Once upon a time, many workers didn’t need to worry about how they would spread 401(k) savings across their retirement years. Instead, they participated in a defined-benefit pension plan. Employers contributed to the plans and managed them; at retirement, a monthly check started arriving in the mail, and the checks continued until the retired employee died.
But the availability of these plans has plunged over the past few decades: In 1989, 32% of workers had a traditional pension versus just 12% in 2019, according to the Center for Retirement Research at Boston College. Most of that decline occurred in the private sector; pensions remain the central retirement benefit for most state and municipal workers.
But some experts think there’s a chance for the defined-benefit pension plan to make a comeback in the private sector, at least among larger employers.
At the recent annual conference of the National Institute on Retirement Security, two speakers made the provocative argument that conditions are ripe for at least some companies that have closed, frozen, or terminated their defined-benefit plans to restart them or bring back plans with updated features. What impact could this have?
Defined-Benefit Pension Plans’ Impact on Retirement and Employee Security
The revival of defined-benefit pension plans would be a positive development for retirement security in the United States.
The tax-deferred defined-contribution saving system, which largely has replaced defined-benefit plans in the private sector over the past four decades, has primarily accrued wealth for the affluent. The system has not come close to closing the gap left by the decline of defined-benefit pensions, which provide a benefit to all covered employees.
The brief from the Center for Retirement Research at Boston College analyzes Federal Reserve data indicating that the median balance in a retirement account in 2019 for a working household nearing retirement (age 55-64) was just $144,000—an amount that will not last very long in retirement. And it looks worse beyond the median figures, as most of the assets are being accumulated in the two highest quintiles of income.
Also consider the Elder Index, produced by the Gerontology Institute at the University of Massachusetts Boston, which measures the cost of living for older people living as couples or alone. It is built around the typical budgets of seniors, and it shows that roughly half of Americans over age 65 living alone have incomes that are below the index.
Meanwhile, Social Security is bogged down in political debate about how to avoid a steep 20% cut in benefits if we reach the point of trust fund exhaustion in 2035—not to mention that everyone born after 1960 will receive lower benefits because of the higher retirement ages legislated in 1983.
So, even a scintilla of hope for defined-benefit pension plans is intriguing. “Some organizations I’ve spoken with that terminated their plans are wondering if this is something that they need to come back to,” says John Lowell, a partner at October Three, a firm that provides consulting services to plan sponsors. A key reason is the current tight labor markets and the so-called “war for talent,” he says.
“Attracting and retaining workers is a number-one issue for all employers right now,” he says. “People are changing jobs more quickly, and unwanted turnover is costly. The promise of a defined-benefit pension plan offers a way to attract and retain employees.
The Fundamentals of Defined-Benefit Pension Plans Remain Strong
A reassessment of the cost and risk associated with defined-benefit plans also is underway. Jared Gross, head of institutional portfolio strategy at J.P. Morgan Asset Management, argues in a recent paper that plan sponsors have developed a “collective blind spot” about defined-benefit plans, based on historical shortcomings that no longer exist.
Today’s private-sector plans are well-funded, and sponsors have learned the lessons from the problems sparked by the bursting of the tech bubble in 2000, when aggregate funding levels plunged.
“Sponsors have learned over the last 20 years how to manage defined-benefit pension plans with an appropriate level of risk and return,” Gross says, noting that the typical asset allocation has become much more conservative. “If you go back to the days before all the problems, there was a much more pronounced tilt toward riskier assets.
“But today, the common argument in the pension sponsor community is that the DB plan is ineffective because participants don’t really value it. It requires people to stay long term at one firm in order to capture the full value, and that it’s risky.
“There are elements of truth to all those things. But they also perceive defined-contribution plans as cheaper to run—but I would say that’s usually because it’s a less generous benefit. To say something is cheaper because you’re not giving as much benefit is not a particularly valuable insight.”
And Gross argues that defined-contribution plans actually are more expensive than defined-benefit plans to operate. Every dollar contributed by an employer to a defined-contribution plan is a cash expense. A defined-benefit plan’s benefit is fixed, but the assets can outearn that liability. “The ability to generate that investment performance allows the sponsor to subsidize the cost of the benefit,” he says. “That is going to be a win for the participants, because it allows the sponsor to offer a more generous benefit.”
The Case for Combining Elements of Defined-Contribution and Defined-Benefit Pension Plans
Gross is quick to acknowledge the value of defined-contribution plans as well—chiefly their portability and the ability to accumulate savings that deliver value to participants no matter how long they live. “The participant owns their money, and no matter how they choose to spend it, what a lot of people value is that they don’t want to get the actuarial bet wrong with an annuity-style benefit. If you start receiving a pension and then you only live a couple more years, that’s an enormously bad outcome from a financial standpoint.”
Gross and Lowell both think the most attractive path is a dual-track employee benefit that includes both defined-benefit and defined-contribution elements.
“The path forward may be allowing each of those vehicles to do what they do best,” Gross says. “Offer a DB that can be a part of the benefit package, supplementing Social Security as a life annuity. And simultaneously offer a DC plan that allows for ownership of assets, management of risk by the participants, and greater discretion on when you take your benefit.”
Dual-track benefit plans also could allow employees to choose how much of their benefit to allocate to each component, and even cross-capitalize.
“Why not allow a DB participant to take a partial lump sum, and move that money into the DC plan, if he doesn’t think he will live to be 90 or has a major need for capital at the point of retirement?” asks Gross. “Or, allow him to take part of a DC balance and buy more DB income if he’s worried about longevity risk?”
Lowell adds, “The most attractive DB design might well be a cash balance plan, which involves a defined benefit often defined as a lump sum of money that can be translated into a guaranteed lifetime payment.”
These plans feature greater portability, and benefits can accrue more evenly across an employee’s tenure at a firm, no matter how long that lasts.
The Secure 2.0 legislation recently signed into law includes a highly technical change in the rules that allows employers to credit employees’ accounts in these plans that make them attractive for younger workers who might not stay with the firm over the long haul while providing an incentive for older and longer-tenured employees to remain with that employer.
“Now we’ll have the ability to design plans that have both DB and DC features,” Lowell says.
Defined-Benefit Programs vs. Third-Party Annuities
One irony surrounding the pension revival question is that the benefits industry has been looking for other ways to reinvent them in recent years. The idea here is to add more retirement income solutions to defined-contribution plans.
This effort was part of the Secure Act of 2019 (Secure 1.0), which cleared the path to add annuity components in defined-contribution plans. This approach might include tacking an annuity option onto a target-date fund, for example.
But Lowell argues that a plan that combines defined benefit and defined contribution is much more efficient, especially for large companies that may already have a defined-benefit plan that has been frozen or closed.
“The offerings that I have seen that have in-plan annuities run somewhere between 15% and 40% more expensive,” he says. “That is a huge haircut.”
Plan sponsors tend to move slowly and with caution when it comes to making changes in their retirement programs, but Lowell thinks we’ll begin to see some movement soon.
“Right now, there’s mainly a fair amount of noise, and very few plan sponsors want to be the first to make a move,” he says. “But I also think there are some who would be willing to follow very closely behind a leader or a small group of leaders.”
Mark Miller is a journalist and author who is a nationally recognized expert on retirement and aging. His latest book is Retirement Reboot: Commonsense Financial Strategies for Getting Back on Track. Miller also writes for The New York Times and Reuters, among other publications. He publishes a weekly newsletter on news and trends in the field at RetirementRevised.com. The views expressed in this column do not necessarily reflect the views of Morningstar.