Choosing Between (Traditional) DB and DC -- Decision Points
The following is a summary of key decision points to be addressed in considering which pension design -- defined benefit or defined contribution -- is right for your company. It may be especially useful for companies considering a DB plan freeze.

1. Risk. DC plans are "account based," DB plans are formula based. The practical consequences of this are:

a. In DB plans the employer bears the investment risk if earnings fall short (or benefits if earnings exceed the projected rate of return). In DC plans, the participant bears the risk of losses and benefits from any earnings

b. Generally, in DB plans all other risks are borne by the employer; in DC plans they are borne by the participant. The biggest risk (after investment) is probably mortality, a.k.a. "longevity" -- the possibility that the participant may live longer than expected and thus need a bigger benefit than expected.

DC plans have the virtue (from the employer's point of view) of reducing employer risk. On the other hand, the employer is generally better able to bear/diversify these risks than individual participants.

2. Accrual pattern. DB plans target benefits at older employees; DC plans do not. This is because DB benefits are generally described as an annuity beginning at normal retirement; the closer to normal retirement, the more valuable the benefit. Final average pay formulas and early retirement subsidies may exaggerate this older-employee bias.

This feature has several consequences. Younger participants do not value DB benefits as much as older participants, because these benefits are worth very little to them. Older participants, on the other hand, believe they have a right to continued DB benefits -- to the "brass ring" that has been promised if they stay in the plan until they get older. The result: when sponsors try to terminate DB plans, older employees resent it.

3. Transparency/predictability/volatility of costs. DC plans are more transparent than DB plans. You always know what a DC plan costs. But DB plans involve an accrual today of a promise to pay benefits far into the future. Changes in interest rates and asset returns will affect the current valuation, year-to-year, of these benefits and the plan's funded status in an unpredictable way.

Certain financing options may reduce (at a cost) DB liability/expense valuation unpredictability and volatility, but the fact remains, DC costs are more certain.

4. Portability. DB benefits are paid as annuities, although many DB plans now provide a lump sum option. More critically, final pay DB plans put a premium on staying with an employer and getting pay updates on past service. These features of DB plans make them less "portable" -- less appealing to an employee who does not expect to be at an employer for his or her entire career. DC benefits are simple account balances typically paid as lump sums and are, therefore, the ultimate portable benefit.

The portability issue cuts both ways. For employers that are concerned primarily with providing a current benefit with a clear and fair financial value, regardless of length of tenure, a DC benefit is ideal. For employers concerned with retaining valuable employees, the "tenure equity" and lack of portability that DB benefits provide may be an advantage.

5. Culture. DC benefits ideally fit a "what have you done for me lately" corporate culture, where the focus is on financially transparent compensation for current service, and there is no deep loyalty expected either from the employer to the employee or from the employee to the employer. DB benefits ideally fit a "total career" corporate culture, where the expectation is that the employee will spend most of his or her career at the employer.

The DB vs. DC decision may depend more on the issue of culture than on any other issue. Companies that migrate from a "total career" culture to a "what have you done for me lately" culture may face significant resistance in moving away from a DB plan (see "Accrual pattern" above.)

6. Efficiency. DB plans may cost less to administer. You can also argue that DB plans "point" retirement dollars where they are most appreciated -- at older employees approaching retirement. But 401(k) plans allow those participants with a preference for retirement savings to save and those with a preference for cash not to. Perhaps the most glaring inefficiency of 401(k) plans is investment underperformance -- at larger employers, 401(k) plans underperform DB plans by around 125 basis points. Asking the question -- what do you (the employer) get for your benefit dollar? -- you get 125 basis points a year less from a DC plan.

There are at least three possible reasons for DC underperformance -- poor participant asset allocation decisions; higher transaction costs (e.g., retail fees); and more limited investment strategies. The recent move to default funds, coupled with a focus on improving returns on those funds, may overcome much of the DC underperformance problem.

7. Not necessarily so:

a. "DC plans cost less." They do not. It may be possible to reduce benefits in switching from DB to DC, but, axiomatically, benefits cost what they cost. A rich DC plan costs more than a poor DB plan. Indeed, taking into account administrative costs and asset underperformance, an argument can be made that DC plans cost more than DB plans. As noted, however, DC plans are more transparent, less volatile and less unpredictable than DB plans.

b. "DB plans involve greater litigation risk." Generally, DB plans involve less litigation risk because the employer is "on the hook" for plan losses. But, as noted, redesigning or getting out of a DB plan often disappoints expectations and has led to litigation. Generally, DC plan litigation risk has been limited to issues involving company stock, although recent fee litigation may indicate an increase in DC plan sponsor exposure.

c. "Participants 'like' DC plans more." Generally, younger participants like DC plans more, but older participants like DB plans more, for the obvious financial reasons described above.