The Demise Of The Defined-Benefit Plan

By James E. McWhinney AAA

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 if current trends continue, those steady checks - which came courtesy of a defined-benefit plan - will soon be a thing of the past. Here we look at what seems to be a gradual shift away from defined-benefit plans and toward defined-contribution plans and suggest ways to ensure that you have a dependable income in your post-work years.

Times Have Changed for Employer Funded Plans
From the employee's perspective, the beauty of a defined-benefit plan is that the employer funds the plan and 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.

Of course, there are always two sides to every story. 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, so a recent wave of corporate activity has endeavored to address the situation.

For example, in 2006, IBM announced a freeze on its defined-benefit plan, which means the company stops funding the plan. A freeze is the first step toward the elimination of the plan. Soon thereafter, Verizon, Lockheed Martin and Motorola took similar steps.

IBM announced that freezing its defined-benefit plan was part of its global strategy of shifting away from employer-funded plans and moving toward employee-funded defined-contribution plans. At the time, analysts predicted it would save the company $2.5 billion to $3 billion by the year 2010.

According to a March 2008 National Compensation Survey (NCS) on employee benefits , one-fifth of private industry workers participating in a defined benefit plan are affected by a freeze.

Corporate America defends these moves on the grounds that Congress has been making efforts to force companies to fully fund their pension plans. Under the current system, firms predict the amount of money that they will need to meet their obligations to retirees, but they don't always fully fund the plans. All too often, the money isn't there when it's needed and government is forced to bail out the plans. This path has been taken by several airlines and a contingent of steelmakers, 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.

What Does the End of Defined Benefits Mean for Employees?
The entire scenario is bad news for employees. Unlike a defined-benefit plan, where the employee knows exactly what his or her benefits will be upon retirement, the only certainty in a defined-contribution plan is the amount that the employee contributes. After the money hits the account, it's up to the vagaries of the stock market to determine the ultimate outcome. Maybe the markets will go up, and maybe they won't.

Supporters of this shift in responsibility for retirement planning argue that investors can choose "safe" investments, such as money market funds or U.S. Treasury bonds. However, according to the January 27, 2006 edition of FundFire, experts have noted that the average worker would likely have to invest 12% of his or her pretax income in order to have any hope of generating the type of returns formerly offered by defined-benefit plans. (To learn more, see Money Market Mutual Funds and our Money Market tutorial.) Workers who cannot afford to invest such a high percentage of their salaries need to rely on the stock market to make up the difference.

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. (For further reading, see Lump Sum Versus Regular Pension Payments.)

The New Reality of Retirement
Thomas J. Mackell Jr., Chairman of the Board of the Federal Reserve Bank of Richmond, gave a speech in New York at the end of January 2006 in which he announced that he anticipates that defined-benefit plans will fade away over the next five years.

Even the U.S. government - which raised the eligibility age for full Social Security benefits from 65 to 67 for workers born after 1959, making it harder for younger workers to retire - is concerned. A report issued in 2010 by the Trustees of the Social Security Fund predicted that the system's trust fund will be depleted by 2040.

Pension Protection Act
Congress passed the Pension Protection Act of 2006 (PPA) in December 2005, which made significant changes for defined-benefit plans. These include stricter funding requirements, making it harder for employers to terminate plans that are not fully funded.

Conclusion: Fending for Yourself
In addition to making your voice heard at the ballot box, as Pennsylvania voters did after state legislators voted themselves an illegal double-digit pay raise in July 2005, you need to accept the new reality and fend for yourself. The first thing you need to do is save money. (For more on this, see Determining Your Post-Work Income.)

You can put up to $17,500 per year in an employer-sponsored defined-contribution plan, and you can add an additional $5,500 per year if you are age 50 or older for 2013. If you are married, your spouse can do the same. If you don't have access to an employer-sponsored plan, you can contribute to an IRA instead. For the 2013 tax year, you can contribute $5,500 per year to a Traditional IRA if you are under age 50, and $6,500 if you are age 50 or older. After putting the maximum allowable amount in these tax-deferred investment vehicles, it's time to look at other investments.

A wide variety of investments designed to minimize tax implications - including mutual funds, municipal bonds and more - is available for consideration. If taxes aren't a concern, there is no shortage of investment opportunities designed to meet just about any imaginable investment objective. In order to make the most of your investment decisions, you need to understand the principles of investing. The internet provides a host of tools to help you do just that - resources are just a mouse click away. You should start by learning about asset allocation, as many experts agree that it is the single most important factor in generating portfolio returns. (For further reading, see Modern Portfolio Theory: An Overview and Achieving Optimal Asset Allocation.)

Finally, saving may not be enough if you don't also limit your spending. If you can learn to live below your means instead of beyond them, you can free up more money for your retirement. (To learn more, see The Beauty of Budgeting and Seven Common Financial Mistakes.)

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