Pensions Are Disappearing, Here's How to Save for Retirement

Once upon a time, Americans graduated from high school or college and entered the workforce, typically working for the same employer for a very long time. These jobs offered more than just a reliable paycheck -- they also promised retirement income for life, thanks to company-funded pensions.

In the heyday of pensions in 1980, roughly 38% of workers had one. And though pensions remain relatively common in the public sector (government jobs), pensions have largely disappeared in the private sector. Their return appears unlikely.

Only 18% of private-sector workers had access to a pension in 2017, and just 15% participated in one, according to the Bureau of Labor Statistics. Over time, the number of private-sector workers who have access to a pension is largely expected to trend toward zero.

Below, we'll explain how pensions work, why there are so few of them left, and how you can save for retirement through other (arguably better!) savings plans.

What's a pension, anyway?

A pension is just one of many types of retirement plans. We generally categorize retirement plans as being one of two types: A defined benefit plan (DB) or a defined contribution plan (DC).

If your employer promises to pay you $3,000 per month after you reach age 65, that's a defined benefit plan. Your employer made a promise to pay you a certain amount of income in retirement. The benefit to you ($3,000 per month) is defined. When people use the word "pension," they're almost always referring to a defined benefit plan.

If your employer offers to put $5,000 into your 401(k) every year, that's a defined contribution plan. Your employer isn't guaranteeing that you'll receive a certain amount of money at retirement or that your retirement account will be worth anything at all when the time comes. Instead, it's giving you a defined contribution now, which you can invest however you please. 

Think of a pension or a defined benefit plan as a commingled retirement account. The employer (and sometimes its employees) chip in a certain amount of money into a big pool, which is then invested. As workers reach retirement age, cash starts flowing out. 

In contrast, a defined contribution plan is an individual account. Your 401(k) is yours, and yours alone. You and your employer decide what to put in, but only you can decide how to invest the money, what to take out of it at retirement, and when to start making withdrawals.

How pension benefits work

From the employee's perspective, pensions are simple. At a certain age, the employee will receive a certain amount in benefits, usually based on their ending salary and how long they worked for the company. The equation below is typical of how most pensions calculate benefits for employees.

Average Salary × Years of Work × Benefit Multiplier = Pension Benefit

To give you an illustrative example, if a factory employee earns $60,000 per year in the last few years of work, has worked for the company for 25 years, and has a benefit multiplier of 2%, then he or she would receive $30,000 per year in retirement. ($60,000 × 25 years × 2% = $30,000).

This simple method for calculating benefits is used by virtually every defined benefit plan. Though there may be slight differences -- some plans use the worker's average salary over the last two years, while others use the average of the last five years -- this is the basis for how most pensions work.

Why are there so few pensions left?

There are many reasons why pensions are declining, particularly in the private sector, but one of the biggest reasons is the substantial risk that they bring to an employer. For obvious reasons, making a promise to pay a worker large sums of money after they retire -- which could be 35 years from today -- is a very risky thing to do.

For the sake of simplicity, let's assume that a company believes it will need $1,000,000 in its pension program per employee who retires 30 years from today. Assuming that it can earn 8% on its investments, the employer would only need to set aside about $8,174 per year per employee to make good on its promises.

However, if the pension's investments only return 6% per year (instead of 8%), the employer would have to set aside $11,933 per year per employee in order to pay for the pensions it promised. This kind of variability is the kind of stuff that keeps chief financial officers up at night because, frankly, it's a big risk that a business doesn't have much control over. 

While a portfolio of stocks and bonds should generate a positive return over the long haul, the path toward wealth rarely follows a straight line. Since money is simultaneously flowing into a pension (to save for future benefits), and back out (to pay benefits to existing retirees), pensions need to earn a consistently high return year after year, which is very hard to do.

Data source: Author.

Many businesses naturally conclude that guaranteeing a certain monthly payment to workers in retirement puts too much of the risk on the back of the business. Johnson & Johnson exists because it's good at making prescription drugs and baby shampoo. Of course, because it offers a pension to its employees, it also is in the business of trying to accurately predict the investment returns its pension can generate. 

Rather than place thousands of dollars per worker into a pension each year and hope for the best, many employers would rather contribute similar sums to a defined contribution plan for their employees. This shifts the investment risk from the employer to the employee.

If stocks drop by 37%, as they did in 2008, a retiree who has a defined contribution plan might reasonably decide to eliminate certain expenses and cut back on spending so as to avoid selling investments near their lows in retirement. Pension programs can't exercise the same thrift. If they promise to pay retirees $3,000 per month in retirement, they have to pay out $3,000 per month -- period.

Private vs. public pensions

The decline of the pension in the private sector is not that surprising. The 401(k) plan, which came about from a law passed in 1978, acts as a very good way for private enterprises to help workers save for retirement while minimizing risks to the employer. Whereas an employer can easily increase or decrease the amount it contributes to its employees' 401(k) plans each year, it doesn't have the same ability to change the benefits it promised to workers who are enrolled in a defined benefit pension.

