According to a 2003 survey by the Employee Benefit Research Institute (EBRI) and the American Savings Education Council (ASCE), many Americans are ill-informed about just how much money they will need in retirement, and how to plan accordingly. Traditionally, retirement experts have told us to think of retirement as a "three-legged stool" comprised of personal savings, Social Security and employer sponsored pensions. These days, the stability of all three legs are being challenged - and some people are worried. This week NOW looks at how traditional pension plans are faring. Experts refer to what we think of as "traditional" pensions as "defined benefit plans." Below you'll find more information about these plans as well as about other increasingly popular types of pension plans. Read the Retirement Confidence Survey.
Types of Plans Plans in Trouble Pension Laws Retirement Research Resources
Defined Benefit Plan
Defined benefit pension plans promise workers a specific monthly benefit at retirement. The amount of the benefit is known in advance, usually based on factors such as age, earnings, and years of service. The funding equation is often based on a percentage of salary during the employee's final (most highly paid) years of service. In some cases, employees have an option of taking their pension benefit all at once upon retirement in what is called a "lump sum payout."
Defined Contribution Plan
A defined contribution plan does not promise you a specific amount of benefits at retirement. In a defined contribution plan, the actual amount of retirement benefits provided to an employee depends on the amount of the contributions as well as the gains or losses of the account. In these plans, employee and employer both contribute to the employee's account. The plan usually has a set rate for employer contributions. These funds are most often invested on the employee's behalf. The retiree ultimately receives the balance of the account plus or minus investment gains or losses. Examples of defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans.
A crucial difference between defined benefit and defined contribution plans is where the financial risk lies. Defined contribution plans depend mostly on employee contributions and put much of the investment risk onto the employee. In defined benefit plans the contributions come the employer, who is still obliged to meet defined payment obligations regardless of how the invested funds have fared in the market.
Cash Balance Conversion
Many companies that have defined benefit plans are trying to cut costs by transferring from a defined benefit to a "cash balance" plan. A cash balance plan defines the promised benefit in terms of a stated account balance. In a typical cash balance plan, a participant's account is credited each year with a "pay credit" (such as 5 percent of compensation from his or her employer) and an "interest credit" (either a fixed rate or a variable rate that is linked to an index such as the one-year treasury bill rate). Increases and decreases in the value of the plan's investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks and rewards on plan assets are borne solely by the employer.
This system benefits younger workers, rather the older workers in defined benefit plans whose monthly payout is usually determined by their salary near retirement usually their highest years of pay. In a 1999 report, The Department of Labor noted that those most at risk of losing retirement funds by cash balance transfers "are those who, at the time the cash balance plan is introduced, are nearest retirement and who therefore have the greatest interest in and need for retirement benefits." Such conversions are receiving challenges, both in Congress and through litigation
(Learn more about the laws governing pension plans.)
The Changing Pension Scene
Traditional defined benefit pensions, once a major component of many American's retirement planning are on the decline. Since 1985 the number of companies with these plans has dropped from 114,000 to 32,500. Still, today 44 million Americans in the private sector are expecting retirement income from this type of plan. According to FORTUNE/WALL$TREET WEEK, as the number of workers covered by defined benefit plans has declined, the number covered by defined contribution plans has risen. The Employee Benefit Research Institute's database shows that at the end of 2001 that there were 14.6 million active 401(k) plans in the United States. As changing demographics and regulations on pension fund design and accounting make the costs outweigh the tax benefits of these plans, it's likely we'll see fewer and fewer defined benefit plans.
For the more than half of Americans who do not have any employee sponsored retirement benefits, these problems are irrelevant. They are concerned about the future of Social Security and health care issues.
Learn more about the ongoing Social Security debate.
What You Should Know About Your Pension Rights from the Department of Labor
Plans in Trouble
NOW's story "Pension Pain" details the troubled state of funding for defined benefit plans in the U.S. Companies are required to maintain their pension plans at funding levels that will assure adequate resources to meet current and future obligations. A pension plan is considered underfunded if the liabilities of the plan (how much money the plan must pay out to its current and future retirees) exceeds the assets of the plan (how much the plan is worth today). A 2003 study by Watson Wyatt of pension plans in the United States covering 1,000 or more active participants found that the percentage of underfunded plans increased from 15% in 1992 to 52% in 2002. A late 2002 Merrill Lynch survey found that the pension liability of 348 S&P 500 companies lies somewhere between $184 and $342 billion a drop from a reported $2 billion surplus in 2001.
What happens when plans can't pay? According to the provisions of 1974's The Employee Retirement Income Security Act (more about ERISA), the basic pension benefits of the 44 million Americans in the 32,500 private defined benefits are guaranteed by the Pension Benefit Guaranty Corporation (PBGC). At the end of March, 2003, the PBGC itself had its own reported deficit of $5.4 billion. There are currently 2840 plans under its governorship of the PBGC including those detailed below.
After the airline went into bankruptcy the PBGC assumed the pension plan oversight, but it will only be liable for $600 million of the anticipated $2.5 billion that the plan was underfunded. "Pension Pain" features the story of a former US Airways pilot who had expected a pension of about $75,000 per year, but he's now expecting just about $25,000. The PBGC's maximum benefit rules are set each year under provisions of ERISA. "For pension plans ending in 2003, the maximum guaranteed amount is $3,664.77 per month ($43,977.24 per year) for workers who retire at age 65. This guarantee amount is lower if you begin receiving payments from PBGC before age 65 or if your pension includes benefits for a survivor or other beneficiary." Commercial pilots must retire at age 60, thus are considered early retirees under these rules.
For the former industrial giant, The Pension Benefit Guaranty Corp is now responsible for paying pension benefits to 95,000 workers and retirees. It is the largest plan assumed thus far by the PBGC. The plan is estimated to be only 45 percent funded, with $3.5 billion in assets to cover $7.8 billion in benefit liabilities. Of the $4.3 billion in total underfunding, the PBGC expects to be liable for about $3.7 billion.
The Polaroid Corporation sold its assets, but the new owner, OEP Imaging Corp., an affiliate of Bank One Corp.'s One Equity Partners, refused to take on the pension lability. Thus the PBGC assumed responsibility for 11,000 former employees. PBGC estimates that the Polaroid Pension Plan, with assets of $657 million and benefit liabilities of $981 million, is underfunded by about $324 million.
Sources: The U.S. Department of Labor; Employee Benefit Research Institute (EBRI); 401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2001 - ERBI; "2003 Retirement Confidence Survey - ERBI; "Retirement Savings and Household Wealth in 2002, Analysis of Census Data, JOURNAL OF PENSION PLANNING & COMPLIANCE, Volume 29, Number 2, Summer 2003; "Nest eggs without the yolk," THE ECONOMIST, May 8, 2003; WALL STREET WEEK with FORTUNE, April 22, 2003; Ford Motor Company Annual Report 2003; The Pension Benefit Guaranty Corporation (PBGC); "2002 Survey of Actuarial Assumptions and Funding: Pension Plans with 1,000 or More Active Participants," Watson Wyatt Worldwide Research; "Report of the Working Group Studying the Trend in the Defined Benefit Market to Hybrid Plans," The U.S. Department of Labor, November 10, 1999