Defined Benefit and Defined Contribution Retirement Plans

Note: This short summary of defined benefit and defined contribution plans was prepared as a short introduction to the issues for a legislative committee in February 2005. Further details on the issues presented here are available from the author.

I. History of State Public Pensions in the United States

A. Federal Civil Service Pensions

Federal pensions were created for all federal civil service employees in 1920. They provided for a benefit of 30 percent of final salary at age 70 for a retiree who had worked for 15 years. The benefit could be as high as 60 percent of salary after 30 years' employment.

This plan provided a defined benefit (DB) model—one that specified a benefit on certain terms of age and service--that states eventually adopted. In a number of states, however, the original pension plans were a form of what is now called a defined contribution (DC) plan—one in which benefits are determined by the accumulation of contributions from the employee and employer, plus investment earnings.

B. State and Municipal Pensions

State and local government pensions originated as benefits for police and firefighters in the late 1800s, although some date back to the 1850s. They were expanded to public school teachers, who were mostly covered by state and local plans by the late 1920s. By 1929, 21 states had state-wide teachers' retirement plans.

The first state plan for general employees was created in Massachusetts in 1911, but the idea spread slowly. By 1929, only six states had retirement plans for general state employees (who were, however, not very numerous at the time – 40% of all state/local employees were teachers).

State employee plans became universal after the Second World War; all states offered benefits by 1947. By the 1980s, defined benefit programs had become all but universal among state programs, partly because some older defined contribution or mandatory savings plans could not provide benefits that kept up with post-war inflation.

By the 1980s, all states required membership in retirement plans for full-time state employees. Full-time teachers were universally covered, usually by state plans, but some large city plans remained independent. In some states, one plan covers all state and local employees, with special benefit packages for public safety employees and some other special classes of employees.

II. Public Pensions and Private Pensions

Several major differences exist between public sector and private sector retirement plans.

A. Employer-sponsored retirement plans are available to a larger percentage of state and local government employees (around 98 percent) than of private sector employees (around 50 percent). See table 1.
B. Public sector plans almost universally require employee contributions. Private sector plans rarely require employee contributions.
C. Private-sector retirement plans are more likely to be defined contribution plans than public sector plans. Most new private sector plans in the past 20 years have been DC plans. See table 1.

Table 1. Employee Participation by Type of Primary Retirement Plan
	All Employees	Defined Benefit	Defined Contribution
Full-time state & local employees (1998) [note 1]	98%	90%	14%
Full-time private sector employees (2003) [note 2]	49%	20%	40%
Note: The breakout percentages do not add to the "all employees" percentage because some employees have primary plan coverage from both sorts of plans.

The divergence of public and private sector plans has occurred in the past 20 years. In earlier decades, private sector plans were primarily defined benefit plans. In 1977, almost 40 percent of private-sector employees were covered by a DB plan, down to 20 percent in 2003, as table 1 shows. DB plans still are frequently found among larger companies. Fifty of the Fortune 100 companies offer a DB plan as their primary plans, as do 346 of the S&P 500 companies [note 3].

The proportion of private employees covered by defined contribution plans increased from 7 percent in 1977, to 23 percent by 1996, and to 40 percent by 2003. The number of private sector DB plans fell from more than 100,000 in 1975 to under 31,000 in 2003, according to the Pension Benefit Guarantee Corporation [note 4].

Reasons include:

Workforce mobility. Surveys of companies indicate that they believe that DC plans match workforce mobility and workers' preferences better than DB plans.
Business environment. Low interest rates and investment return and pressures to limit future financial risk are leading companies to move away from defined benefit plans.
Federal regulation. The Employee Retirement Income Security Act (ERISA) of 1974 that regulates private-sector DB plans has made administration of DB plans more complicated and expensive than that of DC plans. ERISA's requirements for funding, payments to the Pension Benefit Guarantee Corporation, and limits on maximum deductible contributions have limited business flexibility. These issues make DB plans more suitable for large corporations than for new start-ups [note 5].

III. Public Defined Benefit and Defined Contribution Plans

A. Defined Benefit Plan Explanation

Defined benefit plans, whether in the public or the private sector, are characterized by a commitment to a formula-driven benefit that depends on length of employment and a person's earnings record, and a vesting (minimum service) requirement [note 6].

Contributions and Funding. Traditionally, public DB plans require contributions from the employee as well as the employer. Many public plans "pick up" the employee contribution, however. This means that the contribution is made by the employer, thus preventing the employee from paying income tax on the money that would be used for the contribution. A few state plans require no employee contribution.

