The Demise of the Defined-Benefit Plan
Why companies replaced traditional pensions with 401(k)s
There once was a time when, after 25 or 30 years of working diligently for your employer, you could expect to be rewarded for your loyalty and hard work with a gold watch and a steady stream of checks lasting the length of your retirement. But times have changed and those steady checks, which came courtesy of a defined-benefit plan, are a thing of the past for most private-sector workers.
In this article, we look at the shift away from defined-benefit plans in the last few decades toward defined-contribution plans, such as 401(k)s, and suggest ways to ensure that you have a dependable income in your post-work years.
How Times Have Changed for Defined-Benefit Plans
Up until the 1980s, defined-benefit pensions were the most popular retirement plan offered by employers. Today, only 15% of private-sector workers have access to one, according to the March 2021 National Compensation Survey from the Bureau of Labor Statistics (BLS).2
From the employee's perspective, the beauty of a defined-benefit plan is that the employer funds the plan while the employee reaps the rewards upon retirement. Not only do employees get to keep and spend all the money they earn in their paychecks, but they can also easily predict how much money they will receive each month during retirement because payouts from a defined-benefit plan are based on a set formula.3
Of course, there are always two sides to every story. Estimating pension liabilities is complex. Companies offering a defined-benefit pension plan must predict the amount of money that they will need to meet their obligations to retirees.
From an employer's perspective, defined-benefit plans are an ongoing liability. Funding for the plans must come from corporate earnings, and this has a direct impact on profits. A drag on profits can weaken a company's ability to compete. Switching to a defined-contribution plan such as a 401(k), which is mainly funded by employee contributions, saves a significant amount of money.
Putting the Freeze on Pensions
Over the last few decades, private-sector companies increasingly stopped funding their traditional pension plans, which is known as a freeze. A freeze is the first step toward the elimination of the plan.
General Electric is an example of a major corporation to do so. It announced plans in October 2019 to freeze its pension for 20,000 U.S. employees and shift to a defined-contribution plan as steps to help reduce the deficit of its underfunded pension by as much as $8 billion.4
Other high-profile examples of major corporations freezing pensions over the years include IBM, which in 2006 announced that it was freezing its defined-benefit plan to shift toward employee-funded defined-contribution plans, which ultimately saved the company billions. Verizon, Lockheed Martin, and Motorola soon took similar steps.
Corporate America has defended these moves on the grounds that the government has made moves to force companies to fully fund their pension plans. The Pension Protection Act of 2006, for example, mandated stricter funding requirements to help ensure that employees get paid benefits.1
But companies haven't always fully funded the plans. All too often, the money hasn't been there when it's needed, and the government has been forced to bail out the plans. This path has been taken by several airlines and a contingent of steelmakers over the years, all of which filed for bankruptcy and shifted the responsibility for their retirement plan obligations onto the U.S. government. The government, in turn, shifted the burden to taxpayers.
Defined-benefit pension plans are still somewhat common in the public sector, especially for those who work in the government.
Impact of Shift to Defined Contribution Plans
So what does the end of defined-benefits plans mean for employees? The entire scenario is bad news. Unlike a defined-benefit plan, where employees know exactly what their benefits will be in retirement, the only certainty in a defined-contribution plan is the amount that the employee contributes. Many employers also offer matching contributions.
After the money hits the account, it's up to the employee to choose how it's invested (typically from a menu of mutual funds) and the vagaries of the stock market to determine the ultimate outcome. Maybe the markets will go up, and maybe they won't.
On the other hand, many employees who were relying on their employer-funded plans were left to fend for themselves when their employers failed to fund the plans. Similarly, many employees were left in a bind when their employers terminated defined-benefit plans or downsized their staff, giving the workers a one-time, lump-sum payout instead of a steady income stream.
Today's Retirement Reality: Fending for Yourself
When it comes to a financially secure retirement, you need to fend for yourself. For most, Social Security benefits aren't enough to live on in retirement. The first thing you need to do is save money—as soon, and as much, as you can.
