Redefining Defined Benefit Pensions
By Holly A. Bell
For most people in the private sector, defined benefit pensions have become a distant memory. Something their grandfather talks about over Thanksgiving dinner while reminiscing about his days at “the plant”. These plans, which guaranteed a certain percentage of a worker’s wages or salary in retirement, have been replaced with defined contribution plans like 401(k)s. However, is it possible that a defined benefit hybrid model based on employee contributions might be a better, yet equally sustainable model?
There were several reasons traditional defined pensions proved to be unsustainable: Built in cost-of-living increases, benefit rates up to 90 or even 100% of annual earnings, earnings calculations based on the highest five years of earnings, the inclusion of generous health insurance benefits, early retirement ages (and longer life expectancy), inadequate funding or companies raiding pension funds, high return rate assumptions on pensions, and economic changes that often left more people on the retirement roles than actively employed. These factors were just too much for traditional pensions to bear. In an effort to make sure individuals had retirement savings, employers switched to 401(k) programs in which employees deferred some of their compensation (tax free) and put it into retirement plans, often with a company match. This essentially shifted the retirement risk to individuals and away from companies, but it also ensured an employee’s retirement savings would be there for them even if the company went out of business.
The 401(k) retirement system has at least two problems. First, it makes saving for retirement and the amount of income one can expect in retirement quite mysterious. The result is that most people either aren’t saving at all, or aren’t saving enough. While $250,000 in savings might sound like a lot of money, using the 4% rule that turns into only $10,000 worth of income in Year 1 of retirement. The second problem is that the return on most individually managed 401(k) accounts fail to meet the returns on professionally managed accounts. Most of us don’t have the time, energy, or ability to actively manage our investments. So, what’s the solution?
I suggest a hybrid model that combines a defined benefit with employee contributions and professional management. Under this plan employees would continue to contribute a percent of their income tax-free to a retirement plan and employers could continue to match funds. One of the major differences is that the funds would be professionally managed and a defined benefit based on the rate of savings would be guaranteed by the employer. Here’s how it would work:
To determine the defined benefit, a realistic sustainable long-term rate of return would be assumed, say 6%. For purposes of this discussion, let’s say if an individual sets aside 10% of their annual earnings in their pension fund and the employer matches 5%, that would result in a defined benefit of 50% of the average employee’s earnings during their ENTIRE time at the company. This is different from traditional pension plans that often calculated benefits based on an employee’s highest 5 years of compensation. By averaging compensation over the entire tenure of the employee, the benefit is reflective of earnings deferred during that time and does not inflate retirement earnings.
There are several benefits to this approach. First, returns on the employee’s retirement savings would most likely be higher if the fund is professionally managed. Plus, the employee is less likely to be fearful about losing their retirement savings resulting in bad investment decisions. They know what their benefit will be at each level of savings. Second, retirement income is no longer ambiguous. Each quarter employees could be given statements showing what their average earnings are to that point and what percentage they could expect to receive at age 65. They could also be shown what their retirement earnings would be if they increased or decreased their savings rate. This might actually nudge employees into saving more.
The problems associated with traditional pensions were not necessarily associated with the definition of a benefit, but several other issues discussed earlier in this article. There are ways for us to calculate the future value of savings and define a benefit amount. We need to make the retirement savings process and how it translates into retirement income more transparent and less frightening to employees. By defining their benefit, we might help them make better retirement savings decisions.
Holly A. Bell is a business professor, author, analyst, and blogger who lives in the Mat-Su Valley of Alaska. You can visit her website at www.professorhollybell.com.