Budget & Tax
Curtis Shelton | April 14, 2022
Why defined-contribution retirement plans are preferable to defined-benefit plans
“One of the notable trends in the U.S. retirement system over the past five decades,” the Congressional Research Service reports, “is that private-sector employees have become less likely to be covered by defined benefit (DB) pension plans and more likely to be covered by defined contribution (DC) pension plans.”
In 1975 there were 27.2 million participants in a DB plan and 11.2 million in a DC plan. Fast forward to 2019 and there were just 12.6 million in a DB plan and 85.5 million participants in a DC plan.
To understand why DC plans have become the preferred model we first have to understand what each model looks like.
A defined benefit (DB) plan guarantees a retirement benefit based on a formula that generally uses an employee’s time of service (years employed) and salary (typically an average of a certain number of final years’ compensation). These benefits are paid out monthly for the life of the beneficiary.
A defined contribution (DC) plan is designed to create an investment account into which employees and employers can deposit money throughout the duration of the employee’s career. This account sees gains or losses, depending on the market, and the retiree then draws down whatever income is needed from the account during retirement. A 401(k) is a typical example of a DC plan.
There are a few reasons why a DC plan is preferable to a DB plan. First, the burden of risk on a DB plan is put on the employer (in the case of public pensions, this is state or local governments), whereas DC plans put the risk on the employee. Because DB plans guarantee returns, taxpayers are on the hook no matter how the market performs. This is one of the primary drivers for the underfunding of the public pension systems across the country. State and local pensions had a funding ratio of 52 percent in 2019. This is why public pensions pose such a grave threat. Government officials have access to an immediate cash infusion through the form of tax increases to bolster the system, whereas a private company must either cut benefits or close up shop when funding levels crater.
Another problem with DB plans, such as the Oklahoma Public Employees Retirement System (OPERS), is that they use an employee’s final salary based on the employee’s final three years’ compensation to calculate benefits. This detaches previous contributions from future benefit payments. Simply put, an employee’s yearly benefit payments can be near or even exceed lifetime contributions. For example, former Oklahoma Attorney General Drew Edmondson contributed a total of $185,188 throughout his career but receives a benefit of $149,934 every year.
Looking at the aggregate data shows how liberal the state’s DB plan can be compared to private-sector DC plans. Vanguard’s “How America Saves” report provides data on nearly 5 million DC plan participants. This report shows the average employee contribution rate is 7.2 percent and the combined employee-employer contribution rate is 11.1 percent.
Participants in OPERS, by contrast, contribute just 3.5 percent with state taxpayers contributing 16.5 percent—for a combined rate of 20 percent. So OPERS plan participants have a much higher contribution rate despite contributing less of their own salary.
OPERS recipients also have a leg up on how much money will be available during retirement. Vanguard reports that the median account balance for individuals aged 65 and over is $82,297.
According to the Oklahoma Public Employees Association, the average yearly benefit for a recipient is $18,184. The average life expectancy in the U.S. is 80 years, meaning that if someone retired at 65, they would, on average, spend 15 years in retirement. So an OPERS participant who retired at 65 would receive $18,184 per year for 15 years, giving them a total retirement benefit of $272,760.
Bolstering Oklahoma’s newly created DC system would be a good approach for both public employees and taxpayers. It creates a more stable system that retirees can rely on while providing financial responsibility for taxpayers who fund the system.
Policy Research Fellow
Curtis Shelton currently serves as a policy research fellow for OCPA with a focus on fiscal policy. Curtis graduated Oklahoma State University in 2016 with a Bachelors of Arts in Finance. Previously, he served as a summer intern at OCPA and spent time as a staff accountant for Sutherland Global Services.