Employee contributions are relatively fixed and rarely change, although in theory they could be increased or decreased as needed, subject to state law and collective bargaining agreements. In practice, the employer bears any burden imposed by a need for higher contributions as well as receiving the benefit of investment earnings that allow contributions to be reduced.

Contributions are deposited in a trust fund and invested by the governing board of the system. Benefits and administrative expenses are paid from the trust fund. Individual members of the system do not have an individual account, and have no control over investments.

DB plans typically retain an actuary to assess plan obligations annually. The assessment determines the amounts the plan sponsor should place in the pension fund in order to maintain its actuarial funding level. A plan is said to be funded when its current assets plus reasonable estimates of future investment earnings and contributions will equal its obligations. If such assets are not equivalent to obligations, the plan is said to have an unfunded actuarial accrued liability.

Defined benefit pension payments are heavily dependent upon investment earnings. From 1982 through 2002, investment earnings contributed 62 percent of public systems income in the United States. Employer contributions made up 26 percent, and employee contributions made up the remaining 12 percent [note 7]. Over the past 25 years, public pension funds have tended to shift investments from bonds to equities for the sake of higher returns, which has increased the possibility of fluctuations in their long-term funding status.

Formula-driven benefits. In public sector DB plans, benefits are determined by a formula, and are not linked to the amount of an employee's contributions.

The benefits formula is established in the plan guidelines or in law. The formulas take years of service and final average salary into account. The benefit is a designated percentage of the product of multiplying final salary by years of service. This basic formula applies to all defined benefit plans:

(years of service) x (final average salary) x ( percentage multiplier).

Years of service include actual years of employment, but in most public plans can also include service credit awarded for or purchased to represent, for example, military service, or service with an another employer.
Final average salary is the average of annual salary over some recent period, for example the employee's highest three consecutive years or highest three of the last 10 years, with many variants. Generally, the shorter the period is, the higher the base for calculating the pension benefit will be.
Percentage multiplier. Multipliers range from 1.2 percent (for short-term service in Minnesota) to 3 percent (for service over 21 years in Rhode Island), but generally fall between 2 percent and 2.5 percent. The multiplier represents the percentage of final average salary a beneficiary receives for each year of credited service.
For example, the benefit for a person who has 25 years of service and a final average salary of $40,000 in a system that uses a multiplier of 2 percent would be calculated like this: $40,000 x 25 x .02 = an annual benefit of $20,000.

Benefits. In defined benefit systems, benefits are paid as annuities, although a few systems now allow a person to withdraw a limited lump-sum amount upon retirement, and to receive a proportionately reduced annuity thereafter. Annuities are guaranteed for the life of the beneficiary, and usually allow an optional benefit schedule to allow for a benefit for a survivor.

About two-thirds of all state plans include a formula-driven annual cost of living adjustment (COLA). For the remaining plans, COLAs are at the discretion of legislatures.

Benefits are a contractual obligation of the plan sponsor, and the full financial risk of the payments rests upon the plan sponsor—generally a state or a local government in the case of public plans. As a general rule, benefits promised to an employee cannot be reduced, a rule supported by case law and in some states explicit statutory or constitutional provisions.

Vesting. Defined benefit plans require employees to "vest" before they are entitled to an eventual benefit. Vesting means an employee must be a member of the plan for a specified number of years to be entitled to a benefit.

Table 2. Vesting Requirements in the 100 Largest State Retirement Systems
More than 10 years	1
10 years	21
6-9 years	3
5 years	57
Less than 5	15
None	2
Source: National Education Association

The Arizona and Wisconsin consolidated retirement systems are the only two statewide plans that allow immediate vesting. While 22 of the 100 largest state systems impose a vesting requirement of 10 years or more, vesting requirements have been steadily diminishing in the last 20 years. Nearly three-quarters of these systems now vest benefits at five years or less.

Requirements for Retirement. The formulas that determine the amount of benefits for a defined benefit plan require an employee to meet specific age and service requirements for benefits as determined by the formula (referred to as "full benefits").

The formula requirements vary substantially from system to system. Five of the 100 largest state systems grant any member full benefits at age 60, regardless of the number of years of service the person has. Fifteen more systems allow full benefits to anyone 60 or older who has five years of service. Yet other systems provide full benefits when the sum of a person's age and years of service equals 80, or in some other states 85. IN the largest state plans, the most common requirements are five years of service and a specified age in the 60s, with age 60, 62 or 65 the most common choices.

