Running head: From Standard, Traditional Plans to 401(k)s and 403(b)s

Transitioning from Defined Benefit Plans to Defined Contribution Plans

Camille D. Tilghman
University of New Haven
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Running head: From Standard, Traditional Pension Plans to 401Ks.

Abstract
"Despite superior performance in providing retirement income, employers are turning away from
defined benefit vehicles and toward the use of defined contribution plans such as 401(k)s, and
403(b)s as the sole savings or retirement vehicle for their employees" (Berger 2012). This paper
will uncover the reasons why companies are transitioning from defined benefit (DB) plans to
defined contribution (DC) plans. It will explore the types of defined benefit and contribution
plans offered to employees and identify the advantages and disadvantages of DB and DC plans.
This paper will conclude on how this transition has impacted the workforce.
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Running head: From Standard, Traditional Pension Plans to 401Ks.

Introduction
Defined benefit and contribution plans are retirement plans and originated from the
Employee Retirement Income Security Act of 1974 or ERISA. ERISA is a federal law that sets
minimum standards for retirement plans in the private industry (U.S. Department of Labor 2020).
Its main goal is to protect the assets placed in these funds for every American's work-life until
retirement. ERISA establishes standard funding rules that require plan sponsors to provide
adequate funding for the person's plan of choice – a defined benefit or contribution plan.
Defined benefit (DB), or traditional pension, plans are funded by the employer and promises the
employee a specific monthly benefit at retirement. DB plans either state the promised benefit in
its exact dollar amount – the amount is accrued monthly from the date of retirement until death –
or calculates the benefit through a formula (U.S. Department of Labor, 2020). This formula
typically includes factors like one's salary, age, and the number of years the employee worked at
the company. Companies usually require employees to work a minimum number of years to
receive the pension, and they must reach a certain age before receiving their monthly retirement
payments (LaPonsie, 2020). Employers also give their employees the option to receive their
pension in a lump sum. These set requirements make the employers fund the pensions, so the
employees don't make any contributions towards DB plans.
Defined contribution (DC) plans do not promise the employee a specific amount at
retirement. These employer-sponsored benefit packages allow the employee and/or employer to
contribute money to his/her account (U.S. Department of Labor, 2020). The SIMPLE IRA plan,
SEP, employee stock ownership (ESOP), and profit-sharing plan are other examples of defined
contribution plans. Yet, 403(b)s and 401(k)s are common types of defined contribution plans. A
403(b) is used in the public sector and is a retirement account for public school and tax-exempt
organization employees, such as teachers, school administrators, professors, nurses, doctors,
government employees, and librarians (Kagan, 2020). A 401(k) is used within the private sector
and investments are made towards retirement are controlled by employees. The employee or
employer can make contributions from his/her paycheck before taxes are subtracted. Employees
can contribute up to $19,500, and those 50 and older are entitled to make $6,500, for a total
annual contribution of $26,000 (LaPonsie, 2020). Employers also make contributions to workers'
401(k)s, by matching a certain percentage of the employee's contributions.
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Running head: From Standard, Traditional Pension Plans to 401Ks.

Types of Defined Benefit Plans

Pension plans, or qualified-benefit plans, offer a single-employer plan, agent multiple-
employer plans, and cost-sharing multiple-employer plan. A single-employer plan provides
pensions to employees with only one employer. An agent multiple-employer plan pools its
assets, but separate accounts are created for each employer from which to pay his/her pension
benefit obligations to employees. Cost-sharing multiple-employer plans pool the pension assets
and obligations of more than one employer. The pension plan assets pay the employee's benefits
for any employer that contributes through the pension plan (Colorado PERA, 2020). Pension
plans also provide employees with different types of payout options: lump-sum payment, single-
life annuity, or a qualified joint and survivor annuity. A lump-sum payment is the employee's
entire benefit value in a single payment. A single-life annuity provides the employee with a fixed
monthly benefit until his/her death. The qualified joint and survivor annuity payout gives a fixed
monthly benefit until death, and the surviving spouse can continue receiving the employee's
benefits after death (Kagan, 2020).
Types of Defined Contribution Plans
There are four types of 401(k) plans: traditional, safe harbor, SIMPLE, Roth, and
automatic enrollment 401(k) plan (U.S. Department of Labor, 2020). The Roth 401(k) and
traditional 401(k) are the two most commonly used 401(k) plans. Traditional 401(k)s plans offer
a tax deduction whenever contributions are made. The money grows tax-deferred but is subject
to income taxes once withdrawn for retirement. If the money is withdrawn before 59½, he or she
is subject to a 10% penalty fee. Once the retiree reaches 72, he or she must deposit a minimum
distribution or pay a penalty up to 50% of the distribution amount (LaPonsie, 2020). Roth 401(k)
plans differ because they don't provide a deduction for contributions, yet they can be withdrawn
tax-free in retirement. Roth 401(k) plans also penalize employees on early withdrawals, but only
on their investment gains. Otherwise, there is no penalty for withdrawing a portion of the
principal early. Unlike traditional 401(k)s, there aren't any required minimum distributions in
retirement. Regarding 403(b)s, the features of traditional and Roth 403(b)s are very similar.
403(b)s offer the same contribution limits of $19,500 (Kagan, 2020).

Advantages and Disadvantages of DB Plans

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Running head: From Standard, Traditional Pension Plans to 401Ks.

