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.
Key Takeaways
- Defined-benefit plans in the private sector were once common but are rare and have been replaced by defined-contribution plans, such as a 401(k).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 pension plans.
- The shift to defined-contribution plans has placed the burden of saving and investing for retirement on employees.
- The Pension Protection Act of 2006 mandated stricter funding requirements to help ensure that employees get paid the benefits they are owed.
- Regardless of what kind of plan your employer may offer, you need to fend for yourself if you want a retirement that's financially secure.
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.
Defined-benefit pension plans are still somewhat common in the public sector, especially for those who work in government.
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).
68%
The percentage of private-sector nonunion employees who have access to a defined-contribution plan, according to the Bureau of Labor Statistics.
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.
What Is a Defined Benefit Plan?
A defined benefit plan provides a fixed benefit for employees when they retire. Commonly, a company calculates the benefit through a plan formula that takes into consideration factors such as salary and years of service. This type of plan tends to be more complex and costly for a business to establish and maintain than other types of retirement plans.
What Is a Defined Contribution Plan?
This type of retirement plan—examples include 401(k), 403(b), and profit-sharing plans—doesn't promise a specific benefit amount to employees when they retire. An employee or employer (or both) contribute to the employee's account, sometimes at a set rate, such as a percentage of annual earnings. The contributions are typically invested on the employee's behalf. Upon retirement, the employee receives the balance in their account.
Has IBM Restarted Its Defined Benefit Plan?
In a way, yes. In 2006, IBM announced that it was freezing its defined-benefit (DB) plan to shift toward employee-funded defined-contribution plans, which ultimately saved the company billions. However, in January 2024, IBM unfroze it's pension plan and stopped making contributions to its employees' 401(k) accounts (employees can still contribute to them, just without IBM's match incentive).
Now, IBM is making a 5% contribution per employee into a new plan, which it calls a "retirement benefit account," which employees are immediately vested in and can take with them if they leave the company. As the new plan is embedded in the old DB plan, IBM determines how the money it is contributing is invested. But this new account is not as generous as the defined benefit plans of the past.
Other large corporations could decide to follow IBM's example and thaw their frozen pensions to start this type of DB plan in the future.
Why Did Companies Switch From Defined Benefit to Defined Contribution Plans?
Corporations underfunded their pension plans, which led to a transition to defined contribution plans. Initially, 401(k) accounts were designed to be supplemental, but they eventually gained a more prominent role in workers' retirement planning.
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.