Traditional pension plans are disappearing from the private sector, except for plans tied to labor union contracts. Public sector employees are the largest group with active and growing pension plans. The setup of traditional pension plans is easy to understand, as are the reasons for their disappearance.
The most common pension plan is a defined benefit plan. Employees receive a payment equal to a percentage of the average salary that they received over the last few years of employment with their employer. The formula, which includes years with the same company, sets the payment amount. A combination of employee and employer contributions fund benefits, with employers paying the largest share.
Private plans typically are configured to pay 1% for each year of service times the average salary for the final five years of employment. An employee with 35 years of service to one company and an average wage of $50,000 would receive an annual payment of $17,500. Union defined benefit plans base payments on years of union membership and time spent with multiple employers. Private plans seldom have a cost-of-living escalator, though many union plans do.
Public employee pension plans are more generous than private plans. The nation’s largest pension plan, the California Public Employees' Retirement System (CalPERS), pays 2% per year of service to regular employees and 2.5% to public safety workers. An employee with an average salary of $50,000 receives $35,000 annually, and a police officer earns $ 43,750 a year. Public pension plans usually have a cost-of-living escalator.
Private plans are subject to the Employee Retirement Income Security Act of 1974 (ERISA). ERISA sets minimum standards regarding running the pension plan for the benefit of participants and is primarily concerned with the participant's understanding of how the program operates, as well as the participant's legal rights.
ERISA established the Pension Benefit Guaranty Corporation (PBGC). The PBGC is a pension insurance fund and charges employers a premium to guarantee workers retirement benefits if the employer goes out of business. The maximum amount guaranteed in 2016 for a 65-year-old retiree from a private company is $60,136 per year. The multi-employer plan guarantees $12,870 annually. A 2015 report from the Government Accounting Office (GAO) shows that the PBGC had $184 billion in future liabilities and $64 billion financial deficit.
ERISA does not cover public pension funds. Public pension funds follow the rules established by state governments and sometimes state constitutions. The PBGC does not apply to public plans. In most states, taxpayers are responsible for meeting any failed obligations of public employee plans.
ERISA does not regulate a pension plan’s specific investments. ERISA does require plan sponsors to operate as fiduciaries. No conflicts of interest between plans and any people or entities related to the fiduciaries are allowed. Investments are to be both prudent and diversified in a manner that is intended to prevent significant losses.
Pension plans themselves do set mandates as to projected average rates of returns. The higher the projected rate of return, the less money that the employer must place in the plan. The 7.5% rate used by CalPERS is a normal benchmark. Unfortunately, between the financial crisis and volatile markets, most plans are missing investment mandates. Many private and public pension funds are significantly underfunded, requiring plan sponsors to add additional capital.
The key to investment style is for the fiduciary responsibility to be prudent and diversified. The traditional investment strategy splits assets between fixed-income investments, such as bonds, and equity investments, such as blue-chip dividend stocks, preferred stocks, and commercial real estate. Many pension funds have given up active stock portfolio management and only invest in index funds.
An emerging trend is to place some assets in alternative investments in search of higher returns. These alternative investments include private equity, hedge funds, commodities, derivatives, and high-yield bonds. (For related reading, see "Provident Fund vs. Pension Fund: What's the Difference?")