What’s the Big Idea?
Ernest Hemingway once said, “Retirement is the ugliest word in the language.” Maybe that’s true, but it’s getting considerably sweeter thanks to the unprecedented benefits packages on offer from today’s most competitive employers.
The global race to attract and retain talent has lead to an increasing number of attractive options for workers when it comes to employer-sponsored savings programs. About half of all private sector workers in the United States have access to retirement planning through their employer, and every worker in the UK who has paid into the NIC for at least one year is eligible for a pension.
Recently, a dramatic worldwide shift from defined benefit to defined contribution plans has also given employees the ability to take planning into their own hands. But with this freedom comes a significant amount of confusion: what’s the difference between a defined benefit and a defined contribution plan? What’s the role of the employer versus the role of the employee?
We asked Alicia Munnell, a retirement policy wonk who has served as a Member of the President’s Council of Economic Advisers, to enlighten us. Watch the interview:
What’s the Difference Between a Defined Benefit Plan and a Defined Contribution Plan?
A defined benefit plan is your grandparents’ savings plan. Under this arrangement, employers set aside a monthly benefit for each employee based on a prearranged formula taking into account his or her age, tenure, and earning history. Defined contribution plans, by contrast, are individual savings accounts, like a 401k or a thrift savings plan, which are tied to an investment portfolio and therefore fluctuate with the market.
Under defined contribution plans, employees rather than employers make choices about how their retirement money is invested. There are many potential upsides: greater efficiency for both employees and employer, higher quality investment offerings aligned with employee needs and local expectations (which is relevant for global corporations), simple and effective governance and risk management framework, and flexibility to evolve plans. But there’s a catch: according to a recent study, 50% of the time “retirement objectives will not be met if retirement plan calculations are based on average investment return and average life expectancy” for members of defined contribution plans.
What’s the Significance?
Clearly, employers can’t just hand over the responsibility to their employees without any education or support. Effective financial planning programs means happy employees, but the programs will only be effective if employers make a genuine commitment to teach employees how to use them.
“Here are some things you, the employer, could do to make life easier,” says Munnell. “One, you could automatically enroll all employees in your plan and do it annually. That means everybody is in unless they go to the HR department and say they’re out.” Another option is to automatically enroll employees at a meaningful contribution rate and automatically increase it over time — so that they’re opted in to the path of sound financial planning.
Finally, Munnell stresses the importance of giving employees the ability to take money out of the plan in an orderly way. “My sense would be that you should have—and employers can’t do this without some legislation—but have the default be that some portion of the money is automatically annuitized.” That way, unless an employee has good reason to go to the HR department and ask for the whole pile at once, it’s slowly doled out over time, again, according to the principles of sound financial planning.
These are smart choices that require conscious thought, and businesses would do well by their employees — and themselves — to give a little guidance.
Image courtesy of Shutterstock/NatUlrich.