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This paper illustrates that the common vesting provisions of defined benefit (DB) and defined contribution (DC) retirement plans can lead to substantial differences in accumulated benefits. It discusses how many of the features touted as making DB plans the better choice can be reproduced by DC plan participants, and should make little difference to the choice of a plan. It then shows how to determine the rate of return that produces parity between the income of a DB plan and that of a DC plan given assumptions about salary, work life and years of retirement. Several examples are provided of this parity rate under varying assumptions. Finally, the portfolio allocation needed in a DC plan to achieve parity with the income of a DB plan is discussed.
The relatively recent introduction of defined contribution (DC) plans as an alternative to defined benefit (DB) plans has spurred debate in both the academic and professional press as to which is better. In this paper, we attempt to clarify the issues surrounding the choice of a plan. We begin with a description of the plans, along with an analysis of the impact of each plan's vesting provisions on participants' potential future income.
We then discuss how some features that come packaged with DB plans can be reproduced through products available to DC plan participants. We suggest these features should not be motivating the participant in choosing between the plans. Then, we present a simple technique for determining how well a DC plan must do to match the income of a comparable DB plan for a given set of assumptions about salary, work life and years of retirement. This parity rate can be calculated using the internal rate of return (IRR) function found in spreadsheets.
Finally, we contend that the choice between DB and DC plans, outside of vesting issues, comes down to the willingness and ability of the employee to bear
The Plans and Vesting
Under a DB plan, the participant is guaranteed a fixed income-that is, a defined benefit-once he or she is eligible for retirement. DB plans require a certain number of years of service before a participant is entitled to the income (becomes vested). Although most private plans are non-contributory, Foster [1997,...