Investments

Pension Plans: Defined Benefit Plans vs. Defined Contribution Plans

By Chris Duderstadt

August 10, 2023

Pension Plans: Defined Benefit Plans vs. Defined Contribution Plans

Key Points – Pension Plans: Defined Benefit Plans vs. Defined Contribution Plans

  • The Pros and Cons of Defined Benefit Plans and Defined Contribution Plans
  • Pension Plans Make Big Headline Amid Yellow’s Bankruptcy
  • PBGC 2023 Monthly Maximum Benefits
  • Reviewing Questions That We Receive About Pensions
  • 9 Minutes to Read | 23 Minutes to Watch

Pension Plans: Defined Benefit Plans vs. Defined Contribution Plans

Pension plans have long been a cornerstone of retirement planning, but the landscape has evolved and understanding these options is crucial. Both defined benefit and defined contribution plans have their pros and cons. Recent news headlines have highlighted the significance of pension plans with Yellow Trucking’s sudden bankruptcy affecting thousands of workers and their pensions. Such events underscore the importance of considering factors like pension solvency, survivorship options, cost-of-living adjustments, inflation impact, and more.

Did you know that only 15% of private companies offer pension plans today? That’s compared to 86% of state and local governments that have pension plans. Obviously, there are a lot of people that don’t work for the government and don’t have access to pension plans, though. Nevertheless, we see people with pension plans and help them all the time. If you have questions about pension plans, follow along here as we break down the differences between defined benefit and defined contribution plans.

Why Are Defined Benefit Pension Plans Becoming a Rarity?

Let’s start with the demise of the defined benefit plan and why companies started choosing to go with a defined contribution plan instead. With defined benefit plans, which is what people view as the traditional pension plan, it’s all on the company. The company funds the plan and is responsible for wisely investing the money. That way the company has enough funds for each retiree that they can then give them a defined benefit—a certain amount every month—for the rest of their life.

They can choose a joint life with a spouse, a single life, a joint and 50%, or maybe a joint and 75%. All those are different options. Or maybe they can choose a lump sum. Not every pension offers a lump sum, but most pensions do.

“That puts a lot of risk on the company. They’re solely responsible for funding those.” – Dean Barber

The Advent of the Defined Contribution Plans

Defined contribution plan, a.k.a. the 401(k) plan, is what most people are familiar with. Other examples of defined contributions plans include 403(b)s, 457s, and SIMPLEs. With defined contribution plans, the employer allows the employee to define how much they want to put into that plan up to a maximum. Then, the employer has the option to create a matching contribution. Most companies have some sort of matching contribution where they’re going to put in a portion of what you put in it. However, there’s no guaranteed benefit at the end with defined contribution plans.

There’s nothing that says you’re going to receive X-amount of dollars every month for the rest of your life. That puts the onus of the investment making decisions on the employee as opposed to the employer. Under the defined benefit plan, they have a professional manager managing that pension plan fund.

“The defined contribution plan did put the responsibility on the employee. A lot of people who aren’t very well initiated into investing get very nervous about that.” – Bud Kasper

Attention-Grabbing Headlines About Pension Plans

As we alluded to early, pension plans have been a bit of a hot topic in the news the past couple of weeks with Yellow Corp. filing for Chapter 11 bankruptcy protection on August 7. The announcement put about 30,000 people out of work. Yellow claims that the International Brotherhood of Teamsters, which represents nearly 22,000 former Yellow employees, for needing to file for bankruptcy. Teamsters claims otherwise, saying that Yellow’s greed is to blame. 

 About two weeks prior to filing for bankruptcy, Yellow avoided a strike that was being planned by the 22,000 people represented by Teamsters. The reason that they were threatening to strike was because Yellow owed more than $50 million in the form of employee benefits and pension accruals to its workers. The loss of that pension income would clearly be like pouring salt in the wound for those people who had just lost their jobs. 

“We have seen some catastrophic headlines involving major corporations that are, let’s say, 35% underfunded. That means they don’t have enough money to fund the employees who are waiting for their defined benefit checks to start.” – Bud Kasper

PBGC to the Rescue

There have been companies that have put a freeze on defined benefit plans. Some companies have filed for bankruptcy and needed the Pension Benefit Guaranty Corporation to step in. In Kansas City, there have been two major failures in pension plans over the past few decades with TWA and Hostess. Both filed for bankruptcy and all their pension plan funds were basically gone, so the PBGC stepped in.

