Types of Pensions
Defined benefit (DB) pension plans offer Association members a secure retirement by providing a guaranteed benefit that can never be taken away. Such plans are the primary retirement benefit for a majority of K-12 public school teachers, education support professionals, and other public employees. Despite claims of DB plan opponents, there is research and strong evidence that DB plans are a better deal for workers and employers than DC plans.
DB plans are less expensive to operate and they earn higher investment returns than DC plans. A recent examination of the cost savings of a DB plan found that a pension for a 30-year-old teacher, projected over the course of a 30-year career and calculated to provide a modest retirement benefit of $2,200 a month, was more expensive in a DC plan than in a DB plan (requiring $354,962 to be set aside for a DB plan v. $549,903 for a DC plan).
Want more evidence? The West Virginia Teachers Retirement Plan offers an excellent example of the superiority of the DB over the DC approach. Until 1991, this retirement system provided benefits through a DB plan. The state switched to a DC plan for new hires in 1991—and then switched back to a DB plan in 2008. The reason was cost. It proved simply less expensive to provide a given level of benefits through a DB than through a DC plan.
The efforts of some conservative groups and some elected officials to undermine or eliminate DB plans have not been very successful, but they are on the increase. To date, only Michigan (for state employees), Alaska, and the District of Columbia (for ESPs) require employees to enroll in a primary DC plan. Nebraska (for state and county employees) and West Virginia (for education employees) have actually moved away from primary DC plans back to DB plans because of higher costs.
Defined contribution (DC) plans (often called 401(k) plans after the tax law provision that covers such plans in the private sector) cover many workers either as their primary retirement savings plan or as a supplement to their pension plan. A DC plan is an account in which contributions are invested and earn income. These accounts can also lose value when the stock market declines.
When a DC plan participant retires, the amount in the account represents the employee’s retirement savings. The participant can opt to gradually withdraw funds from the account or take money out at one time, commonly known as receiving a lump sum. The stock market crash of 2008, which left many private sector employees near retirement age with inadequate savings for their retirement, illustrates the problems associated with DC plans.
Several states have developed hybrid plans that combine features of DB and DC plans. In some plans, the employer’s contributions fund a DB plan and the employees’ contributions fund a DC plan. When employees retire, they receive two streams of income, one from the DB plan and the other from the DC plan. These plans offer a less secure, and typically a lower, benefit.
Recently, the cash balance plan design has been receiving increased attention. A cash balance plan is a plan that superficially combines elements of both defined benefit and defined contribution plans, but is in fact a defined benefit plan, which typically provides less generous benefits. It is a defined benefit plan because IRS regulations require that it provide a “definitely determinable” benefit and because the employer is obligated to fund the difference between the accumulated assets and liabilities of the plan.
A cash balance plan accumulates a “notional” or “hypothetical” account balance for each employee. The account is credited each year with a pay credit (such as 5 percent of compensation from the employer) and an interest credit (either a fixed rate or a variable rate that is linked to an index such as the one-year Treasury bill rate). While benefit payment options can vary, upon retirement, the hypothetical account balance may be converted into an annuity (this option is required by IRS regulations).
Depending on the plan, part or all of the annuity value may be reconverted into a partial or full lump sum, a step that is even permitted by the IRS for traditional defined benefit plans. The benefits paid at retirement under a cash balance formula are typically less than the benefits paid under a traditional defined benefit plan because they are based on the employee’s entire career earnings, their lowest to highest earning years.
Traditional defined benefit plan calculations are based on the employee’s final years of service, when the employee’s salary is usually at its highest level. A cash balance plan could provide equivalent benefit levels to defined benefit plans, through higher notional account balance credits, but this would be more expensive since participants who terminate prior to retirement would be credited with higher account balances as well.
Proponents of these plans argue that cash balance plans provide a better benefit for employees who leave employment before retiring. In such cases, employees receive the amount in their notional account. However, this provision increases plan costs by raising the cost of providing benefits to career employees.