Reinventing Retirement Income in America

Policy Reports | Retirement

No. 248
Monday, December 31, 2001
by Brooks Hamilton and Scott Burns

The Change in Retirement Pension Plans

"Traditional defined benefit pensions are disappearing."

Traditional defined benefit pensions, company-sponsored and company-paid, are disappearing. They have been replaced by defined contribution plans, funded mostly by employees themselves. A defined benefit plan specifies the monthly payment a retiree will receive. A defined contribution plan specifies the annual contributions to an employee's pension fund.

Defined Benefit Plans. Just a generation ago, the average employee probably participated in a defined benefit pension plan that essentially guaranteed a monthly pension at normal retirement age (nearly always 65) based on two things: (i) final average pay (FAP) and (ii) years of service (YS). Typically:

B = FAP x YS x .015

To illustrate this, assume John Doe was hired at age 30, has had an average annual pay of $80,000 between ages 60 and 65 and intends to retire at age 65. His annual pension would thus be $42,000 [$80,000 x 35 x .015], or $3,500 per month.

Advantages of Defined Benefit Plans. During his 35-year career, Doe will benefit from several very important characteristics of the defined benefit pension:

  • He will be protected (both before and after retirement) from any market risk - i.e., whether the stock market soars or crashes, he will receive the same benefit (which is one reason these types of plans are called "defined benefit" plans).
  • He also will be protected from preretirement inflation, since his benefit will be based on his average pay over the last five years worked.
  • He will not be required to make a personal contribution to the plan and will pay none of the fees and expenses for investing the annual contributions made by the employer to the plan's assets (although economists agree that the employer's contributions are a substitute for wages).
  • Finally, he will have no responsibility for managing the investment of the money contributed to the plan.

Disadvantages of Defined Benefit Plans. Defined benefit pensions also have drawbacks and risks. Since pensions traditionally rewarded loyal, practically lifetime service, they imposed vesting requirements. Vesting means that a worker may have to remain with one firm for a number of years, depending on the firm's vesting policy, before becoming entitled to any retirement benefits whatsoever. And workers may not be fully vested until they have worked at that same firm for five to seven years, again depending on the firm's vesting policy.11

"Defined benefit plans penalize workers who change jobs."

As workers have become more mobile, those who change jobs have been serially shut out of pension plans tied to employment with one firm. Even a worker who changes jobs only infrequently and vests in each is affected because the pension benefit is always based on the final average pay of each job rather than the final average pay at retirement. The sidebar illustrates how this affects benefits for a worker who changes jobs.12

Although the pensions nominally are paid by the employer, some employers do not back their promises with sufficient invested funds. Thus although the employee is shielded from the direct risk of investing in the market, if the company fails in the marketplace the employee may not get all that was promised. Prior to the passage of the Employee Retirement Income Security Act of 1974 (ERISA), pensioners took their place in line behind other creditors of bankrupt companies. As a result, employees and retirees of some firms found themselves with reduced or nonexistent pension benefits. ERISA requires employers to maintain reserves to pay pension benefits, and many defined benefit plans are insured by the Pension Benefit Guaranty Corporation (PBGC), which collects and invests premiums from covered plans. However, even ERISA insurance does not guarantee that 100 percent of promised benefits will be paid. The maximum guarantee is $3,392.05 per month for someone retiring at age 65 and less for someone retiring earlier.

Defined Contribution Plans. Today the assets in a worker's defined contribution account determine retirement income. Consider John Doe II, now 39 years old and earning $32,750 annually. Assume that his pay will increase 4 percent annually; and that his average pay between ages 60 and 65 will be $80,846, or approximately the same as John Doe I in the old "replacement income" model. John Doe II's company has a 401(k) plan to which John contributes 6 percent of annual pay, with his employer matching 50 cents on the dollar (i.e., 3 percent). If Doe II's account earns an average of 10 percent annually over the 25-year period from age 39 to age 65,13 it will give him a benefit of $43,961 annually at retirement.

Thus Doe I will get $42,000 annually from contributions paid 100 percent by the employer, while Doe II, with a 401(k) plan, will get $43,961 annually, with most of that benefit paid by him personally.

Advantages of Defined Contribution Plans. Unlike Doe I, who can draw the maximum benefit only by staying with the same company throughout his career, Doe II can change jobs. And unlike with the defined benefit plan, Doe II's contributions plus the employer's vested match and any interest or dividends reinvested in the plan are Doe II's property and can be passed on to adult children or other heirs, even if there is no surviving spouse or dependent child.

Disadvantages of Defined Contribution Plans. All this comes at a price: John Doe II has to live with far more uncertainties. Some of the uncertainties:

  • Doe II is not protected from market risk, so if the stock market plummets, especially during his last working years, Doe II could be in a very tough spot.
  • Doe II is not protected from preretirement inflation, and if inflation roars during his last working years as it did in the 1970s, Doe II could see a significant reduction in the purchasing power of his plan account assets. (Of course if all prices rise, the prices of stocks in his account may rise too.)

"Defined contribution plans shift the investment responsibility to employees."

At the same time, Doe II's employer will enjoy a large reduction in the cost of providing Doe II's benefit - from the average defined benefit pension cost of around 7 percent of payroll just a generation ago to a cost of only 3 percent of payroll for Doe II. And instead of directly paying none of the plan's total fees and expenses, which can far exceed the 1.25 percent in our example, Doe II and the other employees will pay all of them. This does not mean that employers gain financially from defined benefit plans. Economists generally agree that wages plus benefits tend to equal the value of each employee to the firm. What it does mean is that the responsibility shifts. Regardless of Doe II's investment skills, Doe II has complete responsibility, albeit with a limited number of investment choices, for managing the money contributed to the plan to provide his benefit - even if Doe II is a novice (or worse).

Most contend that Doe II is being empowered with the opportunity to personally direct the investment of his own funds. Others believe that amateurs are being forced to direct the investment of their own funds.

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