Every system also allows alternative combinations of age and service, and most provide for reduced benefits at age 55 (with a service requirement), or at any age after 20 to 25 years of service. Early retirement benefits are reduced from the full benefit level to provide a life-time benefit equivalent to what the beneficiary would have received from an annuity that started at the time of normal retirement.

B. Defined Contribution Plan Explanation

In a defined contribution plan, the contributions, rather than the benefits, are determined by the rules that govern the plan. Benefits are not determined in advance. They result from the accumulation of employee and employer contributions and investment earnings in an individual fund. At retirement, the beneficiary can withdraw the total in a lump sum, convert it to an lifetime annuity, or receive it in a set number of periodic payments [note 8].

Contributions and Funding. Public sector defined contribution plans that act as the primary coverage for employees usually require a contribution from both employee and employer, unlike private sector plans that usually are fully funded by employers.

In states where a defined contribution plan has been added as an optional alternative to a defined benefit plan, employee and employer contribution levels are the same for both plans. Some states, however, deposit part of the employer contribution in the old defined benefit trust fund if it has a accrued unfunded liability.

A defined contribution plan can allow employees to determine, to a degree, how much they want to contribute. In Michigan, the state contributes 4 percent of salary to a member's account. The employee is not required to contribute, but can receive a dollar-for-dollar match from the state for contributing up to 3 percent of salary. The match is on top of the state's 4 percent contribution. Employees may contribute more, but the state matches only the first 3 percent.

Unlike defined benefit plans, defined contribution plans do not require a trust fund administered by the plan sponsor. Since the employer's responsibility for the pension plan is limited to making contributions to employee accounts, there is no possibility of an accrued unfunded liability, and there is no employer responsibility to manage investments.

Individual Accounts and Investment. Defined contribution plans provide for an individual account for each member into which all contributions are deposited. The member directs how the funds will be invested – among nine options in Ohio and 20 in Florida. Members may move investments from fund to fund. The member's accumulation of contributions and investment return make up the eventual benefit.

Benefits. The individual account is the benefit. At retirement it can be taken as a lump sum withdrawal, converted to an annuity, or taken in installments over a number of years, depending on plan provisions and the employee's preferences. The employer has no responsibility for cost of living adjustments or for providing a lifetime annuity. Employees also have the option, when leaving employment before retirement, of rolling their vested contributions into another retirement fund or withdrawing them, although there can be a federal tax penalty for early withdrawal.

Annuities can be designed to provide protection against inflation and to provide survivor benefits, as is done by the Florida Retirement System Investment Plan, a defined contribution plan.

Vesting. Public sector defined contribution plans tend to have different vesting requirements than defined benefit plans. Michigan allows immediate vesting in employee contributions and gradual vesting in employer contributions, which comes to full vesting in four years. Ohio also provides for immediate vesting in employee contributions, and gradual vesting over five years for employer contributions. Florida has a one-year vesting requirement.

Requirements for Retirement. Terminating employment and reaching the age of 59½ (before which federal law can impose tax penalties on withdrawals from defined contribution plans) are the only considerations a defined contribution plan member must keep in mind. Beyond that, the beneficiary is free to decide when to receive benefits from his or her individual account, until reaching the maximum age by which (under federal law) withdrawals must be made.

Table 3. Features of Defined Benefit and Defined Contribution Plans
	Defined Benefit Plans	Defined Contributions Plans
Benefit Deign	Benefits are determined by a formula, and benefit levels are guaranteed.	Benefits are determined by the contributions and investment earnings in a person's account.
Contributions	Members' contributions are set; sponsors are responsible for contributing as must as necessary to provide the promised benefits	Members' and sponsors' contributions are set.
Employee Salary Changes	Salary increases affect both past and future benefits, because the benefit is determined by final average salary.	Salary changes affect future contributions.
Cost of Living Adjustments (COLAs)	Two-thirds of public plans provide automatic COLAs. In other public plans, there is no guaranteed protection from inflation.	Public plan provisions usually do not but can provide for annuities that offer an adjustment for inflation.
Benefit Adequacy	Depends on plan provisions	Depends on investment return
Investment Risk	Regardless of investment performance, employer pays specified lifetime benefit. The employer bears the risk.	The employer's responsibility is to make the scheduled contributions. The employee bears the investment risk.
Investment Results	Investment performance affects funding, and does not directly affect benefits, directly. Strong investment performance can lead to enhanced benefits.	Investment performance will help determine the employee's retirement benefit.
Longevity	Benefit levels are guaranteed for a retiree's lifetime. Retirees are often given the option of providing survivor benefits.	Benefits consist of the account balance, which can be annuitized for lifetime income.
Portability	Limited	Full
Individual Control	Members have no individual control of benefit levels, but affect them collectively through political action	Members have individual choices among investments and in some plans have choices among contribution amounts.
Simplicity	Members often are confused about the relationship of salaries and retirement benefits	Structure is easily understandable
Partially based upon: Committee on Pensions and Investments, Texas House of Representatives, A Report to the House of Representatives, 77th Texas Legislature: Defined Contribution/Defined Benefit (Austin, Texas: 2000).

