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My Two Cents

Keeping Traditional Pensions

Chris Farrell Apr 17, 2007

In the 1980s, companies started retreating from offering their workers traditional “defined benefit” pension plans in favor of “defined contribution” plans, such as 401(k)s and 403(b)s. In essence, with the traditional defined benefit pension plan the employer bears all the investment risk and commits to a fixed payout of money, typically based on a salary and years-of-service formula. In sharp contrast, with the 401(k) and similar tax-deferred retirement savings schemes, workers take greater responsibility for their retirement plans and funding arrangements. Employee’s decide how much money to invest and where to invest it, depending on the limits established by law and the choices offered by the employer. Employees bear all the investment risk. The trend away from traditional pensions in the prviate sector gathered momemtum in recent years.

For workers, there are a lot of advantages to traditional pensions. They don’t have to make investment decisions today that will impact their standard of living in three decades. After all, most of us aren’t steeped in modern portfolio theory. And they can better plan for their Golden Years knowing that they’ll have a fixed pension payout. But from the company’s point of view there were a lot of drawbacks to traditional pensions–especially their cost. Just ask the chief executive officer of General Motors

This article from the Center for Retirement Research suggests a different path toward restructuring pensions:

In response to the perfect storm of falling stock returns and interest rates that hit pension funds in 2000, many companies in the United States and the United Kingdom have shifted from defined benefit (DB) to defined contribution (DC) schemes. In contrast, Dutch pension plans have mainly preserved their defined benefit character in recent years, although they have switched from “final-pay” to “average-wage” schemes. The average-wage plans may be better viewed as hybrid DB-DC schemes. They are like DB plans in that accrued pension rights are based on an employee’s wages and years of service, and contribution rates can be raised in response to a funding shortfall. They are like DC plans in that the annual indexation factor, which is applied to both the accrued rights of active workers and the benefits of retired workers, is tied to the fund’s financial status and, therefore, investment returns. As a result, these hybrid plans have two mechanisms – contribution rates and indexation – to control solvency risk, effectively minimizing the risk of under-funding.

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