The Basics of Pension Plans Regulated by ERISA

Types of Pension PlansWhat are the types of private trusteed pension plans?
What is a defined benefit plan?
What is a defined contribution plan?
What is the primary difference between a defined contribution plan and a defined benefit plan?
What risks are borne by participants in defined contribution and defined benefit plans?
How does the risk to the employer differ with a defined contribution plan vs. a defined benefit plan?
What are some of the current areas of interest in private pension plan design?
What are "hybrid" plans?
What is the difference between a cash balance plan and a pension equity plan?
Why would an employer with an existing defined benefit plan choose a hybrid plan instead of a defined contribution plan if a change is contemplated? 

Q:  What are the types of private trusteed pension plans? 

A:  Single employer plans are established and maintained by corporations or non-profit organizations for their employees, while multiemployer plans are maintained pursuant to collective bargaining agreements between a union and two or more employers.  The union and the employers share representation on a joint board of trustees, which oversees all aspects of plan administration.  It is estimated that at the end of 1999, single employer plans represented 91.5% of private trusteed plan assets, with multiemployer plans representing the balance.

Pension plans are of two distinct types: defined benefit and defined contribution plans.  At the end of 1997, it is estimated that defined benefit plans accounted for 55% of private trusteed plan assets, while defined contribution plan assets accounted for the balance. Defined benefit assets represented 62.4% of total pension plans assets of CIEBA members as of the end of 2000, virtually unchanged from 1996 when defined benefit assets represented 63.5% of CIEBA member assets.

Q:  What is a defined benefit plan? 

A:  In a defined benefit plan, the benefit payment for each participant is calculated ("defined") by a formula as specified in the plan.  The formula is most often based on factors such as level of pay and length of service.  The projected future benefit payments for all participants are then aggregated and discounted to obtain the plan's liability, also sometimes referred to as the plan's obligation.  That liability or obligation is funded by employer contributions (and sometimes employee contributions) and their cumulative earnings.  The value of the assets is measured independently of the liability and is based on fair market value.  A defined benefit plan can thus be overfunded or underfunded depending on whether the value of the plan's assets is greater than or less than the amount of the liability. By contrast, in a defined contribution plan the asset and the liability are by definition always equal in value. 

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Q:  What is a defined contribution plan? 

A:  A defined contribution plan is a retirement savings vehicle that provides benefits "defined" by the contributions to the plan and investment earnings on those contributions.  These contributions and the subsequent earnings thereon are credited to an individual account for each participant.  The amount owed to participants at retirement is based solely on the account balance at the time of withdrawal.  Participants often bear responsibility for managing the investments of their account.  They may need to choose among investment options that are offered by the employer (plan sponsor).  The amount of investment earnings a participant accumulates is directly related to that participant's investment choices. 

Q:  What is the primary difference between a defined contribution plan and a defined benefit plan? 

A:  The primary difference between defined benefit and defined contribution plans is who bears the risk of a shortfall in investment results.  This risk is borne by the employer in the case of defined benefit plans, and by the employee in the case of defined contribution plans.  A typical defined benefit plan promises a benefit upon retirement linked to pay and years of service.  If contributions and investment earnings on the contributions do not provide enough funds to meet that promise at retirement, then the employers must make additional contributions to meet the shortfall.  If investment earnings exceed expectations, then the employee still receives only the promised benefit.  In defined contribution plans, on the other hand, higher than expected investment returns are passed on directly to the employee, who must also accept the risk of a lower asset value if returns are disappointing.

Other important differences include the fact that in the early years of an employee's career account values in defined contribution plans generally grow faster than in defined benefit plans (but generally grow more slowly in the later years).  Additionally, depending upon the design of a defined benefit plan, defined contribution plan assets are generally more portable.

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Q:  What risks are borne by participants in defined contribution and defined benefit plans? 

A:  As discussed above, many defined contribution plans are participant-directed, meaning that participants are responsible for deciding how their individual account assets are invested among a plan's available investment options.  Because participants make these investment decisions, they also assume responsibility for the consequences, and therefore take on the investment risk themselves.

Mortality risk is also transferred to the participant.  Mortality risk is the risk that the participant may live longer than average, and thus outlive predicted benefit requirements.  In participant-directed plans, the employee has more control over the building of retirement assets, through the selection of investments and the ability to direct a portion of his or her pay to the plan.  However, participants have few avenues of recourse should their accumulated assets turn out to be insufficient for their retirement needs. 

Insufficiency of retirement assets can be ascribed to several factors:

In a defined benefit plan, on the other hand, the employer is responsible for bearing both investment risk and mortality risk.  The Pension Benefit Guaranty Corporation (PBGC), a U.S. government agency that insures the pension plans of private U.S. corporations, provides an additional level of security.  In the event the company does not fulfill its obligations, some residual risk of insufficiency in a defined benefit plan is also borne by the participants, to the extent that the PBGC may not cover 100% of the promised benefit.  For most employees this risk is generally considered to be small.

