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.

Key Takeaways

  • Traditional defined-benefit pension plans are vanishing from the retirement landscape.
  • Pension plans are funded by contributions by employers and employees, the former pay the largest share.
  • Public employee pension plans tend to be more generous than plans from private employers.
  • Private pension plans are subject to governmental regulation via ERISA.

Basic Pension Fund Structure

So how does a pension work? The most common pension plan is a defined-benefit plan. Employees receive a payment equal to a percentage of their average salary over their last few years of employment. 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 in its main tiers. An employee with an average salary of $50,000 receives $35,000 annually. Public pension plans usually have a cost-of-living escalator. 

1% vs. 2%

The percent of salary per year that private plans pay vs. public plans

Pension Plan Regulations

Private plans are subject to the Employee Retirement Income Security Act (ERISA) of 1974. 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 2020 for a 65-year-old retiree from a private company is $69,750 per year. The multiemployer plan guarantees anywhere from $4,290 to $17,160 annually, depending on the employee’s years of service.

A 2019 report from the Government Accounting Office (GAO) shows that the PBGC had nearly $185 billion in future liabilities ending fiscal year 2018, and an additional $54 billion financial deficit for its multiemployer programs. It estimates that the fund has a 99% chance of becoming insolvent by 2026.

ERISA does not cover public pension funds, which 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.

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Pension Fund

Investment Mandates

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 historically used by CalPERS was a normal benchmark until the fund decided to reduce the rate to 7%. 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.

Though there are considerable disparities in retirement income by race, that is not the case with regard to workers with defined-benefit pension plans, with 17% of Blacks having pensions vs. 21% of non-Hispanic whites.

Investment Style

The key to investment style is for the fiduciary responsibility to be prudent and diversified. The traditional investment strategy splits assets among fixed-income investments, such as bonds and equity investments, 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.