aside more money to guarantee them. This had a direct impact on their bottom line.
  • It was cheaper to just give people a bag of cash (in the form of a 401(k) or pension buyout) in exchange for the right to not have to pay them money for the rest of their life.

By being able to transition their workforce from a defined benefit (guaranteed pension) to a defined contribution (bag of cash i.e. 401(k)), most companies were able to keep their ERISA tax benefits while reducing or eliminating their pension obligations, which directly improved profits.

Look at the automotive industry bailout.  While the move from defined benefit to defined contribution was largely executed by the IBMs and GEs of the world decades earlier (and completely avoided by the Microsofts and Apples), the Big Three were saddled with billions of dollars in pension obligations this almost crippled the entire automotive industry.  Not only did corporate America recognize this trend, but so did the rest of the U.S. Government.

In 1987, the US Government replaced the Civil Service Retirement System (CSRS), with the Federal Employees Retirement System (FERS).  While both systems had elements of defined benefit (pension) and defined contribution (Thrift Savings Plan), it was clear that FERS was more focused on the employee’s responsibility to manage a larger portion of their retirement plan.  We’ll talk about that next.

The impact to the employee

That’s great for the company, being able to save money and all.  What about the employee?  That’s where things get a little dicey.

Regardless of your employer, think of funding your retirement as a measure of risk.  Let’s define that risk as the ability to have money available to fund a certain income stream in retirement.  Under a defined benefit plan, it was the company’s responsibility to fund that income—all your grandfather had to do was set his budget to that income, and your grandparents were set.  Your grandparents didn’t have to know how the company did it, but as long as the company existed, they kept getting the same pension and could actually budget to it, because it was guaranteed by the company.  The company, on the other hand, had to set aside a certain amount of money to make sure they could keep pumping out those retirement checks.

Under a defined contribution plan, that changes.  The company no longer has to set aside that money for pensions.  However, if you want that same cash flow, you do.  Now, you have to:

  • Pay a lot closer attention to your cash flow needs
  • Manage the actual cash flow in your retirement from your accumulated savings
  • Wisely invest your money, over the course of your life and in your retirement, so that you have enough to support your cash flow needs

In other words, while your grandfather didn’t have to worry about where his pension came from, YOU DO!  Moving from a defined benefit to a defined contribution plan means shifting the investment risk from the company to the employee.  You can think of this as a 0-100 scale.  In blended programs, like the government FERS program, the risk is somewhere in between, since there are defined benefit and defined contribution elements.

What’s the shift (in broad terms) for the military’s pension plan?

In a broad brush aspect, this retirement system reform is the government’s attempt to shift some (not all, at least not right now), of that retirement risk from the military to servicemembers and their families.  It might sound like a good deal, in certain circumstances, it is, especially in today’s environment where people with less than 20 years walk away with zero government contribution to their retirement savings.

However, in the case of people who end up with a military retirement, the new program (or signing up for it if there’s a choice) means giving up a part of that security in exchange for having to (or having the opportunity to, depending on how you see this) manage more of your future.

What is the impact to me, and what do I do?

First of all, stay tuned.

If you’re grandfathered into the old system, there’s nothing you can do about it, so just be thankful that you can plan to the system you’re familiar with and move on.  If you’re mandated into the new system, learn as much as you can about it, and educate yourself on how you can better manage your financial future.  If you’ve got the option, take a REAL close look at the two systems.  If you know you’re getting out before 20, you should probably take the new system and get something.  However, if you even think you might serve a 20 year career, you should be very leery, even if it seems like you’re getting a lot of cash.  That cash is the government’s effort to buy out part of your pension, which could do you more harm than good in the long run.

As always, please feel free to follow this blog or contact me at:  forrest@westchasefinancialplanning.com, if you like this blog, have concerns or questions, or have a topic that you would like for me to address.  Until next time, take charge of your life!

About Forrest Baumhover

I'm a career naval officer, and a fee-only financial planner. Half-way through my career, I discovered that I had a passion for financial planning, and have pursued this as my second career. My specialty is working with military professionals who are looking to separate or retire from the service, and who feel they need some professional guidance to make sure they're on track.
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One Response to Back to Basics – Defined Benefit vs. Defined Contribution Pension

  1. Pingback: Weekend Wrap-up: Military Personal Finance Articles You Should Read (7/15-7/21) - Military in Transition

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