The Demise of the Defined-Benefit Plan and What Replaced It

There was a time when, after 25 or more years of working diligently for your employer, you could expect to be rewarded for your loyalty and hard work with 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, or pension, are a thing of the past for most private-sector workers.

In this article, we look at the shift away from defined-benefit plans in the last few decades toward defined-contribution plans, such as 401(k)s, and suggest ways to ensure that you have a dependable income in your post-work years.

How Times Have Changed for Defined-Benefit Plans

Until the late 1970s more American workers participated in defined-benefit pension plans than in other types of retirement plans. But the numbers have long been in decline. By 1987, defined benefit plans represented 28% of all retirement plans, a drop from 32% in 1975, according to Employment Benefit Research Institute (EBRI) data. Today, only 10% of private-sector nonunion workers have access to a pension plan, according to the March 2023 National Compensation Survey from the Bureau of Labor Statistics (BLS).

From the employee's perspective, the beauty of a defined-benefit plan is that the employer funds it 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 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 vesting rules and a worker has to be employed by a company for enough time to earn the benefit. And 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 past few decades, private-sector companies increasingly have stopped funding their traditional pension plans, which is known as a freeze. A freeze is the first step toward the elimination of the plan.

In January 2024, Minnesota-based 3M recently announced that it would freeze its pension plan for nonunion workers in 2028, in a move that it said was part of a long-term plan to transition from a defined benefit to a defined contribution plan. GE 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. A long list of companies, including Verizon, Lockheed Martin, and Motorola have taken similar steps.

Corporate America has defended these decisions 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

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. With current levels of inflation, market volatility, and people living longer, it's becoming clearer that defined contribution plans have serious shortcomings.

Many employees who were relying on their employer-funded pension 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. That means you need to start saving 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.

You can put up to $23,000 in 2024 in an employer-sponsored defined-contribution plan, and you can add an additional $7,500 if you are aged 50 or older (for a total contribution of $30,500).

IRAs

Whether or not you have access to an employer-sponsored plan, you can contribute to an individual retirement account (IRA) (and depending on your tax situation, you may be able to deduct both from your taxes). In 2024, you can contribute up to $7,000 per year to a traditional IRA or Roth IRA and $8,000 if you are age 50 or older. After putting the maximum allowable amount in these retirement accounts, it's time to look at other investments. After putting the maximum allowable amount in these retirement accounts, it's time to look at other investments.

Choosing Investments

You can consider a wide variety of investments designed to minimize tax implications—including mutual funds, municipal bonds, and more. 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.

Limit Spending

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 not, 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 your employer doesn't offer one, 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.