DB pension plans offer guaranteed income for the employee and the employee's spouse
thereafter. Employees don't have to contribute any income towards their retirement, and the
payment lasts throughout retirement; this makes budgeting for retirement is easier. The employee
also doesn't have to worry about their retirement income or payout options – this is the
employer's responsibility. The downside with DB plans is that an employee can't withdraw funds
until they meet the requirements set by the employer, like age and the employee's working years.
Employees have limited control over how they wish to receive their pension – the employer
determines the payout option for his or her employees. Employees have no opinion on how their
money is invested, and they can’t invest more money into their plan. The employer has complete
autonomy over how the money is invested, but he/she bears the risk of poor investment and
expenses.
Advantages and Disadvantages of DC Plans
DC plans allow the employee to invest in him/herself and control his/her retirement
investments. So, employers have no investment risk because it's in the hands of their employees.
Employees have more flexibility with their DC plans, and these plans are portable. So,
employees can change jobs or become self-employed and take their savings with them.
Employees, age 50 or older, have the option for catch-up contributions. Catch-up contributions
allow employees to deposit additional money if they haven't reached the plan limit's max dollar
amount. Catch-up contributions and daily contributions allow the employee to have a higher
monetary retirement savings plan. Unfortunately, poor savings and bad investments will affect
the employee's DC plan and can result in a zero-retirement savings plan. The amount of money
saved depends on the employee's investment and withdrawal decision, so there's a possibility of
the DC plan depleting early into one's retirement. Unlike DB plans, DC plans don't guarantee
lifetime income to employees. Some employees find DC plans to be more expensive then DB
plans.

Factors Contributing to the Shift from DB to DC plans

Gerhart, Newman, & Milkovich (2017, p. 451) believe there are two sets of factors,
employer and employee, contributing to this shift. Employer factors deal with the total
compensation cost, costs relative to benefits, competitor offerings, legal requirements, and the
role of benefits in relation to attraction, retention, and motivation. The employee factors focus on
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Running head: From Standard, Traditional Pension Plans to 401Ks.

equity and their personal needs. Other factors linked to this organizational shift are industry
changes, generational differences, and flexibility. As the workforce aged, the funding costs for
DB plans rose since benefit levels increased due to early retirement and longevity (Broadbent,
Palumbo, & Woodman, 2006, p. 19). These funding costs started affecting the profits of multiple
organizations. According to Stoltzfus (2016, p. 6), employer total compensation costs typically
included wages and salaries, plus benefit costs. The cost for defined benefit plans is based on
plan investment returns that fluctuated often. Thus, it quickly became a financial burden for
administration because these costs were legal requirements and the employer's responsibility.
Another cost, known as worker participation costs, became an issue. Worker participation costs
are determined by an individual's benefit-cost divided by the participation rate (U.S. Bureau of
Labor Statistics, 2012, p. 4). As more workers participated with DB plans, the costs increased.
The U.S Bureau of Labor Statistics (2012) stated that in March, worker participation costs were
more than 70% higher for defined benefit plans than defined-contribution plans (p. 3). Worker
participation costs depended on the organization's size, bargaining status, and occupational
group. Occupations such as construction, maintenance, and manufacturing were prime users of
DB plans.
As the industry and generations changed, the need for DB plans diminished. Since
America is no longer a manufacturing hub and technological advancements, like artificial
intelligence, replaced many jobs, America shifted to a service industry. The demand for DB
plans decreased because they didn't meet society's needs. Millennials are replacing the baby
boomers and generation x within the workforce, and organizations don't want to be liable for
their employee's retirement. As of 2017, millennials make up the majority of the labor force;
there are about 56 million working millennials (Infield, 2018). The idea of investing in oneself
appealed to this generation, so they became more familiarized with the stock market, bonds,
mutual funds, and retirement plans. Using U.S. Census Bureau retirement savings data in 2012,
Infield (2018) concluded that "millennials are the first generation to rely primarily on defined
contribution plans for saving." The trend towards DC retirement plans occurred because
millennials weren't interested in the promise of monthly benefit payments at age 65. Instead, this
generation wished to take their finances and retirement future into their own hands. Baby
boomers and generation X don't have this mindset. They aren't susceptible to change, and their
job loyalty prevents them from leaving. At the time, DB plans matched this generation's needs
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Running head: From Standard, Traditional Pension Plans to 401Ks.

because they remain at their jobs until retirement. Millennials prefer flexibility and have an
affinity for changing jobs. DB plans aren't flexible or portable, and this made millennials feel
constrained. DC plans offer millennials freedom with their careers and retirement future.

Conclusion
As years passed, a change in the industry and generational differences caused the demand
for defined benefit plans to decrease. By the end of 2011, most DB plans were underfunded and
couldn't be terminated (Berger, 2012). This affected the employees because their defined-benefit
plans became frozen. Organizations closed DB plans to new participants and either continued or
froze benefit accruals for existing participants. Once these plans were terminated, employees
received their benefits as a lump sum. Terminating DB plans is costly which is why there are still
DB plans offered. As DB plans continue to phase out, DC plans will become the sole retirement
savings plan. For now, defined contribution plans meet society's needs, but as the world evolves
and generation Z enters the workforce, a new retirement savings plan may arise.
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Running head: From Standard, Traditional Pension Plans to 401Ks.

References
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https://www.dol.gov/sites/dolgov/files/EBSA/about-ebsa/our-activities/resource-
center/faqs/retirement-plans-and-erisa-compliance.pdf