Choosing between a defined benefit and defined contribution retirement plan
I was recently speaking to a friend who just got a new teaching job and was offered a one-time choice between enrolling in a traditional defined benefit pension plan or receiving a match in a defined contribution plan, such as a 401(k) or 403(b) plan. With a defined benefit plan, your pension is typically paid out to you as a guaranteed income based on a formula that factors in your income and how long you’ve worked there. Your employer takes full responsibility for funding and investing the money in the plan. With a defined contribution plan, you invest the money contributed to your 401(k)/403(b) account (by you and/or your employer) and receive the balance.
While the former has become increasingly rare, you may find yourself presented with such a choice – either as a new employee like my friend or as a longtime employee being offered the option of enrolling in a new plan. This is an important decision because it generally can’t be changed once you make it. Here are some things to consider:
1) Which plan can be expected to provide you the most retirement income?
This is an obvious place to start but will require a lot of assumptions. Both plans will need you to estimate how much your income will grow and how long you’ll work at the company. Be sure you use the same estimates for both so you’re comparing apples to apples.
You can then plug those numbers into the defined benefit plan’s formula to estimate your benefit. For example, my friend would get about 40 percent of the average of her five-highest income years after working for 25 years. If that five-year income average is $80k in today’s dollars, she’d get a benefit of about $32k a year, or $2,667 per month.
On the defined contribution side, you’ll also have to assume an average rate of return on your investments to calculate how much extra you’ll have in the plan at retirement. For example, if my friend earned that same $80k for the 25 years, received an 8 percent match, and earned a real (after inflation) average annualized return of 5 percent a year on her investments, she’d end up with about $318k. At today’s annuity prices, she would be able to purchase an immediate income annuity paying about $1,700 a month in NY, starting at age 65.
2) Do you prefer stability or flexibility?
If running the numbers was all that mattered, the defined benefit plan would win in a slam dunk. However, there are a few other things to consider. One is that the defined benefit plan might force you to take an annuity at retirement, while the defined contribution plan would provide you the option of taking a lump sum. The lump sum option might be more appealing if you don’t need the security of a defined benefit (you expect to withdraw 4 percent or less from your nest egg at retirement) or just prefer the flexibility of being able to invest and access the money throughout your life and pass the remainder on to heirs.
On the other hand, you won’t have to worry about investment returns with the defined benefit plan. If you’re more conservative with your investments, don’t have good investment choices, or just prefer not having to worry about them at all, you may prefer the stability of the defined benefit plan. (I should point out that defined benefit plans do have the risk of your employer not being financially able to pay your benefit, but in that case, at least part of your benefit is likely to be insured by the Pension Benefit Guarantee Corporation.) Annuity prices may also be different when you retire so the payments you get may be more or less than projected. (The annuity payments will generally be higher if interest rates are higher and lower if interest rates are lower.)
3) When do the benefits vest?
None of these benefits matter, if you don’t stay with the employer long enough to vest. Vesting is when you actually take ownership of the benefits you’ve earned. In my friend’s case, the vesting period is only one year for the defined contribution plan and ten years for the defined benefit plan. That means if she left after five years, she would be able to take her entire balance in the former and nothing at all from the latter! The risk of not wanting or not being able to stay that long made her initially lean in favor of the defined contribution plan.
As you can see, this decision is very personal and can be quite complex. If you’re not sure what to do, see if your employer offers access to an unbiased financial planner who can provide you with some guidance. If not, you may be able to hire one for an hourly or one-time fee. In any case, make sure your decision is an educated one.