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 times have changed and those steady checks—which came courtesy of a defined-benefit plan—are a thing of the past for most private-sector workers.
Here we look at the shift away from defined-benefit plans in the last few decades toward defined-contribution plans and suggest ways to ensure that you have a dependable income in your post-work years.
- Once common, defined-benefit plans in the private sector are rare and have been replaced by defined-contribution plans, such as a 401(k).
- Companies choose defined-contribution plans instead because they are less expensive and complex to manage than traditional pension plans.
- The shift to defined-contribution plans has placed the burden of saving and investing for retirement on employees.
How Times Have Changed for Defined-Benefit Plans
Up until the 1980s, defined-benefit pensions were the most popular retirement plan offered by employers. Today, only 17% of private-sector workers have access to one, according to the Bureau of Labor Statistics’ 2018 National Compensation Survey.
From the employee's perspective, the beauty of a defined-benefit plan is that the employer funds the plan while 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. Estimating pension liabilities is complex. Companies offering a defined-benefit pension plan must predict the amount of money that they will need to meet their obligations to retirees.
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. Switching to a defined-contribution plan such as a 401(k), which is mainly funded by employee contributions, saves a significant amount of money.
Putting the Freeze on Pensions
Over the last few decades, private-sector companies increasingly stopped funding their traditional pension plans, which is known as a freeze. A freeze is the first step toward the elimination of the plan.
General Electric is an example of a major corporation to do so. It announced plans in October 2019 to freeze its pension for 20,000 U.S. employees and shift to a defined-contribution plan as steps to help reduce the deficit of its underfunded pension by as much as $8 billion.
Though rare in the private sector, defined-benefit pension plans are still somewhat common in the public sector—in particular, in government jobs.
Other high-profile examples of major corporations freezing pensions over the years include IBM, which in 2006 announced that it was freezing its defined-benefit plan to shift toward employee-funded defined-contribution plans, which ultimately saved the company billions. Soon after, Verizon, Lockheed Martin, and Motorola took similar steps.
Corporate America has defended these moves on the grounds that the government has made moves to force companies to fully fund their pension plans. The Pension Protection Act of 2006, for example, mandated stricter funding requirements to help ensure that employees get paid benefits.
But companies haven't always fully funded the plans. All too often, the money hasn't been there when it's needed, and the government has been forced to bail out the plans. This path has been taken by several airlines and a contingent of steelmakers over the years, 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.
Impact of Shift to Defined Contribution Plans
So what does the end of defined-benefits mean for employees? The entire scenario is bad news. Unlike a defined-benefit plan, where employees know exactly what their benefits will be in retirement, the only certainty in a defined-contribution plan is the amount that the employee contributes. Many employers also offer matching contributions.
After the money hits the account, it's up to the employee to choose how it's invested—typically from a menu of mutual funds—and the vagaries of the stock market to determine the ultimate outcome. Maybe the markets will go up, and maybe they won't.
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.
Today's Retirement Reality: Fending for Yourself
When it comes to a financially secure retirement, you need to fend for yourself. For most, Social Security benefits aren't enough to live on in retirement. The first thing you need to do is save money—as soon, and as much, as you can.
Tax-Advantaged Retirement Plans
The first place to start is with tax-advantaged retirement plans. If you have access to an employer-sponsored plan, such as a 401(k), max out your contributions, if possible, and take advantage of your employer's matching contributions if offered. In 2019, you can put up to $19,000 a year in an employer-sponsored defined-contribution plan, and you can add an additional $6,000 if you are age 50 or older. In 2020, the salary deferral contribution limit increases to $19,500 with $6,500 allowed for catch-up contributions.
The number of private-sector employees who have access to a defined-contribution plan, according to the Bureau of Labor Statistics.
If you don't have access to an employer-sponsored plan, you can contribute to an IRA instead. In 2019, you can contribute up to $6,000 a year to a traditional IRA or Roth IRA and $7,000 if you are age 50 or older. (These limits remain the same for 2020.) After putting the maximum allowable amount in these retirement accounts, 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—are 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.
But in order to make the most of your investment decisions, you need to understand the principles of investing. You should start by learning about asset allocation, as many experts agree that it is the single most important factor in generating portfolio returns. You may want to consult with a financial advisor if making these decisions on your own is too daunting.
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.
The Bottom Line
If you are among the lucky few who work for an employer that still offers a pension plan, you have an advantage when it comes to saving for retirement. If you're like everyone else, you'll need to take on the responsibility of planning on your own.
Contribute to an employer-sponsored plan, such as a 401(k), if you can. If not, IRAs offer another way to save for retirement. Once you've maxed out these options, consider investments outside of retirement accounts to help build your nest egg.