Explainer: The Debate Over Defined-Benefit vs. Defined-Contribution Pensions

Mark J. Magyar | May 27, 2014 | Budget, Explainer
Both approaches have gotten a lot of press of late, here's a way to cut through the doubletalk

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Since January, Gov. Chris Christie has been arguing that the only way out of the state’s deepening pension crisis “is to stop the insanity of a defined-benefit pension system that we cannot afford,” and to switch to some variation of a defined-contribution plan similar to the 401K retirement accounts that are the most prevalent form of pension plan in the private sector.

While the debate over the 2011 pension law focused on how to fix the defined-benefit pension system, Christie’s decision to cut state pension payments by $900 million this year and $1.5 billion next year has sparked a new conversation over the merits and affordability of defined-benefit pensions vs. defined-contribution plans.

Defining “Defined Benefit”: A defined-benefit pension guarantees a retiree a monthly payment for the remainder of his or her life. The benefit is generally determined as a percentage of the retiree’s final salary (often a “final average salary” for the highest three to five years on the job) multiplied by the number of years of service. In New Jersey state government, the multiplier is currently 1.66 percent, so a retiree with a final average salary of $70,000 who worked 25 years would receive an annual pension of $29,050, or $2,421 a month.

Like Social Security, pension payments are usually increased by annual cost-of-living adjustment (also known as a COLA) designed to keep pace with the annual inflation rate. Upon the retiree’s death, a spouse may be paid survivor benefits at a lower percentage of the employee pension rate for as long as he or she lives.

The advantage of a defined-benefit contribution for employees is that they can predict, often years in advance, what their pension payment is likely to be. The disadvantage for employers is that they are required to pay those pension payments for as long as the retirees live, and employers did not expect retirees to live into their 80s and 90s when these pension plans were put in place.

Defining “Defined Contribution”: A defined-contribution pension plan is one that guarantees an employee that their contributions from salary and usually a matching contribution from the employer will be placed in a tax-free retirement account to grow until retirement, at which point the employee has two choices. He or she can either take money out of that retirement account as needed or use it to purchase an annuity based upon a life insurance company’s projection of how long he or she is likely to live. Employees usually have a choice of mutual funds, bond funds, or money market accounts in which to invest their money, depending on their tolerance for risk. The most common defined-contribution accounts are 401K plans or Individual Retirement Accounts.

The advantage of a defined-contribution account for employees is that they have greater ability to manage their retirement funds, but the disadvantage is that a plunge in the stock market — like the 14 percent drop that occurred during the Great Recession — could cripple the retirement expectations of a worker nearing retirement age. For employers, the advantage of defined-contribution plans is that the long-term financial risk falls entirely on the employee. Once the employer makes its annual contribution, its responsibility for that year is over.

Pension envy: Defined-benefit plans were common in the 1940s through the 1980s, when 35 percent of American workers belonged to unions that negotiated defined-benefit plans with employers like U.S. Steel and General Motors. However, globalization and the decline of both manufacturing and the once-powerful manufacturing unions have spelled an end to most defined-benefit plans in the private sector, with the exception of the unionized building trades.

Consequently, Americans who have to rely on often-underfunded 401K retirement plans envy the defined-benefit pensions that unionized teachers, police, firefighters, and state and local government workers receive — and that are paid for by the tax dollars of average Americans plagued by job insecurity and income stagnation.

Are defined-benefit plans the problem with New Jersey’s pension system? Not really. The biggest problem is the failure of state governments under both Democratic and Republican governors and legislatures to keep up with the required pension payments for more than 15 years. That created an unfunded pension liability that currently stands at $38 billion for teachers and state government employees ($54 billion with county and local government employees added in). The unfunded pension liability is the amount of money that future taxpayers would be required to put in the pay the pensions of all retirees and current employees.

Gov. Chris Christie and Senate President Stephen Sweeney (D-Gloucester) teamed up on a pair of pension laws. The first, passed in 2010, required the state to ramp up over seven years to the full actuarially required pension payment by Fiscal Year 2018, when the cost to the state budget is expected to exceed $5 billion — or about one-seventh of all state revenues that year. The second, passed in 2011, cut cost-of-living adjustments for up to 30 years and required current employees to pay more toward their pensions. The two laws together were designed to cut the unfunded liability and save the defined-benefit system for both retirees and current employees.
Christie cut the state’s pension payments by $900 million this year and $1.5 billion next year to plug the latest state budget shortfall, putting the seven-year ramp-up to actuarially required funding and the future of the defined-benefit pension system in doubt.