Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches 11th Edition by Everett Allen,Joseph Melone,Jerry Rosenbloom,Dennis Mahoney

Exercise 6

The text states that in the view of some, a more equitable allocation of employer contributions occurs under a defined benefit plan than under a defined contribution plan. Assume that a participant in a defined benefit pension plan, age 25, is currently paid $15,000 per year and he or she will retire at age 65. At that time, he or she will receive a pension benefit equal to 1 percent of his or her average salary in the last five years, times years of service. Compute the present value of the pension benefit accrued from working an additional year, as a percentage of the participant's compensation, at ages 30, 35, 40, 45, 50, 55, 60, and 64. Perform the calculations under two sets of assumptions: (a) the participant has no wage growth and the discount rate is 3 percent; and (b) the participant's wage growth is 7 percent and the discount rate is 10 percent. Graph the change in the present value of accrued benefits from an additional year's work (expressed as a percentage of compensation) against the participant's age under both scenarios. What conclusions can you draw about the allocation of employer contributions under defined benefit plans (Notice that the discount rate exceeds the wage growth by 3 percent under both scenarios.)