Why would an employee want to participate in a defined benefit plan?
A defined benefit (DB) plan provides a defined level of income in retirement, which can be thought of as retirement insurance funded by the employer. In contrast, a defined contribution plan provides a certain level of contribution throughout a person’s working career and the retirement income depends on the value of the account when the person retires.
Individuals face a variety of risks in retirement and some tip the balance toward a DB plan. A DB plan shifts some to the plan sponsor and shifts other risks to the individual.
The longevity risk is both pooled and shifted to the plan sponsor in a DB plan. When a participant elects an annuity from a DB plan, he no longer has to worry about outliving his retirement income. It is very difficult to manage retirement resources to last a lifetime, but not have too much left at death. A guaranteed retirement income removes the longevity risk from the individual.
Pre-retirement inflation risk is another area where DB plans that base benefits on pay at or near retirement hold an advantage. As long as salary increases keep pace with inflation, which is generally the case, the retirement benefit will be protected against inflation prior to retirement.
A DB plan rewards an individual who remains with the plan sponsor for a good portion of his career. Benefits in a DB plan become more valuable as the individual ages. As a result, the most valuable accruals are earned as the individual nears retirement. A loyal employee benefits significantly from a DB plan.
Employees who are mid- or late-career when starting to work for an employer tend to do better in a DB plan since the most valuable benefits are earned near retirement.
This article was last updated on February 27, 2013