Pension plan troubles have been making the news again. United Airlines recently reached a deal to offload its pension plans on the Pension Benefit Guaranty Corporation. The plan may be nearly $10 billion dollars underfunded. Industry analysts fear that automobile manufacturers' pensions will follow the airlines into deep trouble. Indeed, according to THE NEW YORK TIMES, "The federal government contends that General Motors' pension fund is $31 billion short of what it owes its work force, according to closely held government data, a figure in stark contrast to G.M.'s assurances that its pension plans are "fully funded." What is the problem with pensions? Find out about the changing pension scene below.
According to a "Retirement Confidence Survey" conducted by the Employee Benefit Research Institute (EBRI) and the American Savings Education Council (ASEC), 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.
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 — 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 than 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 has documented the troubled state of funding for defined benefit plans in the U.S. several times in the past few years. 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 2004 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. However, the average funding level increased from 76 percent to 82 percent in fiscal 2003. Watson Wyatt estimates that 71 percent have assets covering less than 90 percent of promised benefits. About half have assets that would cover 80 percent or less of what the plans are supposed to pay. Only 15 percent of surveyed companies with defined benefit plans had plan assets sufficient to meet projected benefit obligations at the end of fiscal 2003.
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 benefit plans are guaranteed by the Pension Benefit Guaranty Corporation (PBGC). The testimony of the PBGC's Executive Director in April, 2005 put the Corporations's position in financial perspective:
The pension insurance programs administered by the PBGC have come under severe pressure in recent years due to an unprecedented wave of pension plan terminations with substantial levels of underfunding. This was starkly evident in 2004, as the PBGC's single-employer insurance program posted its largest year-end shortfall in the agency's 30-year history. Losses from completed and probable pension plan terminations totaled $14.7 billion for the year, and the program ended the year with a deficit of $23.3 billion.
Read the complete testimony.