Defined Benefit: Plan Sponsor Bears Risks

Plan sponsors more or less guarantee a predetermined benefit to participants in traditional pension plans. This is why they’re called defined benefit (DB) plans. Whether plan sponsors spend wisely or foolishly on their plans, the sponsors are still on the hook for paying the agreed-upon pensions to their retirees.

For example, let’s say a plan sponsor invests in a global index fund with an expense ratio of 2% instead of 1%. The additional 1% in expenses has no direct impact on plan participants’ retirement income because participants’ benefits are set independently of investment returns. Also, the extra 1% in expenses comes out of the plan sponsor’s pockets, not the plan participants’. Pensions’ investment portfolio assets belong to corporations, not employees. This contrasts with the situation for defined contribution plans.

Defined Contribution: Plan Sponsors “Off the Hook” for Benefit Level

Plan sponsors make no promises about the level of benefits that participants in defined contribution plans will receive. In fact, the only thing participants know for sure is what is contributed into their defined contribution (DC) plan. The plan sponsor isn’t even required to contribute to participants’ retirement. Moreover, in contrast to the DB situation, the assets in the DC plans don’t belong to the corporation. They are held in trust for the benefit of the participants and their beneficiaries.

Here’s why plan expenses matter in 401(k) plans: The level of portfolio returns will affect the participants’ retirement income. Expenses—along with contributions and investment performance—are an important factor in long-term returns. Plan participants bear all of the risk if their portfolios don’t return enough to provide the retirement income they anticipated.

Higher expenses mean lower returns. This is why DOL sets high standards for DC plan sponsors’ expenses, yet pays little attention to expenses of their DB peers.

Plan sponsors maintain the responsibility to monitor plan expenses. The new fee disclosure regulations will show employees that they the employees are paying all or most of the fees associated with their plan. Questions will begin soon after the regulations take affect January 1, 2012.

Please comment or call to discuss how you will be affected.