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Are defined benefit (DB) pension plans dead? They certainly look dead. Last year, several airlines famously dropped their DB plans onto the government-backed insurer (the Pension Benefit Guaranty Corporation). Meanwhile, in the first week of 2006, the International Business Machines Corp. (IBM) followed the lead of the Sears Holding Corp., Verizon Communications and over 67 other companies, which froze or closed their DB plans to new hires in 2005. IBM and the other “DB freezers” have instead opted for 401(k) plans, which shift the risk of preparing for retirement from the company to the individual worker. Now, retirement savings depend on workers’ ability to save regularly, invest wisely, and at low costs.
However, these trends lead to the misleading conclusion that DB plans are going the way of the dinosaur. Quite the contrary, many employers continue to offer these plans. Most Fortune 500 companies, public sector employers, new small professional firms (Frieswick 2002), schools, and hospitals all maintain DB plans. Additionally, a small number of employers that replaced DBs with defined contribution (DC) plans, such as the state of Nebraska, are now switching back. The truth is employers will continue to sponsor DB plans because both employers and workers often prefer them for sound reasons.
Moreover, the retirement landscape is characterized by three major problems, which can be better addressed by well regulated DB plans than by defined contribution (DC) plans. For one, many private sector employees are not covered by a pension plan. Second, retirement wealth creation has proceeded rather unequally, leaving many low and moderate income families with too few savings. And third, increasingly families are exposed to more and more risks when saving for retirement, which can mean that they will not have the retirement income that they expected.
In all three regards, DB plans continue to offer advantages not shared by DC plans, such as 401(k)s. For one, DB plans automatically cover every eligible worker. This universality cannot be duplicated in the DC world, unless employers are required to contribute for every worker. Not surprisingly, then, DB plan participation is associated with rising pension coverage in general to a larger degree than DC plan participation. In addition, DB plans are more efficient than DC plans. As a result, DC plan participants pay retail marketing, management, and annuitization fees — DBs pay wholesale, which means that more of each dollar saved will actually go towards retirement benefits under a DB plan. Moreover, workers are protected from a number of important risks under DB plans: idiosyncratic risk, market risk, and longevity risk. DBs are professionally invested, which substantially reduces the risk of making unwise or unlucky investment decisions. Also, DB plans have a long time horizon, which allows them to ride out bad market performances, thus reducing market risk. And DB plans typically pay a monthly lifetime benefit upon retirement, thereby reducing the risk that a worker runs out of savings.
DB plans, though, are not only beneficial for employees. Employers can use them as an important personnel management tool. This is particularly true in companies that are in need of high skilled labor. Moreover, as the retirement of the Baby Boom generation creates a labor shortage of skilled workers for many firms, such tools to retain an important resource will gain in relevance.
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