The Demise of the Defined-Benefit Plan
Why companies replaced traditional pensions with 401(k)s
There once was a time when, after 25 or 30 years of working diligently for your employer, you could expect to be rewarded for your loyalty and hard work with a gold watch and a steady stream of checks lasting the length of your retirement. But times have changed and those steady checks, which came courtesy of a defined-benefit plan, are a thing of the past for most private-sector workers.
In this article, we look at the shift away from defined-benefit plans in the last few decades toward defined-contribution plans, such as 401(k)s, and suggest ways to ensure that you have a dependable income in your post-work years.
How Times Have Changed for Defined-Benefit Plans
Up until the 1980s, defined-benefit pensions were the most popular retirement plan offered by employers. Today, only 15% of private-sector workers have access to one, according to the March 2021 National Compensation Survey from the Bureau of Labor Statistics (BLS).2
From the employee's perspective, the beauty of a defined-benefit plan is that the employer funds the plan while the employee reaps the rewards upon retirement. Not only do employees get to keep and spend all the money they earn in their paychecks, but they can also easily predict how much money they will receive each month during retirement because payouts from a defined-benefit plan are based on a set formula.3
Of course, there are always two sides to every story. Estimating pension liabilities is complex. Companies offering a defined-benefit pension plan must predict the amount of money that they will need to meet their obligations to retirees.
From an employer's perspective, defined-benefit plans are an ongoing liability. Funding for the plans must come from corporate earnings, and this has a direct impact on profits. A drag on profits can weaken a company's ability to compete. Switching to a defined-contribution plan such as a 401(k), which is mainly funded by employee contributions, saves a significant amount of money.
Putting the Freeze on Pensions
Over the last few decades, private-sector companies increasingly stopped funding their traditional pension plans, which is known as a freeze. A freeze is the first step toward the elimination of the plan.
General Electric is an example of a major corporation to do so. It announced plans in October 2019 to freeze its pension for 20,000 U.S. employees and shift to a defined-contribution plan as steps to help reduce the deficit of its underfunded pension by as much as $8 billion.4
Other high-profile examples of major corporations freezing pensions over the years include IBM, which in 2006 announced that it was freezing its defined-benefit plan to shift toward employee-funded defined-contribution plans, which ultimately saved the company billions. Verizon, Lockheed Martin, and Motorola soon took similar steps.
Corporate America has defended these moves on the grounds that the government has made moves to force companies to fully fund their pension plans. The Pension Protection Act of 2006, for example, mandated stricter funding requirements to help ensure that employees get paid benefits.1
But companies haven't always fully funded the plans. All too often, the money hasn't been there when it's needed, and the government has been forced to bail out the plans. This path has been taken by several airlines and a contingent of steelmakers over the years, all of which filed for bankruptcy and shifted the responsibility for their retirement plan obligations onto the U.S. government. The government, in turn, shifted the burden to taxpayers.
Defined-benefit pension plans are still somewhat common in the public sector, especially for those who work in the government.
Impact of Shift to Defined Contribution Plans
So what does the end of defined-benefits plans mean for employees? The entire scenario is bad news. Unlike a defined-benefit plan, where employees know exactly what their benefits will be in retirement, the only certainty in a defined-contribution plan is the amount that the employee contributes. Many employers also offer matching contributions.
After the money hits the account, it's up to the employee to choose how it's invested (typically from a menu of mutual funds) and the vagaries of the stock market to determine the ultimate outcome. Maybe the markets will go up, and maybe they won't.
On the other hand, many employees who were relying on their employer-funded plans were left to fend for themselves when their employers failed to fund the plans. Similarly, many employees were left in a bind when their employers terminated defined-benefit plans or downsized their staff, giving the workers a one-time, lump-sum payout instead of a steady income stream.
Today's Retirement Reality: Fending for Yourself
When it comes to a financially secure retirement, you need to fend for yourself. For most, Social Security benefits aren't enough to live on in retirement. The first thing you need to do is save money—as soon, and as much, as you can.
The Demise of the Defined-Benefit Plan
