Pensions may soon become a distant memory in all but a handful of jobs. Just a few years ago 28% of employees were working towards receiving a pension. As of last year that number was down to 18%. If you look back just one generation that number was almost 75% of the population. As the American economy has headed towards service based business, not manufacturing business, the number of pensions has dropped significantly. Pensions used to be the norm. However, companies found this type of retirement plan to be very expensive to adequately fund, maintain, and disperse. Pensions are referred to as “defined benefit” plans. This means that once an employee retires, the amount of their retirement is calculated and the chosen payout frequency and amount are set. Then it continues on until the person passes away, and in many cases will continue to pay a reduced benefit to the surviving spouse until he or she passes away. In this respect, the company has “defined” the benefit amount by promising how much your check will be very month. It is also for the actuaries to figure an almost definite amount of money that will need to be paid out over the course of one’s retirement.
This type of plan became problematic for the companies offering them. People began to live much longer and receive their pension payments for many more years. When social security was enacted a person’s typical retirement was only 2-5 years. Many pensions were only paid out along that same time line. Retirement today can routinely last 20-30 years. So, these companies simply cannot afford to pay out an employee for this length of time. Another issue with pension plans is the amount of money that must be pumped into them and the amount of risk that can be taken. You probably noticed in recent headlines that some pension plan administrators ignored some guidelines and lost pension money. But by and large, pension plans are good stewards of the company’s money. The company is making ongoing contributions while the person is working. So they can’t wait for a person to retire to put his or her money into the pension plan. The money the company contributes could be used to expand and grow, but rather it has to be put aside. To compound that problem, the pension plan must be very cautious with its investing. Preserving the principal becomes job number 1. The pension must then hoard large amounts of cash and invest it very conservatively, limiting its ability to make money once you consider inflation and taxes. All of this combined to make pension plans large, expensive drains on the companies offering them.
The solution was found in what is known as “defined contribution” plans. Well, at least the “solution” as far as companies are concerned. These are your 401k, 403b, and other present day retirement plans. The “defined contribution” part is directed at the fact that the payout is not guaranteed, but what is quantifiable is the amount of money you contribute to a plan, and the amount the company will contribute on your behalf as well. Now, many of these plans either have no employer match or something along the lines of 50 cents on the dollar up to 3-6%. Each plan can be different, but I’m sure you can see how this will cost a company far less money. The burden of saving towards your retirement is now on you, the employee. The company can spend less, offer you a 401k, and not be on the hook for any payments that may extend 30 years into your retirement. The company also illuminates investment risk since it doesn’t have to manage a portfolio any longer. All of the investment decisions are up to you…for better or for worse. It does give you much more flexibility and a number of choices. In fact, if you are the type of person who switches jobs every few years, this type of retirement plan is a better fit for you. You can usually enroll fairly soon after starting a new job and the plan is portable. It is easily rolled into an IRA and taken with you. If however, you plan on making a career with one company or are a safer minded person who likes guarantees, then a pension plan would be a better choice.
Please stay tuned for my next article in this series on pensions. I will cover how to plan effectively for retirement while incorporating your pension. We will also cover the 3 biggest mistakes people make with their pension.