“Many of the TWA pilots were expecting pensions in the $100,000-plus range. At that point in time, the maximum amount available from the PBGC was a little over $30,000 per year. So, those pilots were forced to take a significant haircut on what they thought was going to be their retirement.” – Dean Barber

Companies Can Offer Defined Benefit and Defined Contribution Plans

A lot of people who work at companies that offer defined benefit plans also have access to defined contribution plans. The employees that work for companies that offer pension plans and 401(k) plans can get set up far more nicely for retirement than employees who just have one of those two.

When you look at that, you need to take your spouse into consideration. The question on the pension benefit is whether the spouse will get the same amount as when their husband or wife was alive, who was the pensioner. The answer is yes. There’s usually a provision associated with it, but it’s usually at a discounted amount that they had when they first started retirement.

PBGC 2023 Monthly Maximum Benefits

Since we’re talking about the spousal benefit and the PBGC, we should mention that the PBGC’s 2023 monthly maximum benefit for a person age 60 that does a single life option is $4,387.50. If you wanted to do a joint and 50% survivor from the PBGC, you’re going to get a 10% haircut. With most pension plans, if you’re married, your option that is chosen for you is joint and 100% survivor. Joint and 100% survivor is a 20% haircut.

“Let’s say you’re going to get a $5,000 a month pension plan and you choose a joint and 100% survivor. Your pension is going to be $4,000 a month. If you pass away, your spouse continues to get $4,000 a month all the way until your spouse passes away.” – Dean Barber

Buying Life Insurance on Yourself

Now, there are drawbacks here. With most of the pension plans, if you choose that option of the $4,000 amount to try to protect your spouse and suddenly your spouse passes away early on, you’re stuck with $4,000 a month for the rest of your life. It doesn’t kind of bounce back up. In those cases, we counsel people on the best decision to make.

“In that example, if I’m taking $1,000 a month hit on my pension, I would be asking what it would cost me to buy life insurance on myself. That way, I can make sure that if I die first, my spouse continues to get the same amount of income and use life insurance to fund that.” – Dean Barber

Life insurance comes in one lump sum and it’s tax-free. And if the spouse dies first, you can either cancel the policy and still get $5,000 a month as opposed to $4,000 or you could keep the policy and it can then pass a lump sum to your beneficiaries.

The longer you live, the lower the amount of insurance that you need. So, you can tier that insurance over time with how that insurance is declining in value because the net present value of the future income need decreases as life expectancy shrinks.

The Choice of a Lump Sum

The other thing that happens is a lot of people with pension plans have the choice of a lump sum. Let’s use another Kansas City-based company as an example. Evergy, which is power company, had an option for a lump sum. We have quite a few clients that worked at Evergy and they got a notification late in 2022 that if they were going to choose a lump sum option in 2023, it was going to be significantly reduced from what it would be if they retired in 2022. So, a lot of people retired in 2022 to get that larger lump sum option.

You might be asking why they did that. Well, because the formula for calculating what the lump sum is going to be is all based on current interest rates. As interest rates rise, the lump sum does the opposite and goes down.

With interest rates being smashed to the ground ever since the Great Recession, the best option was the lump sum as opposed to a single life or a joint life with 50% or 100% survivor. Today, that’s going to be a more complex calculation because interest rates are higher than what we’ve seen in almost two decades.

“That raises the point from a corporate perspective as to whether a company wants to support a defined benefit plan or do the defined contributions plan. We know the answer in most cases is the defined contribution plan.” – Bud Kasper

Social Security Is a Defined Benefit Plan

Pension plans require a lot of work. Now, let’s also talk about another type of defined benefit plan, and that is Social Security. Social Security, by its definition, is a defined benefit plan. Just go to ssa.gov and look at what your future estimate of benefit is going to be.

Claiming your Social Security and the complexities that come with that are just as critical to retirement success as how you take your pension plan. In the financial planning process, it’s pivotal to understand when to turn Social Security on so that your plan is successful.

So, we technically debunked the myth we mentioned earlier about 15% of private employees having access to a defined benefit plan. One hundred percent of employees, no matter who you work for, have access to some form of defined benefit plan, whether it’s your Social Security benefit or a pension plan.

