In addition to a guaranteed monthly retirement benefit from your employer, would you also like investment opportunities, funding control and flexible distribution options? This was the question put to workers 30 years ago, in the form of the 401(k), and most of them eagerly said “Yes!”
Unfortunately, one of the unforeseen consequences of embracing the 401(k) was that many employees lost their guaranteed retirement checks. And the extra opportunities, control and flexibility haven’t been able to make up for the loss. With the clarity of hindsight, many would forfeit the retirement options they have today to get back some of those guarantees.
Defined Benefit Pension Plans: The Old Standard
Guaranteed monthly retirement checks are a principal feature in employer-sponsored pension plans. These plans are also referred to as defined benefit (DB) plans, because the monthly benefit is determined by a formula, typically based on an employee’s years of service and average salary.
DB plans are attractive for long-time employees; they are funded by the employer, and a worker with 40 years of service can anticipate a lifetime pension equal to 60 percent or more of pre-retirement pay. But because these plans usually have lengthy vesting periods (such as requiring an employee to stay with an employer for 10 years to become eligible to receive any retirement income), those who change jobs frequently often forfeit retirement benefits. Most plans can include payments to a surviving spouse, but the only way to receive benefits is as a monthly check. And the pension benefits are not estate assets that can be left to heirs.
A DB plan is controlled by the employer. The company determines the benefit formula, funds the plan, selects the investments and administers payments. The only risk for the employee: that the plan might, because of underfunding or poor returns, become insolvent, and unable to deliver the promised payments. But this risk is moderated by insurance from the Pension Benefit Guaranty Corporation, which is also paid for by the employer.
Defined Contribution 401(k) Plans: The Current Standard
In contrast, a 401(k) is an employer-sponsored defined contribution (DC) plan that allows employees to defer a portion of their wages into an individual account. Employers may make deposits on behalf of the employees as well, usually in the form of matching contributions. These deposits, and any gains that result, accumulate income-tax free until distribution. Withdrawals are made at the retiree’s discretion (although minimum annual distributions are required after age 70½).
All employee contributions to a DC plan are immediately vested, no matter how long the employee has worked for the company, and no matter when they leave. Further, DC plans offer an array of investing options that could produce returns (and income) greater than what is promised by the DB plans. And besides the flexibility in taking withdrawals during retirement, any unspent accumulations can be passed to beneficiaries.
DC plans place all the responsibility for retirement success—the funding, investment management and distribution—on the employee.
Unforeseen Consequences
When introduced, DC retirement plans were presented as a format for employees to supplement an existing pension with personal saving. What happened was employers stopped offering pensions.
Defined benefit plans are expensive liabilities for employers, and the expenses and liabilities tend to increase as the plan ages. The perceived advantages for employees in 401(k)s made it plausible for many companies to terminate their pensions, and replace them with defined contribution plans.
What would have been annual contributions to fund pension obligations became matching contributions for 401(k) participants. These matching contributions may have been equivalent to what the company would have contributed to its pension fund, but now these funds were given to all participants, not just those who were vested. And if investment returns exceeded what would have been required to provide pension benefits, individual participants could add the profits to their account balance.
In theory, these changes seemed beneficial to employees. But the switch to DC plans also off-loaded all retirement responsibilities to the employee. Companies had no obligation to make matching contributions in the future, or to remedy income shortfalls from under-funding or poor investment performance.
The reality is that many individuals are not good savers, investors or retirement-income managers. They have not saved enough, have not made good investment decisions and find themselves ill-prepared to manage these assets for the rest of their lives. After 30 years of experience, there has been a shift of opinion about the desirability of DB retirement plans. Today, those who have pensions don’t want to lose them, and many of those who don’t have them wish they did.
In August 2017, the National Institute on Retirement Security (NIRS) released a report that surveyed eight states where public employees have their choice of the following retirement saving formats:
- a. a defined benefit pension
- b. a defined contribution plan
- c. a defined-benefit/defined-contribution hybrid plan
The NIRS researchers found that more than 75 percent of employees in every state chose the traditional defined benefit pension. In two states, the numbers choosing the pension were 95 and 98 percent.
This report mirrors other surveys indicating most American workers prefer pensions. A recent Gallup poll found that 51 percent of workers would leave their current job for a job that offered a pension.
Will Defined Benefit Pension Plans Make a Comeback? (Maybe, But Probably Not.)
The toughest task in retirement planning is funding. Someone—employer or employee—has to set aside money for the future. And guaranteeing how much those savings will be worth in terms of future income is almost as difficult. It is understandable that employees would prefer a retirement plan that puts those responsibilities on an employer. It is also understandable that most employers, particularly those in the private sector, would rather avoid the open-ended financial obligations that come with funding and maintaining a defined benefit plan.
Conceptually, pensions are very attractive to employees. But historically, the default outcomes of pension plans are termination or insolvency. This is true even with public-sector plans. In October 2017, CNBC reported that in all but two states, the average public pension funding ratio was 68 percent; i.e., plans had just 68 cents for every dollar owed in future payments. In response, some states have decreased or frozen existing benefit levels, and closed the plans to new hires. As currently configured, it’s hard to see conventional defined benefit pension plans making a comeback.
However, there are alternatives that incorporate many of a pension plan’s benefits. Two examples:
- • The guaranteed lifetime income feature of a pension can be duplicated by using DC plan savings to purchase a lifetime annuity from an insurance company.
- • Although the tax treatment may not be the same, some non-qualified deferred compensation (NQDC) plans often have employer funding provisions along with future income guarantees. NQDCs have long been used for individualized executive compensation packages, and can be customized to suit many employee scenarios.
Employees may think they want their pensions back. What they really want is employer assistance with retirement funding, and relief from investment risk and income management. Individually and corporately, there are ways to address these concerns without returning to a format that hasn’t proven to be sustainable.
Whether you’re an individual who wants more financial certainty in your retirement program, or part of a management team that wants to offer more attractive retirement options to its workers, now might be a good time to explore pension alternatives with your financial professionals.
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This article was prepared by an independent third party. Material discussed is meant for general informational purposes only and is not to be construed as tax, legal or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon only when coordinated with individual professional advice.
Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS), 355 Lexington Avenue, 9 Fl., New York, NY 10017, 212-541-8800. Securities products/services and advisory services offered through PAS, a registered broker/dealer and investment adviser. Financial Representative, The Guardian Life Insurance Company of America (Guardian), New York, NY. PAS is an indirect, wholly owned subsidiary of Guardian. Wealth Advisory Group LLC is not an affiliate or subsidiary of PAS or Guardian.
PAS is a member FINRA, SIPC.
Neither Guardian, PAS, Wealth Advisory Group, their affiliates/subsidiaries nor their representatives render tax or legal advice. Please consult your own independent CPA/accountant/tax adviser and/or your attorney for advice concerning your particular circumstances.
2018-62911 Exp. 5/8/2020
Submitted by Elozor Preil
