Opinion Editorial

Monday, March 30, 1998  

Workers Benefit from Pension Ownership

One of the most profound developments in the U.S. economy over the last 20 years has been the extraordinary shift from defined benefit (DB) to defined contribution (DC) pension plans.

Under a defined benefit plan an employer promises an employee a specific income at retirement of so many dollars per month. Under a defined contribution plan, an employee, through his employer, contributes a percentage of his pay to an individual account, which then is invested to provide retirement income. A typical DC plan is the popular 401(k) plan, which allows workers to save for retirement with before-tax income, often matched with employer contributions as well.

The switch from DB to DC plans has had an enormous impact on the stock market. The reason is because under a DB plan employers need only contribute as much to the pension plan as necessary to pay the specific benefits promised. When the stock market rises sharply, therefore, DB plans often have more assets than necessary to pay promised benefits. At this point, companies can stop making contributions to the plan and may even reclaim excess contributions. They can do this because legally the assets belong to the company, not the worker.

By contrast, a worker owns and has full control of a DC plan. When the stock market goes up, as it has in recent years, he, not the company, keeps all the gains. In theory, a worker could stop making contributions once the assets in his DC plan were sufficient to provide him with an adequate retirement income, just as employers do with DB plans. In practice, however, few workers do so for three reasons:

  • Contributions to DC plans reduce one's taxes, by reducing taxable income.

  • Employers often match contributions to DC plans that would cease if a worker stopped his own contributions.

  • Assets in DC plans become part of one's estate, in contrast to DB plan benefits that usually end with one's death.

Thus we can see that DB plans put a kind of brake on the stock market, because firms disinvest once the plan's assets reach a certain level. But workers with DC plans may continue to invest long after they have enough assets to buy an annuity equivalent to what a DB plan would pay. Mutual fund managers investing DC plan assets, therefore, must continue to buy stocks for their clients no matter how high the market gets. In this way, DC plans have been a major factor causing the stock market to rise to record levels.

Source: Bruce Bartlett (senior fellow, National Center for Policy Analysis), March 30, 1998.

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