Is Social Security Going to Run Out?

An average 62-year-old couple will have north of 600 different iterations on how they claim their Social Security. The difference between the best and worst can be a substantial amount of retirement income, assuming the same life expectancy and the same earnings history.

Some people will say they’re conflicted because they want to get their money immediately because of the threat of Social Security running out in 2032. Bud is confident that Congress will extend that.

“Remember that the Baby Boomers are now tailing off. In other words, they’re dying. As that happens, that’s taking some of significant pressure off that at the same time that payments are going out to those people.” – Bud Kasper

We know that Social Security will be underfunded sometime in the early 2030s just like a lot of pension plans were underfunded after the Great Recession. That doesn’t mean that it can’t be fixed, but it’s going to take something to fix it.

Understanding Pension Plans and How to Claim Social Security with Our Retirement Plan Checklist

We can’t stress enough that your spouse needs to be involved in your decision of when to claim Social Security. You can begin to see how important that is by reviewing our Retirement Plan Checklist with your spouse. This checklist has yes-or-no questions that gauge your retirement readiness, and many of them involve pension plans and how you’re going to claim your Social Security.

If you don’t have a pension plan, maybe you don’t need to read the part about the pension plan. But you’re going to claim Social Security. Our Retirement Plan Checklist also includes timelines of important retirement considerations that take you to and through retirement. Make sure to download your copy of the Retirement Plan Checklist below.

Pension Plans

Retirement Plan Checklist

Understanding the Tax Implications

When it comes to claiming Social Security and the defined benefit plan, you need to understand the tax implications. Even though Social Security isn’t in and of itself a defined benefit plan, the way Social Security is taxed is totally different than the way the pension plan is taxed. You need to understand that because you can’t spend 100% of what you get because Uncle Sam wants his share.

“It doesn’t make any difference how much you make; it’s how much you keep. That only comes through tax planning strategies. At Modern Wealth Management, our in-house CPAs work with our CFP® Professionals to get the best outcome for our clients.” – Bud Kasper

The goal is to control taxes and reduce them over a lifetime, not just in a single year.

Summing Up What We’ve Discussed About Pension Plans

We’ve learned that everyone has access to a defined benefit plan. And we’ve learned that it’s critical to make the right decision on what option you take. The decision can be done mathematically by creating the financial plan and running all the different pension options and options of claiming Social Security to come up with the optimum strategy for each individual.

“There’s no blanket statement that says everybody should claim their Social Security this way or everybody should choose this option on the pension plan. The plan needs to be created and then you put in the options. Then, you can see in black and white which option is most advantageous for you, your spouse, and your beneficiaries.” – Dean Barber

Questions About Pensions

If you have a pension plan, we also want to review some key questions to ask yourself that Dean and Logan DeGraeve mentioned on America’s Wealth Management Show. We covered some of them in this article as well, but they bear repeating.

  • Is your pension solvent?
  • What are the survivorship options or the term options?
  • Do you have a cost-of-living adjustment to keep up with inflation, better known as COLA?
  • How is inflation going to impact your decision?
  • Will your pension affect your tax strategy?
  • How does the pension decision affect your Social Security claiming decision?

Addressing Your Pension-Related Questions with a CFP® Professional

We could list more questions about what to consider with pension plans, but those are some good ones to start with. If you’re unsure of where you stand with those questions or have other questions about pensions, we’re here to help.

You can ask us your questions during a 20-minute “ask anything” session or complimentary consultation with one of our CFP® Professionals. To schedule an in-person, virtual meeting, or phone call with one of our CFP® Professionals, click here. We look forward to meeting with you and figuring out how your pension can help give you a more fulfilling retirement.

Pension Plans: Defined Benefit Plans vs. Defined Contribution Plans | Watch Guide

00:00 – Introduction
01:11 – The Fall of Defined Benefit Plans
03:30 – The Dawn of the Defined Contribution Plan
05:06 – Major Company Failures and Lost Pensions
06:35 – TRIVIA
07:40 – Defined Benefit Plans: Spousal Info
12:59 – Defined Benefit Plans: Lump Sum
14:25 – TRIVIA
15:16 – Everyone Has a Pension (Social Security)
18:15 – Retirement Plan Checklist
19:30 – Taxes and Pensions
20:33 – What We Learned Today

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The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Adviser. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.