The year is 1980…
Ronald Reagan was just elected president of the United States, the Atari 2600 is state of the art, and if you’re an American worker, you probably have a company pension. In the early 1980s, pensions were the only retirement benefit for 60% of private sector employees. And now? That number is just 4%.
What happened to all the pensions?
If you’re a company offering retirement benefits to your employees, there are two ways to go about it. The first is a defined benefit plan, like a company pension, which is a promise to pay workers an ongoing paycheck in retirement. The other is a defined contribution plan, like a 401(k) account, which means the company provides workers with access to a retirement account and may (or may not) match employee savings, but doesn’t make any promises beyond the initial contribution.
TL;DR: “I’ll pay you $2,000 a month for life after you retire” is a defined benefit, and “I’ll give you $10,000 to invest in your retirement account” is a defined contribution.
The “problems” with defined benefits
Problem 1: Investment risk
The promise to keep paying former employees a lifetime retirement paycheck comes with some obvious risks for the company. First, the responsibility of managing the money in the pension fund—and the investment risks that come with it—fall squarely on the company’s shoulders. If the market crashes or the company makes a bad decision like investing with Bernie Madoff (which many, many pension funds did), the employer is still responsible for making good on their promises.
Problem 2: Longevity risk
The other reason defined benefit plans are disappearing is something called longevity risk. When pensions first became common, retirement was a short proposition. If employees work until 65 and die at 68, pensions are easy. But as workers’ life expectancies increase, the amount of money employers have to pay does too. Having a massive unknown amount of debt on the books can make companies nervous. Switching to a defined contribution removes all of the uncertainty.
The reasons pensions have become unpopular with employers are the same reasons pensions were so popular with employees, especially unions. From the employee’s perspective, the only real drawback of a pension is that it ties you to the employer. If you were to change jobs prior to hitting the number of years required for your pension, you walked away from your retirement plan too.
The rise of defined contributions
Despite how common 401(k)s are today, their creation came about almost by accident. In the late ‘70s, Congress passed an income tax reform bill called the United States Revenue Act of 1978, a typically dull law that reduced individual and corporate income taxes and established flexible spending accounts for medical expenses.
An addendum was added to limit the use of cash-deferred plans by executives unless rank-and-file employees also had access, called—you guessed it—section 401(k). The paragraph-long section was little more than an afterthought until a workplace benefits consultant named Ted Benna saw an opportunity.
As he describes in a post on his website, Benna came up with the idea while consulting for a bank, whose president wanted to replace its cash bonus plan with tax-deferred profit sharing that employees couldn’t access until they no longer worked at the bank. While the bank president wanted the tax benefits that come with deferring income, the employees wouldn’t love losing out on their cash bonus until retirement. Benna remembered the obscure 401(k) provision and it gave him an idea: he could design a plan that gave each employee a choice of how much of their bonus to defer.
The only catch in section 401(k) was that the lowest-earning two-thirds of the bank’s employees had to choose to defer enough of their bonuses to allow the top third access to the same benefits. His solution? An employer match to sweeten the pot. Between the tax benefits of deferral and free money from the company, Benna was sure the idea would be a hit.
Ironically, Benna’s proposal was rejected, since the bank’s attorneys were uncomfortable with his legally questionable plan. But despite some initial skepticism, the idea became popular with workers, and two years later the IRS issued new rules allowing employees to fund their own 401(k) accounts through payroll deduction. (At the time, they had the unfortunate title of “salary reduction plans.”)
From their humble origins, 401(k) plans have grown to account for $5.6 trillion in assets, with 55 million Americans participating. They’ve replaced pensions almost entirely in the private sector, and it’s easy to see why companies love them.
With a defined contribution plan, the company can still offer retirement benefits to recruit and retain employees, but without the investment and longevity risks that come with managing a pension fund. If the market takes a downturn or a medical breakthrough dramatically extends lifespans, funding an unknown number of years of retirement is up to the individuals.
Even the creators and early proponents of 401(k) plans are surprised at how dominant the 401(k) has become. The original intention was to supplement pensions and Social Security with individual retirement savings, but they’ve nearly supplanted them instead.
The good news is that even if your company doesn’t offer a pension, both longevity and investment risk can still be offset. You can convert 401(k) savings into an annuity that guarantees lifetime income, much like a pension. And just like a pension, longevity and investment risk are shifted from the individual back to the group. (The insurance company in this case, rather than your employer, so even if you change jobs you keep your retirement income.)
The bad news? Over half of Americans have less than $10,000 saved for retirement. Even among Americans close to retirement age—those aged 56-61—the median retirement savings is just $17,000, according to the Economic Policy Institute.
Even among those who do have significant retirement savings, very few actually buy annuities. With a pension, people are aware from the beginning that the money isn’t a windfall, but instead will be used to provide a baseline income that you can’t outlive. Even though you earn the money in the same way that 401(k) contributions are earned, most people view pensions as more akin to Social Security than a savings account.
A lot of people are working on ways to solve the upcoming longevity crisis, but for people retiring now without a pension or enough savings to last into their 90s, relying on family might be the primary (or only) solution. And that’s why we created AgeUp.