At some point the popularity of defined benefit (DB) pension plans gave way to defined contribution (DC) plans. This is perhaps best exemplified by the numbers of 401(k) plans, which so many employees are now (or should be) contributing to on a regular basis. We looked into some of the factors behind this shift.

Q: What were the main reasons the landscape of retirement plans changed during the 1980s and 1990s?

A: For very small plans, those set up mainly as temporary tax shelters by small business owners such as doctors and dentists, the Tax Reform Act of 1986 changed rules sufficiently to cause them to get out of the game. For larger plans, there was a mantra emanating from performance-oriented compensation strategies about portability and paternalism: both uprooting pension plans in favor of DCplans such as the 401(k).

Q: What is it about portability or paternalism that made DB plans so ill fitting?

A: Many consultants were decrying how the workforce had become more mobile over the years. Mobile workers, it was said, couldn t take their DB plan benefits with them when they left; they were not easily portable to the next employer. The mantra was so quick to pick up steam and repeated so often that I m afraid there were reactions to it that clearly indicated misunderstanding or confusion.

Q: What kind of confusion could that have caused?

A: Once you look at it, portability was all about being able to cash out a prior employer benefit and roll it over to the next employer. The notion that DB plans could not accommodate this is nonsense. There is no reason why a DB plan could not allow it and there can even be DC plans that do not. As a matter of sponsor choice, you deal with it that way. It was not and is not a matter of plan type, DB better than DC. And because people really didn t stop and think about it, the main problem with portability (i.e., job-hopping employees) was not that the money could or could not follow you around (so what if it couldn t?) it was because of how career benefits can be radically affected by job-hopping. If five companies have the same retirement plan, DB or DC, and I take my turn at employment at each over my career, then my benefit can be significantly less than if I stay with the first employer my entire career.

Q: That sounds terrible. Then it's a good thing to get out of a DB plan?

A: No, not at all. I didn t say those five employers identical plans were DB or DC. In fact, it's irrelevant. You can have the same outcome either way. It's not a matter of plan type (DB vs. DC) but rather benefit structure that does or does not support job-hopping. If your goal is to do this then you want every one of those five employers to have a career-average type of benefit formula rather than final-pay formulas. Whether they should be all DB or all DC comes from analysis of other issues, such as shareholder value creation, etc.

Q: Were there any other "confusing" issues floating around that led companies to ditch DB plans?

A: Yes, one in particular paternalism. I wasn t there, but somehow paternalism became a dirty word with the emerging "pay for performance" crowd. DB plans were too paternal and paternalism meant entitlement. I don t get this, for two reasons.

First, whether my benefit goes up or down depends on my pay and the ongoing generosity of benefit enhancements offered by the employer. Neither of those would turn out well if the company did not perform. Higher-performing companies, it makes sense, reward their employees better than lower-performing companies. Higher pay leads to higher benefits. In this way, "pay for performance" was inherent and equally distributed across the enterprise.

Second, paternal DB plans were claimed to reward long-tenured employees at the expense of the highly mobile group, and DC plans were said to be the answer. The way I look at this is as follows. For a given benefit level and structure, a DC plan will provide upwards of three to five times as much value in the earliest years of anyone's tenure compared to the DB plan. This relationship flips at the other end of the tenure spectrum, with the DB plan providing three to five times as much to a tenured employee in a DB plan compared to the equivalent DC plan. By ditching the DB plan for a DC plan, you re saying it's OK for the employer and shareholders to plunk down three to five times more money for people who leave the company at the expense of those who stay. Rewarding those who leave and punishing those who stay seems like paternalism run amok.

Q: Were there any other issues contributing to the DB plan demise?

A: Yes. One was the regulatory uncertainty, which I never understood because there are as many or more pages of regulations for DC plans as for DB plans. The other was financial concerns about the unpredictability of annual costs. The first speaks for itself. The second, the cost volatility issue, I think we have neutralized of late.