Retirement plans for employees are generally divided into two types. The first is a defined contribution plan, where the employee contributes a set amount of money each pay period, and upon retirement the amount contributed and any interest or profits made on those contributions will become available to be drawn down at the discretion of the employee. The most popular form of defined contribution plan is a 401(k). The second type of plan is the defined benefit plan, where an employee is guaranteed a pre-determined payment at the time of retirement based upon the amount of time that the employee works for an employer prior to retirement. This type of plan is commonly referred to as a pension.
A defined contribution plan places the financial risk on the employee. If the investment return on the retirement savings is weak or the employee lives longer than planned, the employee risks not having enough income to survive through retirement. By taking on the financial risk, the employee also retains full control over their retirement savings. The retirement funds are placed in the name of the employee, not the employer. An employee can access the funds at any time; however, to avoid tax and early withdrawal penalties they must wait until they are 59 ½ years old. At that point they can access as much or as little of the funds as they desire.
A defined benefit plan places the financial risk on the employer. An employer commits to paying an employee a predetermined amount at the time of their retirement for life. This could come in the form of a percentage of salary annually, or a set dollar amount per pay period. An employee typically has to remain employed for a certain period of time before they are eligible for retirement benefits, this is known as a vesting period. Once an employee is vested, they are eligible to receive retirement benefits upon reaching a retirement age even if they change jobs, making it possible to qualify for multiple retirements benefits. This poses a risk for employers that have no guarantee that the amounts contributed by the employee or employer will be sufficient to cover retiree benefits. If investment performance or age of retirees exhaust the pension fund, an employer will still be responsible for covering benefits.
The manner in which pension benefits are calculated incentivize the employee to remain with a single employer. For instance, if a pension is calculated at 1.5% of final salary per year of service: a person that works 10 years from ages 25-35 and is earning $50,000 at the time they stop working, will entitle them to (10years * 1.5% * 50,000) $7,500 per year in retirement, an amount that will lose purchasing power due to inflation over the 30 years prior to reaching retirement age. The person could then work the next 25 years under the same pension system which would entitle them to (25 years * 1.5% * 100,000) $37,500, for a combined benefit of $45,000. On the other hand, a person that works 35 years from 25-60 and has reached a $100,000 salary by age 60, the employee would be entitled to (35 years * 1.5% * 100,000) $52,500 per year in retirement, replacing more than half of their working income. Changing jobs in this example costs an employee $7,500/year.
Readers, have you kept at a job you didn’t care for just to get your pension vested? What do you think on the defined benefits versus the defined contribution?