Table 4. Employees Who Benefit Most

Defined Benefit Plans

Defined Contributions Plans

Career employees and employees hired in mid-career.

Employees who terminate employment at a young age

Employees with substantial pay increases over a career

Employees with modest pay increases over a career

Married employees

Single employees

Employees with long life expectancy

Employees with short life expectancy

Employees who die or become disabled early in their career

Employees who achieve a higher rate of investment return, through personal investment selection

Employees who retire early

Employees hired at very young ages

Partially based upon: Buck Consultants, Study of Retirement Plan Designs for the State of Colorado (Denver, Colorado: November 2001), 12-13.

Buck Consultants note:

The pattern of benefit values over an employee's working career is typically different between DB and DC plans. Under a traditional DB plan that provides a pension based on final average pay at retirement, the benefit value escalates substantially as the employee nears retirement age. This increase is caused by the compounded effect of increasing salary and service, a shortening of the discount period to expected retirement age, the increasing probability that the employee will reach retirement eligibility, and the value of subsidized early retirement benefits that become available upon reaching specific age and service requirements.

Under a DC plan, the benefit value, referred to as the account balance, typically grows as contributions are deposited and investment earnings are credited. For most plans, the result is a DC benefit pattern that is higher than the DB benefit during an employee's early years. Then the benefit value switches to favor the DB plan in the later stages of an employee's career.

Also, most DB plans provide preretirement death benefits to surviving spouses of deceased active employees, thereby shifting benefit costs from single to married employees.

In addition to the comparison of benefit values, cost considerations also affect an employer. The employer assumes the risk under a DB plan, while employees assume the risk under a DC plan.

Table 5. State Retirement Systems' Defined Contribution Plans

This list includes state defined contribution retirement plans designed as primary coverage for a group or class of state employees or state teachers: that is, it includes plans that eligible employees are required to join, or that are one of two or three alternative plans among which employees are required to choose.

It does not include optional deferred compensation plans, like Section 457 plans, which all states offer employees and teachers as a means of augmenting primary pension coverage. Many states have offered defined contribution plans to higher-education faculty; this report is not intended to include all such plans.

Part 1. Defined Contribution Plans as Primary Plans

These plans are the government's primary, mandatory retirement plan for the identified class of employees.

The District of Columbia. In 1987, the District closed its defined benefit plan to new employees and replaced it with a defined contribution plan and Social Security membership.

Michigan. A state defined contribution plan has been mandatory for new state employees since March 31, 1997. Members of the closed defined benefit plan were allowed to transfer to the new DC plan if they chose.

Nebraska. The primary Public Employee Retirement System plan was a defined contribution plan from 1967 to 2002. It was closed to new employees on January 1, 2003, and replaced with a cash-balance plan.

In the Nebraska cash balance plan, employees contribute between 4.3% and 4.8% of salary and the employer contributes about 7.5% of salary to an employee account. The employee cannot control investment of the account, but is guaranteed an annual return of at least 5% a year. The account can receive a higher return, depending on investment earnings. At retirement, the employee may buy an annuity, or withdraw the balance in a lump sum or in installments. Principal differences from a defined-contribution plan are the employer's guarantee of a minimum investment return and control of investments.

West Virginia. In 1991, the state created a defined contribution plan for teachers and closed its defined benefit plan to new enrollment.

A Number of States in recent years have created defined contribution plans as the primary coverage for elected officials and political appointees, sometimes including legislative staff. To some degree these plans are a response to term limits for legislators and other elected officials. Such states include Colorado, Louisiana, Nevada, Vermont and Virginia.

Part 2. Defined Contribution Plans as an Optional Primary Plan

In the states listed below, new employees may elect to be members of a defined benefit plan or a defined contribution plan, but must be a member of one or the other. Under current law in these states, both kinds of plan remain open to new members, and limited transfer between them is available.

