Posted By Chris Ciminera, Supervisor
I have been auditing a nonprofit organization for a few years now. The organization currently has a defined benefit plan and this year I was asked by our contact at the organization to provide some information on switching from a defined benefit plan (DB) to a defined contribution plan (DC). Specifically the organization was looking to switch to a 403(b) defined contribution plan. Retirement benefits in a defined contribution plan are funded partially by employees who contribute a portion of their salary to their retirement account. Defined benefit plans are funded by the employer.
I did not want to recreate the wheel and figured there had to already be a summary document on the internet somewhere that clearly outlined the differences between these plan options. I was happy to come across numerous websites that outlined the information. Here is my summary of what I found which includes a few important factors to consider if the need to decide between a defined benefit plan to a defined contribution plan arises:
1. The Cost of Switching – Advantage DB Plans
Organizations may not realize it, but a switch from one type of plan to another is not as easy as picking up the assets and moving to another plan. Defined benefit plans must remain open to cover the benefits previously guaranteed to all eligible participants. Thus, the defined benefit plan must be maintained for many years after the new defined contribution plan has begun. Administrative costs for two plans will generally have to be paid by the employer, unless the costs of the defined contribution plan are paid from the plan assets.
2. Portability, More Control and Ease for Employees – Advantage DC Plans
If an employee leaves the employment of the organization, then it is possible for them to roll over the assets in the qualified defined contribution plan to another qualified plan administered by their new employer or to an individual IRA. Also, participants have more control over how they invest the assets in their account. It seems that defined contributions plans are so popular now that employees are expecting an organization to have this type of plan.
3. Retirement Benefits – Advantage DB Plans
Defined benefit plans provide a better benefit at retirement. Employees receive a steady stream of income from the plan at retirement until they die and possibly to their beneficiaries after their death. Also, investment risk is maintained by the employer. Defined contribution plans, on the other hand, provide only benefits limited to what is contributed to the account balance and what is earned or lost. As recent economic events have highlighted, and unfortunately impacting some soon-to-be retirees, participants in defined contribution plans bear this investment risk, causing possible delays in their retirement. Another factor, is that it is not likely that participants will reduce their investment in stocks to less risky investment vehicles as they near retirement. Another assurance factor for defined benefit plans is that they are guaranteed by the Pension Benefit Guaranty Corporation (PBGC).
4. Employer Contribution Costs – Advantage DC Plans
In defined benefit plans, employer contributions are based on an amount actuarially determined necessary to fund the plan. As recent times have highlighted, in poor economic times when organizations are tighter on cash, a defined benefit plan will most likely need an increase in employer funding due to the market losses. In defined contribution plans, employer contributions have more flexibility. Organizations may elect in the plan document to make discretionary contributions which give the organization greater flexibility when it is not able to fund contributions.
5. Additional Factors – Audit Requirements and Legal Fees – Tie
Generally, audit requirements are the same for both defined contribution and defined benefit plans. Audit requirements are based on the number of participants a plan has at the beginning of the year. Generally, if a plan has less than 100 participants, the plan is considered a small plan and, generally, if the plan has greater than 100 participants, it is considered a large plan and will most likely need an audit.
To complicate things a little, there are additional plans deemed “hybrid” plans, which combine aspects of defined benefit plans and aspects of defined contribution plans. I won’t get into detail with these plans, but want to highlight that they are out there and may be advantageous in certain circumstances.
There is no easy answer between choosing one over the other and it depends on a number of factors that are specific to each organization. Defined benefit plans are a more secure way for participants to ensure a retirement that will last as long as they live, but due to economic considerations and the popularity, portability and ease of defined contribution plans, organizations will not be at a disadvantage when switching from one to another.
For now, I will call this a split-decision!