The Basics of
Pension Plans Regulated by ERISA
Types of Pension PlansWhat are the types of private trusteed
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
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
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
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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
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
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
- failure by employees to set aside enough of current
- adverse market results;
- limited investment choices;
- poor investment fund selection or asset allocation by the
- a greater need for retirement assets than originally
anticipated due to changing personal circumstances or mortality
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
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
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
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
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
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
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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
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
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
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