Shift Towards Defined Contribution Plans and Reduced Pension Benefits in the Public Sector.

Shift Towards Defined Contribution Plans and Reduced Pension Benefits in the Public Sector.

Introduction

In the United States, there has been an increased pressure from different interest groups to shift the public sector pension plans from the defined benefit to defined contribution. (Bodie, Marcus, & Merton (1988)describes a defined benefit plan as a pension plan where a retired employee receives a specified amount of money for life. The received amount, in most cases, will include a joint amount for the beneficiary and his or her spouse. On the other hand, (Bodie, Marcus, & Merton (1988) describe a defined contribution plan as a retirement saving plan where both the employer and the employee contribute towards the savings account for the entire period of employment. In the defined contribution plan, however, there is no guarantee of receiving retirement benefits. In the past five years, Broadbent, Palumbo, & Woodman, 2006 state that there has been a gradual increase in the number of public sector employees enrolled in the defined contribution program. Broadbent, Palumbo, & Woodman, 2006 argue that the shift mostly revolves around issues such as equity, affordability, and risk. However, Cairns, Blake, & Dowd (2006) states that the cost of maintaining defined benefit plan has become unaffordable to most governments and the fact that taxpayers’ money is used to sustain the project. The argument, therefore, is that the defined benefit program poses unnecessary economic pressure to both the current and future taxpayers as the number of retired public employees increases. Broadbent, Palumbo, & Woodman, 2006 states that the responsibility of the monthly or lump sum amount available to retired employees should be determined by their savings during their working stage. This paper, therefore, focuses on understanding the shift from defined benefit to defined contribution in the public sector.

History of Defined Benefits Policy

The concept of defined benefits or pension was first introduced in the United States after the Revolutionary War. The American government promised to pay its soldiers a pre-determined amount of money after the war. The received money was meant for several reasons: one, to cater for their hospital bills as most of the soldiers were injured during the war, to sustain their families, and as a reward for their loyalty and dedication at war. Although the amount paid decreased every year, the concept spread drastically to significant sectors in the U.S. Five years after its introduction, the entire country embraced the idea where long-serving employees were rewarded after their retirement to cater for themselves and their families. As the U.S. market became more industrialized, the workforce increased the pressure to make pension a till death system, which was enacted in 1945.

As described by Broadbent, Palumbo, & Woodman, 2006, defined benefit became increasingly popular due to several reasons: One, pension covered the employee for their entire life. Therefore, the employees felt that the system was essential to cover their needs in their unproductive age. Besides, the defined benefit considers critical factors such as inflation risk, market forces, among others, which affect the value of money. To the employees, therefore, having a pension meant that they would receive a specific amount after retirement. On the other hand, the defined benefit system places the risk to the employer instead of the employee. In this case, the employer takes all the investment decisions before and after the employee retires. Similarly, the pension system became popular as organizations are expected to have a longer time horizon than most of its employees. Since then, the defined benefits system has been most common in the public sector as governments aimed to improve the lives of their former employees. However, some of the significant private organizations such as McDonald’s still uses the system for its top executives and other permanent employees. Over time, the system has evolved, mainly in the private sector, where contracts above 10 years are pensionable ((Bodie, Marcus, & Merton (1988))..

Factors Leading to the Shift from Defined Benefits to Defined Contribution

Regardless of the benefits associated with the defined benefit system, there has been a shift towards the more flexible defined contribution system. Currently, in the U.S., approximately 67% of the employees in the public sector are enrolled in the defined benefits system (Broadbent, Palumbo, & Woodman, 2006). However, Huberman, Iyengar, & Jiang (2007) describes that there defined contribution has gradually gained popularity, especially among the millennials. Some of the significant factors that have led to the shift include:

Portability is one of the significant factors that have increased the popularity of defined contribution plans. In the defined contribution system, the contributions of the employer are paid directly to the individual’s account. Therefore, the amount immediately get to the employee’s control, unlike in the defined benefit system where the funds become available after retirement. In a case where the employee wants to change jobs, they can move without losing any of their contributions. As described by Cairns, Blake, & Dowd (2006), the defined contribution frees the employee to make career choices without fear of losing pension due to their short-term tenure in an organization. In comparison to the defined benefit, all the contributions are kept as a pool without identifying a particular employee’s portion. Therefore, employees are limited from changing jobs as the benefit formula depends on the time an employee was engaged with the organization. With the defined contribution, however, the system reflects contributions from all the organizations that an employee has worked in.

Aging population has increased the pressure on governments as the pension bill becomes unbearable. The author states that in most developed countries, 71% of employees working in the public sector are above 45 years. The high percentage of aging employees is due to the high level of experience required in the government sector (Huberman, Iyengar, & Jiang (2007)). Cairns, Blake, & Dowd (2006) states that the government has also led to the shift from defined benefit to the defined contribution by declining to offer tenure to most jobs. In this case, the public sector, especially the parastatals, have adopted the contract system where employees are not assured of pension. To the government, aging employees pose a risk of a higher pension budget in the next 10 to 15 years. To mitigate such risks, the government has reduced the benefits associated with defined benefits and increased flexibility in defined contribution plans. The government has also ceased providing the defined benefit plan to new employees.

