Defined Benefit and Defined Contribution Retirement Plan Simulations

Abstract

The focus of this paper is the effect of changes to employer sponsored retirement plans on employee retirement benefits. Today’s retirement benefits consist mainly of three types of plans: defined benefit (DB), defined contribution (DC), and “hybrid” plans. Many employers have changed the type of plan they offered in recent years. Specifically, there is a shift from DB plans to DC plans. A retirement benefit comparison is made between a DB plan and a DC plan under different scenarios which depend on years of work, market yield, interest rates, and predicted wage increases. Using simulation modeling, DB and DC benefits are compared over different career lengths for a worker with a starting salary of $50,000. Simulated fluctuations in annual market yield and average national wage increases are used to project DC balances. DB benefits are simulated using random fluctuations in both wage increases and interest rates used for lump sum conversions. The resulting simulated benefits show that DC plans are generally inferior to DB plans. In addition, simulated DC retirement account balances have a much higher standard deviation than the present value of traditional DB plan annuities. However, DB benefits that are converted to lump sums have standard deviations closer to those of DC lump sums due to the variability of interest rates used in the conversion of DB annuities to a lump sum.