Under ERISA there are two major types of retirement plans allowed: Defined benefit and defined contribution.
The former promises a certain level of benefit upon retirement, usually as a function of how long an employee was with the company, salary level, and things of that nature. This is the sort of thing you’ll hear old folks talk about when they say “pension”. And you might’ve heard a little recent news about United Airlines, Ford, and General Motors having a bit of trouble with their pension funds. You might also have heard about a long-standing government program called Social Security*.
The latter, defined contribution plans, pay out based on what participants put in. Participants contribute money up-front, it’s invested, and they get the results upon retirement. The IRA, Roth IRA and 401(k) all fall into this category. Interestingly, the 401(k) was invented because of a loophole in the US tax code.
With 401(k) participation at around 70%, these plans are clearly the employer-sponsored plan of the future. In the last 24 years the 401(k) has essentially taken over the employer-sponsored retirement plan market, and that’s fortunate. Defined benefit plans had a place, but moving forward into a much more dynamic labor market, the defined contribution plan looks to be a much better deal.
First of all, since the Baby Boom, the duration of a single job has dropped. The Baby Boomers held an average of 10.2 jobs between the ages of 18 and 38. Granted, they tended to hold more during the first half of the period, but still averaged 2.5 jobs between 27 and 38. That works out to just about 4.4 years at a single job during that period.
Meaning, of course, that there’s very little time for any real benefits to accrue in a defined benefit plan. Pensions usually have benefits dependent upon time with the company, if you’re only at a single company for four or so years, that’s really not enough time for anything meaningful to accrue. Even if you stay at a job from the time you’re 38 until the time you retire, you basically missed out on 10 to 15 years worth of retirement savings under a defined benefit plan**. That’s a long period of time, and on the front-end of retirement savings it’ll make a huge difference by the time you retire.
This is the primary advantage of a defined contribution plan in the modern, more mobile, labor market: the plans are portable. If you spend five years here, a year or two there, three years in another place, you can keep all of the savings you’ve done in each plan. There are even ways to roll 401(k)s together under the plan in which you currently participate. Thus, instead of leaving behind minor pensions at previous jobs, you can bring all the savings you’ve ever done with you wherever you go.
For good or ill (I vote good), the “Company Man” is largely extinct. There are exceptions, of course, but it simply isn’t all that common to stay at one company for an entire career anymore. Given that, it makes sense to be able to take retirement savings with you, and not to be reliant on a string of employers for your future.
That brings me around to the other major advantage I see in a defined contribution plan: it separates your future income from the company for which you now work. Even though defined benefit plans are insured by the PBGC there can still be funding short falls and other problems as noted in the links to United and GM above. What’s more, even if you do work at one company long enough to accrue a decent benefit under a defined benefit scheme, your lifetime income is wholly dependent upon the success or failure of one company.
Your present income is, obviously, dependent upon your current employer. Under a defined benefit plan, even given funding requirements and regulations, at least a substantial chunk of your future income will depend on that same employer (presuming you hang around long enough to accrue any benefits). Is that really a position anybody should want to find him or herself in? I should think not.
In a more dynamic economy, and especially in a more dynamic labor market, your best bet is separating your future income from the success or failure of your current employer and a defined contribution plan is the best way to do that. Provided, of course, that you don’t invest all of your 401(k) into employer stock, but that’s an entirely different discussion.
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* Technically Social Security has both a defined benefit and a defined contribution, which is a lot of what’s causing its woes. There are other issues with Social Security that I’ve explored before and may explore again, but I don’t really want to go into it at this time.
** Yes, defined benefit pensions are often in addition to salary, however, the money has to come from someplace and an employer is going to factor in the cost of a defined benefit plan in its hiring and wage decisions. The employee will pay for it, but maybe not directly. Plus, on the 401(k), there’s often employer matching.