The rising cost of employee benefits has increased the burden on the employers’ pension policy. Under the defined benefit system, the employer is mandated to cover basic expenses for the retired employees. Such basics include the cost of accessing medical care. With the increased cost of such basic needs, the employers are being forced to increase the paid amount as such changes in the economy are considered as inflation. To mitigate such costs, most public organizations have declined engaging employees in pensionable contracts. Instead, most civic organizations have, in the past decade, reducing the number of pensionable employees due to the unforeseen economic conditions.

In the defined contribution plan, the control of the contributions is under the employee. Sialm, Starks, & Zhang  (2015) states that one of the primary reasons that have led employees to shift to defined contribution is the personal control attributed to the plan. As contributions are deposited in an individual’s account, the employee can make a personal decision on how to invest the money based on their preferences and needs. In cases where the employees make strategic investment decisions, the return might be higher than what would have been received under the defined benefit policy. Hence, the safety of one’s money is under the individual, unlike in the defined benefit where politicians or government officials can misappropriate the money.

Employer volatility has placed the pension policy under increased scrutiny of the sustainability of the system. In this case, Huberman, Iyengar, & Jiang (2007) describes the decreasing contributions among most of the employees working in the public sector. The author states that the pension management board mostly relies on the current contributions to pay the retirees. In a case where the currently employed members reduce their contributions, the board is forced to seek alternative sources of money, such as loans. Therefore, Sialm, Starks, & Zhang  (2015) states that the pension policy is not sustainable as the payments are not always assured. Such aspects of the policy have increased fear among most of the employees who therefore view the control aspect provided under the define contribution policy as the solution.

The defined contribution has fair benefits compared to pension policy. One, the pension policy requires that the employee work for a single employer. This policy, therefore, awards the longest-serving employees regardless of their rank or productivity. On the other hand, the policy system uses the percentage rule on the final salary as it assumes that longevity leads to higher pay. The pension calculation policy, however, has been criticized for several reasons. One, the assumption that the last salary is the highest ignores the element of promotion and demotion at the workplace. In some cases, the employee’s salary might have been higher at one time and was reduced due to factors such as demotion and salary reductions. The pension policy, therefore, might place the future of employees at risk. On the other hand, the pension policy does not recognize short term spells that younger employees might engage in. For example, an employee’s pension will be calculated from the time they joined the organization until they retire. Such a system limits the employees’ freedom to make career decisions as their pension years will be reduced. All these weaknesses are dealt with under the defined contribution policy. As the contributions are paid monthly at the individual’s account, it is possible for the employee to decide whether to change jobs, where, and when to invest the contributions, among other aspects that increase the flexibility of the retirement benefits.

The defined contribution policy is favorable to the taxpayers. One of the major advantages of the defined contribution is the elimination of any investment risks by the taxpayers. In the pension system, the government is responsible for managing the pool of resources contributed by the employees and deciding profitable investments. In a case where the resources are mismanaged or invested in projects with poor returns, the taxpayers are forced to make up the difference. Under the defined contribution, however, the employee and the employer make equal contributions, and the resources are under the individual’s control. In such a case, all the risks associated with the taxpayers are eliminated.

Conclusion

Retirement benefits are a core element among employees as they aim to secure their unproductive years. Therefore, most employees in the public sector make monthly contributions either through the defined benefit or defined contribution policy. In the past century, employees have mostly relied on the pension system, where they are assured of a monthly pre-determined payment. Under the defined benefit system, the longer the years worked in an organization, the more the pension. However, in the past decade, there has been an increased shift from the defined benefit to defined contribution, where the employee and the employer contribute towards a certain amount on a monthly basis with no retirement pension. The shift has been due to major factors such as portability, aging population, increased control, higher benefits, flexibility, employee preference and emerging trends, employer volatility, and the rising cost of employee benefits. The defined contributing system, therefore, places the employee in control over their retirement funds while reducing the employer’s risk. Additionally, the defined contributing system benefits the taxpayers in several ways. One, the public has no investment risks associated to political issues or mismanagement of the public resources.

References

Broadbent, J., Palumbo, M., & Woodman, E. (2006). The shift from defined benefit to defined contribution pension plans-implications for asset allocation and risk management. Reserve Bank of Australia, Board of Governors of the Federal Reserve System and Bank of Canada, 1-54.

Bodie, Z., Marcus, A. J., & Merton, R. C. (1988). Defined benefit versus defined contribution pension plans: What are the real trade-offs? In Pensions in the U.S. Economy (pp. 139-162). University of Chicago Press.

Cairns, A. J., Blake, D., & Dowd, K. (2006). Stochastic lifestyling: Optimal dynamic asset allocation for defined contribution pension plans. Journal of Economic Dynamics and Control, 30(5), 843-877.

Huberman, G., Iyengar, S. S., & Jiang, W. (2007). Defined contribution pension plans: determinants of participation and contributions rates. Journal of Financial Services Research, 31(1), 1-32.

Sialm, C., Starks, L. T., & Zhang, H. (2015). Defined contribution pension plans: Sticky or discerning money? The Journal of Finance, 70(2), 805-838.