No recruiter wants to hear that a job candidate is overly concerned with retirement benefits, yet these benefits should be one of numerous criteria that are part of your framework for making professional decisions. The main distinction to understand is the difference between defined-contribution and defined-benefit pension plans.

As we saw in Chapter 1, defined-benefit plans are rapidly disappearing in the private sector but are still common in government jobs. Even there, though, financially pressed employers are moving away from defined-benefit plans, and employees can be badly hurt by wrong decisions made during plan conversions.

A defined-contribution plan—401(k), 403(b), or similar programs—is generally funded with pre-tax dollars from the employee and in many cases the company. These plans have some attractive features. All contributions made by the employees are their property regardless of future employment. Once the company’s vesting requirements¹ are satisfied, the funds contributed by the company also become the property of the employee. The employee has significant flexibility and control over the investment options and the resulting financial performance. The investments grow and compound on a pre-tax basis, accelerating the wealth creation opportunity. And the value of these assets is perfectly visible at all times, which allows employees to periodically rearrange the investments for adequate financial security upon retirement. For example, employees can change their annual contributions, adjust planned retirement dates, or change investment strategy based on new information over time. The primary drawback of this plan is simple: Employees assume the risk that the investments they choose will do poorly, putting them in danger of outliving their assets.

By contrast, in a traditional defined-benefit pension plan, the employer promises a specific level of benefits and assumes responsibility for funding this liability regardless of how the investments perform and how long the employee lives. However, five characteristics of a defined-benefit program can significantly decrease the expected value to the employee.

1. A risk of not qualifying. In today’s job markets characterized by free agency and labor mobility, the lack of portability decreases the expected value. An employee may well leave, voluntarily or involuntarily, before qualifying for any retirement benefits. Vesting rules for retirement benefits are governed by each company’s plan documents, but plans can require up to five years to qualify for any benefits and up to seven years to earn 100 percent of the promised benefit. (While employer contributions in a defined-contribution plan are also subject to vesting rules, the employee contributions belong to the employee immediately.)
2. Varying schedules of accumulation of benefits. Even if the anticipated benefits from a defined-contribution and defined-benefit plan are roughly the same, the rates at which employees accumulate benefits differ dramatically. Most defined-benefit plans’ payouts are based on a formula biased toward final average pay—the pension benefit grows substantially faster in the later years of a career than in the early years, in what is known as a J-shaped accrual pattern. The result is that employees who quit or are fired essentially subsidize those who stay. This is a retention tool for the company but a deterrent for an employee who wishes to maximize career mobility. By contrast, a defined-contribution plan grows in a more linear fashion, and you take your share with you whenever you leave.
3. A risk that the rules will change over time. A company can’t reduce the part of a pension that has already been earned, but it may at any time change the rate at which the benefit is earned in the future. The company can change the rules halfway through your career. With pension benefits disproportionately earned toward the end of a career, the cost of switching jobs or plans at that point is likely to be high.
4. A risk that the plan will fail. You must also weigh the likelihood that your company’s plan will be able to satisfy its obligations. Numerous pension plans have failed despite federal regulations requiring companies to contribute enough to ensure financial viability. When the obligations of a plan exceed the capacity to pay, the plan will likely be taken over by the federal Pension Benefit Guaranty Corporation (PBGC). However, the payment from the PBGC is limited to $59,300 per year for a worker who retires at 65 and is usually substantially less. Worse, the PBGC itself is arguably not financially sound. It consistently runs a multibillion-dollar deficit. While pension plan failures are still relatively rare, the negative consequences are so large that they deserve consideration.
5. Inability to direct unused benefits for the benefit of your legacy. As we discussed in Chapter 1, a lesser but still important objective of your financial planning activities is to manage your assets for the benefit of your family or causes of your choosing when you die. While a defined-benefit program guarantees that you, and possibly your spouse, can’t outlive your benefit, it generally has zero value upon death and is therefore of less benefit to your estate.

Obstacles to Planning

Defined-benefit plans create two significant financial planning challenges. The first is the inability to effectively value the expected benefit. The proceeds of a defined-benefit plan are a product of many variables: the stated pension benefit; the likelihood that the employee will vest or make it to full retirement; the likelihood that the company will change the benefit levels during the course of a career; the likelihood that the plan and the company will be financially able to satisfy the obligations to retirees decades in the future; and the distant-future payout policy of the PBGC if the plan and company fail to meet their obligations.

The other major challenge is that once you have spent significant years earning credits in a defined-benefit plan, it becomes difficult and expensive to change employers. Consider someone who has worked for a company for 25 years and can retire with full benefits in another 10 years, but over those past 25 years both the company and its pension plan have become financially shaky. That employee is on the wrong end of the J-curve. Staying the last 10 years is compelling because leaving is punitive, so probably the best alternative is to stay put and hope for the best. In recent history, hope has often proved to be a bad strategy. With a defined-contribution plan, however, employees can vote with their feet, taking their retirement assets with them to seek greener pastures.

Fundamentally, the choice between the two retirement approaches comes down to how much you value control and what risks you are comfortable assuming. I am more comfortable with the risks associated with the defined-contribution option because it gives the employees the flexibility to maximize their labor assets by pursuing the best opportunities throughout a career. This choice also makes the value of retirement assets more transparent at every stage of a career, allowing employees to adjust planned savings, retirement age, and spending patterns as needed. Finally, while many employees highly value the certainty of a defined monthly pension promised by defined-benefit plans, an investment portfolio can be constructed to provide similar monthly income with less risk. We explore this topic more thoroughly in Section III.

Key Conclusions

Consideration of retirement benefits, however distant, has a place in career decisions.

Each type of pension plan has its own risks—in a defined-contribution plan, these include the risks of poor investment choices and outliving your income; in a defined-benefit plan, the risks of unexpected changes in benefit terms, possible inability of the plan or company to pay the promised pension, and constraints on your job mobility.

For those prepared to accept the risks, defined-contribution plans offer valuable flexibility in personal financial planning, career opportunities, investments, and visibility of personal assets.