But while pensions are slowly going extinct in the private sector, they remain fairly common in the public sector. Most full-time state and local government workers are enrolled in a defined benefit retirement plan, and public-sector workers are about five times as likely to have access to such a plan. 

Image source: Getty Images.

In truth, governments are better suited for managing a pension because they have the ability to generate revenue by levying taxes. Ford and GM can't force you to buy cars so that they can sustain their massive pension programs, but a state can force residents to pay higher income or property taxes to make up for any pension shortfalls.

The ability to tax doesn't mean that governments have been immune from problems relating to adequately funding their pension plans. In fact, the average funding level of state and local government pensions has deteriorated significantly in recent years, thanks to low stock returns and low interest rates during most of the 2000s. State government budgets also have shuffled inadequate amounts of money into their pension programs, exacerbating the problem of underfunded pension plans.

In 2001, state and local pensions were funded at 102.1%, on average, implying they had more than enough socked away to pay for future retirement benefits they guaranteed to workers. In 2016, the national funded ratio fell to 71.5%, according to Public Plans Data, meaning governments will need to earn a very high return on their investments or contribute billions to the programs each year to make up for the expected shortfall.

Pensions: Not quite a guarantee any more

One perk of pensions is that they have a government guarantee from the Pension Benefit Guaranty Corporation (PBGC). The PBGC is, in some ways, what the Federal Deposit Insurance Corporation (FDIC) is to the banking system. If a pension can't make good on its promises to its members, the PBGC can step in and cover at least some of the shortfall, just as the FDIC protects your bank deposits in amounts up to $250,000.

The PBGC isn't a perfect backstop. There are limits on how much the PBGC will pay out to people who were part of a failed pension. But it's a protection you won't find on a defined contribution plan like a 401(k). No one will guarantee that your 401(k) will generate a certain return.

In an indirect way, the PBGC guarantees a certain return for pensions. For a long time, this was a big advantage of having a defined benefit plan vs. a defined contribution plan. Defined benefit plans have a guarantee from the PBGC. 

It's becoming increasingly clear, however, that the PBGC, which bails out pensions, will need a bailout of its own at some point. At the end of its 2017 fiscal year, the PBGC had a total deficit of $76 billion. That's how much capital would need to be injected into the PBGC so that its actuaries could be confident it would be able to pay for all the benefits it expects to pay in the future.

Just like the failed pensions it's supposed to bail out, the PBGC and Congress made forecasts that were far too rosy. Josh Gotbaum, former Director of PBGC, had this to say in a 2011 interview:

Congress sets our premiums; they have always set them both too low and in a way that actually encourages irresponsible behavior (what the economists call "moral hazard"). So PBGC gets hit with a double whammy: its premiums are too low and the agency can't use them to encourage responsible behavior. In effect, the PBGC is an insurance company that can't offer a safe driver discount; all it can do is pray that everyone becomes a safe driver anyway.

The PBGC is looking at a number of ways to shore up its financial condition, either through increasing the premiums it charges companies whose pensions it guarantees or by limiting the amount of protection it offers to retirees whose pensions fail, or both. This is a contentious issue you likely will hear more about in the next few years, particularly since one part of the PBGC is expected to run out of money as soon as 2025 because pensions are going belly up faster than anticipated.

During a recent House-Senate committee hearing, the current director of the PBGC, Tom Reeder, said that without changes, some pensioners may ultimately see their benefits cut by as much as 90% since the PBGC simply will run out of money.

The perilous financial condition of the PBGC may be partly to blame for the decline in pensions in the private sector. Gotbaum said in an interview that "healthy companies are seeing their premiums go up to pay for the mistakes of others. And they don't like it."

Private companies pay insurance premiums to the PBGC based on their funding levels and number of pension participants. As more pensions fail, companies that have healthy pensions could see an increase in the insurance premiums they pay to the PBGC. Not surprisingly, companies that manage their pensions well don't want to be on the hook for all the other companies that don't. 

Pensions aren't a bad deal, but...

Many people attribute a successful middle-class America to pension programs. After all, pensions are effectively a forced savings plan. In many cases, an employee doesn't have to do anything at all -- other than show up for work -- in order to benefit from a pension.

Compare that to 401(k)s. The majority of them have historically required employees to enroll in order to start saving. Given that enrolling and contributing to a 401(k) takes some amount of effort and has the effect of reducing the employee's net paycheck every two weeks, workers were less likely to participate and save money with them. (A recent survey of 333 large employers found that 68% automatically enrolled their employees, up from 58% in 2016.)

A pension plan, if fully funded, can be a wonderful thing. However, the value of a pension ultimately depends on the employer's willingness and ability to make sure that it's funded adequately. One of the downsides of a pension, particularly for young workers, is that the assets are commingled. So if a pension makes promises that are too large, the honeypot of cash will dry up long before younger employees can collect their dues.

