Is It Time for Plan Sponsors to Revisit Traditional Retirement Plans?

Years ago, workers with company-sponsored retirement coverage typically had traditional defined benefit pension plans that paid them, upon retirement, a monthly benefit for the rest of their lives. But in the past two decades, corporations have been shifting away from those traditional pensions. Companies searched for ways to scale back defined benefit plans after Congress required them to strengthen the plans' funding to make them more secure. The cost of providing those pensions, along with the added risk of guaranteeing a fixed monthly payment for a lifetime of retirement, was simply too great for companies to bear.

As a result, many companies adopted a less costly kind of plan in which there was no set benefit—the defined contribution plan. Section 401(k) of the IRS Code was later approved, allowing tax-deferred retirement savings for employees. Commonly referred to as "401(k) plans," they became the most popular type of defined contribution plan.

In this benefit structure, the size of a worker's retirement account depended on how much he or she contributed, how much the company matched, if anything, and how wisely the employee invested the available funds. Consequently, 401(k)s effectively transferred the risk of investment from companies to their employees. In other words, employers no longer had to guarantee a certain lifetime benefit—just make contributions. The trade-off was that employees had greater control over how their money was invested and could take their retirement funds with them when they changed jobs.

Had retirement nirvana been attained? So it seemed.

Too Much of a Good Thing?

Millions of American employees have relied on their 401(k) plans as their primary retirement security vehicle. Today, nearly 60% of all households with company-sponsored pensions rely exclusively on 401(k) plans, the most popular type of defined contribution plan. Another 20% rely only on traditional pensions, and about 20% are covered by both, according to an analysis by the Center for Retirement Research at Boston College.

Approximately 47 million American employees participate in almost 367,000 401(k) plans, according to projections by the Employee Benefit Research Institute (EBRI). The retirement assets in these plans total an estimated $2.4 trillion.¹

The Investment Company Institute (ICI), a Washington, D.C.-based mutual fund trade association, reported that mutual fund assets held in employer-sponsored retirement accounts totaled $1.2 trillion in 2001. Within those accounts, the assets in 401(k) plans are estimated at $765 billion. By comparison, there was only $46 billion in 401(k) accounts in 1991.

In the late 1990s, when the stock market soared, an employee's 401(k) seemed destined to provide a more comfortable retirement than that of an employee who had a traditional pension plan. As a result, many employees loaded up their 401(k)s with company stock and stock mutual funds.

However, in the market tumble of the last two years, employees have seen their 401(k) savings plunge nearly 30%, according to some estimates. Recently retired employees who have fallen victim to this market slump can no longer be assured that they won't outlive their money—a very discomforting thought.

Two Sides to Every Story

Recent economic uncertainty, along with the stock market downturn, has magnified the differences between defined benefit plans and 401(k)s. Whereas the extended bull market helped popularize 401(k) plans, the past two years of stock market losses have exposed their risks. The prolonged bear market has brought the old-fashioned, guaranteed-payment pension plan back into the spotlight for plan sponsors.

Despite the significant number of workers with assets currently in 401(k)s, traditional pension plans are still common among unionized workers in large industrial and manufacturing companies, public utilities, and state and local governments (traditional pension plans for public-sector employees are often more generous than similar plans from a private employer.) Employees in these "old-fashioned" pension plans are probably appreciating them a lot more these days and value the security of a steady income stream that's not tied to what the stock market is doing.

In this sluggish economy, it's comforting for retirees and those nearing retirement to know that a traditional retirement plan will pay them a set monthly income for life. The fact that such a pension plan can replace, in some cases, 75% to 80% of one's current salary can be reassuring. Workers such as teachers, police officers, and other state and local government workers are not only promised a substantial percentage of their final average salaries, but also regular cost-of-living increases.

Granted, traditional pensions have not emerged unscathed in the plunging market, but the losses generally don't affect workers' guaranteed payouts. Employees with depleted 401(k) accounts, on the other hand, may have to forego early retirement, postpone the purchase of a second home, and cancel long-awaited travel plans. Instead of looking forward to a comfortable retirement, they're facing the prospect of returning to work. These retirees would undoubtedly like to trade places with their defined benefit plan counterparts.

Is the Tide Turning?

According to William Dudley, chief U.S. economist at Goldman Sachs, the evaporation of retirement savings in the stock market "could inspire a swing back to traditional pensions." There is some legislation under consideration that would encourage companies—through corporate tax incentives—to collaborate in offering traditional pension plans that workers could transfer from one job to another.

Some experts are proposing modifications to defined benefit plans to make them more appealing to companies and workers. For instance, the American Academy of Actuaries is promoting a hybrid plan referred to as a DB-K plan. It would have features common to defined contribution plans, allowing workers the freedom to direct their own investments. But employees also could elect to have companies manage their assets for them, just like an old-fashioned pension, and employers could offer guaranteed minimum returns.

Further complicating the current pension dilemma is the aging U.S. population. Given the large number of baby boomers (estimated at 77 million) poised to retire with insufficient funds, political pressure may also come into play in reviving traditional pensions with plan sponsors. For now, it appears as though plan sponsors are taking a "wait-and-see" approach with regard to what legislation, if any, is enacted.

Is the average worker in an old-fashioned pension plan guaranteed a more secure retirement than workers who invested in a 401(k)? Not necessarily. Keep in mind that the size of payments varies based on factors such as length of service and salary. But the days of watching the balance in your 401(k) skyrocket are over—at least for a while.

¹EBRI Research Highlights Retirement and Health Data, Issue Brief #229, January 2001