Let’s assume that a defined contribution (DC) plan has been designed with the same level of employer contribution as a defined benefit (DB) plan the employer previously sponsored.  A common misperception is that, if the employer’s contribution remains the same, employees won’t be impacted.  However, that is rarely the case.  The employer may spend the same amount of money after the plan change, but it is allocated to the employees very differently.

The key issue that is often overlooked is that in a DB plan most of the benefits are earned at the tail end of an employee’s career when the employee nears retirement age.  On the other hand, contribution credits in a DC plan are earned more evenly throughout the employee’s working career, but the impact of compound earnings on those contribution credits will make the early benefits more valuable at retirement.  Because a DB plan allocates a more valuable benefit accrual to older employees while a DC plan allocates more valuable benefit accruals to younger employees, the employees who are late in their career end up on the short end when the employer changes from a DB plan to a DC plan as the primary retirement benefit.

The benefit reduction is even more dramatic if the new DC plan is designed to save the employer money through lower contributions or if the investment market performs poorly after the move to a DC plan.  While a special transition plan for older employees certainly costs more money in the short run, it should be considered to help long-service employees reach retirement with the approximate financial value they were planning on.

This article was last updated on June 30, 2011