Also, a portion of the defined benefit may exceed the maximum allowable limit that can be paid out of an ERISA-qualified plan, and thus for the higher-paid employee, the excess benefit can bear long-term corporate credit risk.

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Q:  How does the risk to the employer differ with a defined contribution plan vs. a defined benefit plan? 

A:  The employer's reported expense for a defined contribution plan is closely aligned with employer contributions.  In most cases, the amount of employer contributions is far less volatile than contributions to defined benefit plans, which are affected by current interest rates, actuarial assumptions and investment performance.  The reported expense of defined benefit plans is not directly tied to employer contributions and may also be less stable than reporting for defined contribution plans, which may add to operating income volatility.

As stated above, the transfer of investment risk and mortality risk to participants also reduces employers' risk.  For the majority of defined contribution plans, employer contributions are directly related to employee contributions and/or to the company's profitability, not to the value of the assets.  On the other hand, the opportunity to reduce employer contributions is generally available only in defined benefit plans.  If the value of the assets in a defined benefit plan is greater than the promised payments to participants, the required employer contributions may decrease over time (and there is a possibility in a defined benefit plan that excess assets could be used to enhance benefits).  This opportunity to decrease the level of contributions does not generally exist in a defined contribution plan, as contributions are not tied to the value of the assets. 

Q:  What are some of the current areas of interest in private pension plan design? 

A: Because of the increased complexity of defined benefit plan regulations, and an interest on the part of employers in providing a visible and "portable" benefit, there has been growth in "hybrid" plans, whose designs combine defined benefit and defined contribution features, as well as, in defined contribution plans.

Portability depends on several factors, including plan type and vesting.  Vesting simply defines whether the participant is legally entitled to claim all plan benefits.  Normally, the participant is immediately vested in any of his/her own contributions and the earnings on those contributions, but is not otherwise fully vested until the participant has been in the plan for at least three-to-five years.  Defined contribution plans offer portability of existing asset balances, including employer contributions when vesting requirements have been met.  Portability of the participant's benefit value in a defined benefit plan depends upon plan design. 

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Q:  What are "hybrid" plans? 

A:  Legally, every plan is either a defined benefit plan or a defined contribution plan, regardless of what its various characteristics may look like to the participant.  However, hybrid plans have been developed that offer various blends of defined benefit and defined contribution characteristics.  The increasingly popular cash balance plan, for example, often has a portability feature and reports participant "balances" that look just like defined contribution accounts.  However, cash balance plans are actually defined benefit plans.  Similarly, pension equity plans, (also known as retirement bonus plans) report account balances to participants and look like defined contribution plans but are in reality defined benefit plans. 

In both cash balance and pension equity plans, the "accounts" reported to participants are their actual balances, but they are not in any way impacted by actual investment results.  The value of the "accounts" in each case is determined by an established formula rather than by a variable investment return, which qualifies the plans as defined benefit structures.

Other examples of hybrid plans include various "floor" plans, which are actually two coordinated plans, one of which is a defined benefit plan and the other a defined contribution design.  The defined benefit plan normally sets a floor retirement payment.  Investments in the defined contribution plan will determine the retirement payment if its value exceeds the value of the floor payment.  If the value of the defined contribution account drops below the floor, the defined benefit plan funds the gap and the participant receives the floor payment.

Q:  What is the difference between a cash balance plan and a pension equity plan? 

A:  The basic difference between the two types of plans is that the cash balance plan is a career average plan and the pension equity design is a final pay plan.  In a cash balance plan, benefits increase by a rate applied to eligible compensation for each year of employment, without consideration of future salary inflation.  In a pension equity plan, a rate is applied to average final compensation, which generally incorporates the effect of inflation over the service period.  The equity plan rate is a cumulative rate based on age and/or years of service.

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Q:  Why would an employer with an existing defined benefit plan choose a hybrid plan instead of a defined contribution plan if a change is contemplated? 

A:  When an employer decides to change from a traditional defined benefit plan to a plan with defined contribution characteristics, converting the existing plan to a hybrid plan may be the preferred alternative.  A hybrid plan may be the more attractive choice if the existing defined benefit plan is substantially overfunded.  Redesigning the existing plan as a hybrid allows the surplus assets in the plan to continue to prefund employer contributions, thus controlling costs more effectively than a plan termination would allow.  The employer may also prefer to retain control of investment decisions in the plan.

The employer may use a hybrid plan design to improve the workforce recruitment and retention power of the existing plan by giving it some user friendly defined contribution-like characteristics, such as "account" balance reporting and portability.

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