Saving and Investment

Pension Ownership Benefits Workers (SUMMARY) (Text)

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

Under a defined benefit plan an employer promises an employee a specific monthly retirement income. Under a defined contribution plan, an employee contributes to an individual account 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.

The switch from DB to DC plans has had an enormous impact on the stock market. Under a DB plan employers only contribute as much as necessary to pay the benefits promised. When the stock market rises sharply, DB plans often have more assets than necessary. Companies can stop making contributions and may even reclaim the excess, since the plan assets belong to the company, not the worker.

By contrast, a worker owns and has full control of a DC plan. A worker could stop making contributions once his DC plan assets were sufficient to provide an adequate retirement income, but few 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.

Mutual fund managers investing DC plan assets 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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