The Evolving Pension System: Trends, Effects, and Proposals for Reform

Chapter 3. The Shifting Structure of Private Pensions

Since the passage of the Employee Retirement Income Security Act in 1974, the private pension system has evolved along several dimensions. The single largest change has been a move away from defined benefit plans toward defined contribution plans. A second change has occurred within the universe of defined contribution plans, where 401(k) plans have emerged as the dominant form over the past twenty years. A third shift has occurred among the remaining defined benefit plans, a substantial number of which were converted to cash balance plans beginning in the mid-1990s. These changes have drastically altered the nature of private pensions, creating a new set of opportunities and risks for workers and firms. As a result, the changes have generated expressions of both enthusiasm and concern from policymakers and participants. Some view these changes as saving the pension system , others view them as the death knell for pensions. This paper explores several issues surrounding the changing structure of pensions. We begin by describing and contrasting the salient features of alternative types of pensions. We then document the shifting composition of pensions , investigate the extent to which new pension forms have supplemented or 51 The Shifting Structure of Private Pensions william g. gale, leslie e. papke, and jack vanderhei 3 We thank Brennan Kelly, Tats Kanenari, and Samara Potter for outstanding research assistance. Gale gratefully acknowledges support from the National Institute on Aging through grant number AG11836. 03-3117-5 chap3.qxd 11/16/05 2:59 PM Page 51 supplanted previously existing plans, and examine the causes and consequences of these shifts. Alternative Pension Arrangements In a traditional defined benefit plan, employers promise to pay a certain annual pension benefit at retirement.1 The benefit is usually determined by a formula that depends on years of service and average salary over either the highest salary years or the final years of employment. The benefits accrued by an employee are often very low, or zero, for the first few years of the work relationship. Then, at some point the employee becomes vested and a basic level of benefits is established ; after that, benefits often rise rapidly as the employee’s salary and tenure with the firm continue to grow. This pattern of accrual of benefits is referred to as back-loaded, because the employee is not eligible for much of the benefit until he or she has been with the employer for some time. The employer funds these benefits by making pre-tax contributions into a pension fund for all participants. In private sector plans, participants typically do not make contributions, though in public sector plans they often do. The employer owns the assets in the fund, directs the investments, and bears the investment risk. The Pension Benefit Guaranty Corporation (PBGC), a government agency, guarantees the benefits within limits and charges plans insurance premiums intended to cover the agency’s expected costs. Benefits are often paid as an annuity, and employees typically do not have access to funds before retirement . In the event of job separation before retirement, vested benefits are usually frozen at their accrued nominal (not inflation-adjusted) levels. If the employee dies, some limited survivor annuity for the spouse is often available. Defined contribution plans come in several varieties, each of which is quite different from defined benefit plans. Employees typically make contributions. In a 401(k) plan, the most common form of defined contribution plan, employee contributions are tax deductible. Rules regarding employer contributions vary depending on the type of defined contribution plan. Under money purchase plans, employers promise to make specified annual contributions, usually as a function of a worker’s salary. Profit-sharing plans, including 401(k) plans, allow employers to vary the level of contributions on an annual basis (including zero contributions in some years), as long as the contributions are substantial and recurrent. Many firms match some percentage of employee contributions up to a specified percentage of wages. The amount of resources available in retirement depends on the amounts contributed over the years and the investment return. Balances accrue in 52 The Evolving Pension System 1. There are many variations on each basic type of plan design. We will focus throughout the paper on typical formulations of each type of plan. 03-3117-5 chap3.qxd 11/16/05 2:59 PM Page 52 accounts belonging to individual workers, who almost always are able to direct the investments for employee...