From defined benefit to defined contribution plans

In most developed countries, the retirement plan of an employee is a defined contribution (DC) plan—e.g., the 401K in the United States. In the Philippines, however, the norm for an employee’s retirement plan is a defined benefit (DB) plan. What are the differences, and why the advocacy to move away from a DB?

A DB is one where an employer guarantees to pay the employee a predetermined amount of money at the time of retirement—e.g., one month’s salary for every year of service. The employer normally contributes a certain amount every month to a pension fund and takes the risk for the performance of this fund. Any shortfall will have to be funded by the employer. The employee normally has to remain employed for a certain period of time before he or she becomes eligible to receive all or a portion of the retirement benefit.

A DC plan is where the employee contributes a set amount of money each pay period to a pension fund and, upon retirement, receives the amount contributed plus any interest on or profits from the fund. The employer can contribute a portion to the fund or can simply give it as part of the salary. The financial risk on the return on investment of the fund is entirely on the employee. But as the fund is in the name of the employee and under the employee’s control, he or she can access it at any time; there is no need to have been employed for a minimum number of years. The fund is also portable—i.e., employees can take it with them when they transfer employment.

A DC plan is not perfect. The main concerns revolve around the ability of the employee to properly manage the fund and the sufficiency of the fund for retirement, but these can all be managed. The employer or employee can look for a good fund manager—for example, a bank to help them plan and manage the concerns.

In today’s world where employees are quite mobile, moving from one company to another after a few years of working, they will most likely lose out on a DB plan as there is a required minimum number of years of employment before they can get any portion of their fund. More importantly, I have seen how employees of some companies and agencies involved in contracting—security, catering, or building maintenance—have been taken advantage of.

An example is a security agency whose services are bid out every three or four years. When an agency loses out on a contract, it is normal for its employees to be transferred and hired by the winning agency. This is a practical arrangement, especially for large contracts, as the losing agency cannot easily redeploy its employees to another company, and the winning agency cannot easily hire experienced employees to take on the job.

The problem here is that the employees start at year zero when they are transferred to the new agency. The pension contributions they accumulated at their previous agency are not given to them as they lack the required minimum years of service, nor is the fund transferred to the new agency that has hired them. Thus, the contributions become a windfall for the losing agency, at the expense of the poor employees!

Imagine if this cycle is repeated several times over the working life of an employee. He or she will retire with very little to look forward to apart from the Social Security Service pension.

Moving to a DC plan is a win-win decision: Employers will have less risk and incur lower cost while employees will enjoy portability of their pension fund, have full control of it, and get whatever they have contributed without needing to meet any required minimum-employment period!

Edgar O. Chua is chair of the Makati Business Club.