Colorado. In 2004, Colorado created a defined contribution plan as an option for state employees, effective January 1, 2006. On the same date, Colorado will open its existing defined contribution plan for elected officials to general membership, so new employees will have one defined benefit and two defined contribution plans among which to choose.

Florida. In 2000, the state established a defined contribution plan as an optional alternative to its defined benefit plan. Existing DB members could join the new plan. Existing members also were given a third option of transferring to a hybrid plan (described below) that combines features of DB and DC plans. The third option is not available to new employees.

Montana. In 1999, the state created an optional defined contribution plan for state, local, university, and school district employees other than teachers. Current members of the defined benefit plan were allowed one year to transfer to the new plan.

North Dakota. In 1999, the state created an optional defined contribution plan for "exempt" or non-classified state employees, 75% of whom are employees in the higher education system.

Ohio. From 1998 through 2002, the state has created optional defined contribution plans for education employees, teachers and general state and local government employees. Employees not yet vested in the state defined benefit plan had the option of moving to the new plan. As noted below, Ohio also offers a third optional plan, a hybrid that includes both defined benefit and defined contribution features.

South Carolina. In 2000 and 2002, the state created optional defined contribution plans for existing and new state and local government employees and teachers.

Part 3. Hybrid, or Combined, Plans

These plans provide features of both defined contribution and defined benefit plans. They do not allow an employee to choose between the two elements. These plans maintain a defined contribution plan for employee contributions and a defined benefit plan for employer contributions. The defined contribution plan segments, like other defined contribution plans, allow members to choose among options for the investment of their accounts, and provide a benefit based upon account accumulations.

Florida. In 2000, when the state established a its option defined contribution plan, members of the existing DB plan were given a third option of transferring to a hybrid plan. The third option is not available to new employees.

Indiana. For decades, retirement plans for state employees and teachers have consisted of an Annuity Savings Account (a defined contribution component) made up of employee contributions and a defined benefit funded by employer contributions.

Ohio. The retirement plan revisions from 2000 through 2002 that created an optional defined contribution plan for Ohio teachers and other employees also created the third option of a hybrid defined-benefit/defined contribution plan.

Oregon. The state employee retirement plan created in 2003 consists of a defined benefit program called "the pension program" funded by employer contributions and a defined contribution program called the "individual account program," funded by employee contributions.

Washington. The 1998 Teachers' Retirement Plan Tier 3 consists of defined contribution and defined benefit elements, funded respectively by employee and employer contributions. This plan is mandatory for teachers hired since the plan's inception. Legislation in 2000 created a similar but optional Public Employee Retirement System Plan 3 for state and local government and higher education employees. State and local employees who do not select this hybrid plan are enrolled in a defined benefit plan.

Footnotes

U.S. Department of Labor, Bureau of Labor Statistics, Employee Benefits in State and Local Governments, 1998 (December 2000), table 1. Accessed February 8, 2005, at http://www.bls.gov/ncs/ebs/sp/ebbl0018.pdf
Bureau of Labor Statistics, National Compensation Survey: Employee Benefits in Private Industry, 2002-2003 (January, 2005), table 1. Accessed February 8, 2005 at http://www.bls.gov/ncs/ebs/sp/ebbl0020.pdf
National Association of State Retirement Administrators, "Myths and Misconceptions of Defined Benefit and Defined Contribution Plans," (December 2003): 3, accessed on February 9, 2005, at http://www.nasra.org/resources/myths%20and%20misperceptions.pdf
Jack VanDerhei and Craig Copeland, "ERISA at 30: The Decline of Private-Sector Defined Benefit Promises and Annuity Payments—What Will It Mean?" Employee Benefit Research Institute Issue Brief #264 (May 2004): 4.
Buck Consultants, Study of Retirement Plan Designs for the State of Colorado (Denver: November, 2001), 12-14.; VanDerhei and Copeland, 4.
An excellent source for the details of state defined benefit plans is National Education Association, Characteristics of Large Public Education Pension Plans (Washington, D.C.: 2004). Despite its title, the report includes details on both state public employees' and teachers' plans, and includes at least one plan for each of the 50 states and the District of Columbia.
National Association of State Retirement Administrators, "State Pension Systems: Healthy or Not?" Presentation at the NCSL Spring Forum, Washington, D.C., April 30, 2004.
There is no single source for details of state defined contribution plans. The best sources for information about them are the descriptions and handbooks provided by the retirement systems themselves, available at http://benefitsattorney.com/modules.php?name=States&d_op=viewsystem .

Posted February 2005.
Email statebudget-info@ncsl.org for more information.
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