A better employer-sponsored plan -- the 401(k)

If your employer doesn't offer a pension, it may offer a 401(k) plan in which you can start saving for retirement. One of the big advantages of a 401(k) is that many offer an employer match, where an employer chips in cash to match the contributions made by employees. (Instead of a 401(k), you may have access to a 457 plan or 403(b), which have many of the same features as a 401(k).)

According to a 2014 study by BrightScope, about 16% of 401(k) participants received a match equal to 50% of their contributions up to 6% of their salaries. About 16% received a match equal to 100% of their contributions up to 6% of their salaries.

Someone who earns $50,000 per year and receives a 100% match on 6% of their salary could set aside $3,000 each year in a 401(k) and have another $3,000 per year chipped in by their employer, thus setting aside a total of $6,000 per year, or 12% of their salary. These matches can be very lucrative, the equivalent of free money that you receive just for saving for retirement.

Data source: IRS.

One of the biggest perks of a 401(k) is that you can use them to set aside a lot of money for retirement. People who are younger than age 50 can have combined employee and employer contributions of $55,000 in 2018. People who are 50 years old or older can set aside as much as $61,000 this year.

Contributions to a 401(k) are typically made before taxes. Thus, if you earn $50,000 and set aside $10,000 in a 401(k), your taxable income will be reduced to $40,000 before considering any other deductions or credits. Money you put in a 401(k) can grow tax-deferred until retirement, at which point withdrawals are taxed as ordinary income.

Many middle-class savers do well with 401(k)s because they're taxed at higher rates during their working years than at retirement. For example, someone who's in the 22% marginal tax bracket today might be in the 12% marginal tax bracket at retirement. Thus, by making contributions to a 401(k), they avoid paying 22% on their income now and only pay 12% on withdrawals from their 401(k) in retirement.

Going alone with an individual retirement account (IRA)

An individual retirement account (IRA) allows workers to set aside money for retirement in an account that's completely disconnected from their employer. An IRA is nothing more than a tax-advantaged "container" for investments. 

IRAs typically offer more flexibility to invest in ways that are tax smart. Traditional IRAs allow you to set aside pre-tax dollars, but all of the money you take out of the IRA will be taxed as income, much like a traditional 401(k). In contrast, Roth IRAs allow you to set aside post-tax dollars, and any money you take out in retirement isn't taxed at all. 

Traditional IRAs are a better choice if you expect to be in a lower tax bracket in retirement. For example, if you're in the 22% tax bracket today but you expect to be in the 12% tax bracket in retirement, it makes sense to avoid paying 22% now to pay only 12% in taxes later. The opposite is true for Roth IRAs -- they're best when you expect to be in a higher tax bracket in retirement.

IRAs have lower contribution limits than 401(k)s. In 2018, people younger than 50 years old can set aside $5,500 in an IRA. People who are 50 years old or older can take advantage of catch-up contributions and put as much as $6,500 in an IRA this year. The limit on IRA contributions applies to all IRAs that you have. Thus, if you have more than one IRA, the maximum you can contribute to all of them is $5,500 or $6,500 this year, depending on your age.

Picking investments for your retirement accounts

When you save in a 401(k) or IRA, you'll have to decide how you want your money to be invested. There are a few things you can do to maximize your odds of having a retirement balance that can fund the retirement of your dreams.

• Don't bet heavily on your employer's stock. Experts agree that putting your retirement savings in your employer's stock can be a mistake. That's because if your employer has financial difficulty, you could lose your job and your retirement savings.
• Consider the importance of fund fees. One of the best predictors of a fund's future returns is the fee it charges for investing in it. Low-cost index funds carry fees of 0.2% or less, far lower than the average fee charged on actively managed mutual funds. Fees are measured in terms of expense ratios, or the percentage of assets you pay in fees each year to hold a fund.
• Don't trade your retirement accounts. One benefit of having an IRA is that you have more freedom to invest your money how you want to, but that doesn't mean you should become a day trader with your retirement savings. One study looked at the performance of brokerage accounts from 1991 to 1996 and found that individual investors who actively traded their accounts lagged the market by 6.5% per year.
• Diversify. Diversifying between stocks and bonds can help smooth the ups and downs of the market. One common rule of thumb is to use your age as a guide for the percentage of assets you should invest in bonds. The remainder can be invested in stocks. (For example, someone 30 years old could have a portfolio that's made up of 30% bonds and 70% stocks.)
• Don't let your funds sit in cash. Make sure your contributions to a 401(k) or IRA are invested in something. If left unattended, cash is often put into a money market fund, which generates returns equivalent to the low interest rates you earn on your checking or savings account.

While there's no "one-size-fits-all" answer for how much of your income you should set aside for retirement, many experts recommend saving 15% to 20% of your gross income. Your savings rate is the single-most controllable factor that impacts how much you have at retirement.

Predicting future returns from the stock and bond markets is almost impossible, but it's certain that if you save 20% of your income instead of 10% of your income, you'll end up with twice as much at retirement.