2 minute read

Plan Types Pensions and Policy Approaches

A Shift To Defined Contribution Plans

Although the percentage of the workforce covered by a pension plan has remained virtually unchanged since the late 1970s, the nature of pension coverage has changed sharply from defined benefit plans to defined contribution plans. Defined benefit plans provide retirement benefits—in the form of a lifetime annuity—generally calculated as a percentage of final salary for each year of service. For example, a worker with a final salary of $40,000 might receive 1.5 percent a year for thirty years of service, producing an annual pension of $18,000. This form of pension made it easy for employers at the time that they established their plans in the 1950s to grant retroactive credits for older workers for whom they had made little or no contributions. In contrast to defined benefit plans, defined contribution plans are like savings accounts. The employer, and sometimes the employee, contributes a specified dollar amount or percentage of earnings into the account. These contributions are usually invested in stocks and bonds. When the worker retires, the balance in the account determines the retirement benefit.

Within the defined contribution world, the fastest growing type of plan is the 401(k). The defining characteristics of 401(k) plans are that participation in the plan is voluntary and that the employee as well as the employer can make pretax contributions to the plan. These characteristics shift a substantial portion of the burden of providing for retirement to the employee; the employee decides whether or not to participate, how much to contribute, and how to invest the assets. Despite the fact that employees bear much of the risk in 401(k) plans, these plans have grown enormously for a number of reasons. They are less costly to operate than defined benefit plans. They do not require employer contributions. They are fully funded by definition, eliminating the work associated with funding requirements and pension insurance. They are easily portable so employees can take benefits with them, eliminating the need for employers to keep track of pensions for departed employees.

Given their popularity and growth, one would have thought that the introduction of 401(k) plans should have boosted pension plan coverage in the United States. But, as noted above, overall pension coverage has remained virtually unchanged. This means that the enormous expansion of defined contribution plans, especially 401(k)-type plans, has produced a sharp decline in coverage under traditional defined benefit plans. Between 1978 and 1997, active participants in defined benefit plans declined from 65 percent to 32 percent of total participants. This shift is reflected in the financial statistics for the two types of plans. Between 1978 and 1997, assets in defined benefit plans declined from 72 percent to about 49 percent of total pension assets; benefits paid by defined benefit plans declined from 67 percent to 42 percent of total benefits; and contributions to defined benefit plans declined from 67 percent to 17 percent of total contributions.

In the late 1990s, some employers converted their pensions to hybrid plans that have both defined benefit and defined contribution characteristics. The most popular of the hybrids are the so-called cash balance plans. Cash balance plans are defined benefit plans that express each participant's accrued benefit as a balance that is available for distribution as a lump sum. Unlike a defined contribution plan, however, the accrued benefit accumulates at a specified and guaranteed rate of interest, and benefits tend to accrue as a constant percentage of compensation. The plans are attractive because they provide visible and portable benefits like a defined contribution plan, and secure accrual and government insurance like defined benefit plans.

Additional topics

Medicine EncyclopediaAging Healthy - Part 3Plan Types Pensions and Policy Approaches - Coverage Under Private Pension Plans, A Shift To Defined Contribution Plans, Federal Regulation, Major Issues Facing The Pension System