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Benefit Analysis - Same Cost, Same Investment Return

"Let's look at an example," I said, pulling up a spreadsheet on my PC.  "Your defined benefit plan is a typical government plan: 2% of final pay for each year of service beginning at age 60. Benefits increase with inflation after retirement at 2% each year. Your employees are not covered by Social Security. For a new employee, the combination of employer and employee contributions costs about 10% of pay."

"We'll look at a typical employee: hired at age 30, paid $25,000 at hire. We'll start by assuming that the employee gets 5% pay increases each year, and that the rate of return on investment for both the defined benefit and the defined contribution plans is 8%. Let's look at the benefit value accumulated by your defined benefit plan, compared with a 10% contribution into a defined contribution plan." My fingers fly across the keyboard. In a few seconds, I show her the following table:

"Let me see if I have this right," she says. "Under the defined contribution plan, for the same contribution, my employees get a smaller retirement benefit."

"That's right," I responded. "Or you could say that if you want to give your employees the same retirement benefits, it’s going to cost you more."

She nodded her head. "This is what you mean when you say these plans allocate benefits differently."

I started to relax. We were getting somewhere. "That's right, if you give more money to 35-year-olds who walk out the door, you won't have as much money to spend on the people who work for you for 30 years." As always, I needed my disclaimer. "Remember, this assumes that contributions to the defined contribution plan continue at the same rate for the employee's entire career. We've also assumed that the return on investment will be the same for employee investments in the defined contribution plan as it is for the defined benefit plan."