Traditional Pension Plans

Many older Americans have had the good fortune of enjoying what is called a traditional pension plan where you retire and receive defined benefits for the rest of your life. Unfortunately for most workers who first entered the work force ever since the 1970s, these traditional pension plans have been decreasing in number and being replaced with the more modern employee funded IRA and 401(k).

This section helps explain the traditional Defined Benefit Plans.

Understanding what a traditional pension is and how they work.

In general, a pension is an arrangement to provide workers with an income when they are no longer earning a regular income from employment. Whatever the type or form of pension, it is usually a tax deferred savings vehicle that allows for the tax-free accumulation of a fund for later use as retirement income. Pensions should not be confused with severance packages. A pension is paid in regular installments, while a severance package is paid in one lump sum.

Pension plans became popular in the United States during World War II, when wage freezes prohibited outright increases in workers' pay. The defined benefit plan had been the most popular and common type of retirement plan in the United States through the 1980s; since that time, defined contribution plans such as IRAs and 401(k)s have become the more common type of retirement plan.

Defined Benefit plans may be set up by employers, insurance companies, the government or other institutions such as employer associations or trade unions. Retirement pensions are typically in the form of a guaranteed life annuity, thus insuring against the risk of longevity.

Many pensions also contain an additional insurance aspect, since they often will pay benefits to survivors or disabled beneficiaries. Some pension plans will provide for members in the event they suffer a disability. This may take the form of early entry into a retirement plan for a disabled member below the normal retirement age.

Retirement plans often require both the employer and employee to contribute money to a fund during their employment in order to receive defined benefits upon retirement. Funding can be provided in other ways, such as from labor unions, government agencies, or self-funded schemes. Pension plans are therefore a form of "deferred compensation".

Defined benefit plans may be either funded or unfunded.

In an unfunded defined benefit pension, no assets are set aside and the benefits are paid for by the employer or other pension sponsor as and when they are paid with benefits paid directly from current workers' contributions and taxes. The social security system in the USA, for example, is unfunded, having benefits paid directly out of current taxes and social security contributions.

In a funded plan, contributions from the employer, and sometimes also from plan members, are invested in a fund towards meeting the benefits. The future returns on the investments, and the future benefits to be paid, are not known in advance, so there is no guarantee that a given level of contributions will be enough to meet the benefits.

Typically, the contributions to be paid are regularly reviewed in a valuation of the plan's assets and liabilities, carried out by an actuary to ensure that the pension fund will meet future payment obligations. This means that in a defined benefit pension, investment risk and investment rewards are typically assumed by the sponsor/employer and not by the individual. If a plan is not well-funded, the plan sponsor may not have the financial resources to continue funding the plan.

Most private defined benefit plans are funded, because the government provides tax incentives to these funded plans. In addition, non-church-based private employers must pay an insurance-type premium to the Pension Benefit Guaranty Corporation, a government agency whose role is to encourage the continuation and maintenance of voluntary private pension plans and provide timely and uninterrupted payment of pension benefits.

Determining Benefits.

A defined benefit plan guarantees a certain payout at retirement, according to a fixed formula which usually depends on the member's salary and the number of years' membership in the plan.

A traditional defined benefit plan is a plan in which the benefit at retirement is determined by a set formula, rather than depending on investment returns.

Traditionally, retirement plans have been administered by institutions which exist specifically for that purpose, by large businesses, or, for government workers, by the government itself.

The benefit in a defined benefit pension plan is determined by a formula that can incorporate the employee's pay, years of employment, age at retirement, and other factors.

If the pension plan allows for early retirement, payments are often reduced to recognize that the retirees will receive the payouts for longer periods of time. Under the ERISA rules, any reduction factor less than or equal to the actuarial early retirement reduction factor is acceptable.

Many defined benefit plans include early retirement provisions to encourage employees to retire early, before the attainment of normal retirement age (usually age 65). Companies would rather hire younger employees at lower wages. Some of those provisions come in the form of additional temporary or supplemental benefits, which are payable to a certain age, usually before attaining normal retirement age.

Criticisms of defined benefit plans.

Traditional defined benefit plan designs that eventually allow the exact benefit amount grow quite slowly early in an employee's career and accelerates significantly in mid-career. In other words, it costs more to fund the pension for older employees than for younger ones (an "age bias"). Defined benefit pensions tend to be less portable than defined contribution plans, even if the plan allows a lump sum cash benefit at termination. Most plans, however, pay their benefits as an annuity, so retirees do not bear the risk of low investment returns on contributions or of outliving their retirement income. The open-ended nature of these risks to the employer is the reason given by many employers for switching from defined benefit to defined contribution plans over recent years. The risks to the employer can sometimes be mitigated by discretionary elements in the benefit structure, for instance in the rate of increase granted on accrued pensions, both before and after retirement.

The age bias, reduced portability and open ended risk make defined benefit plans better suited to large employers with less mobile workforces, such as the public sector (which has open-ended support from taxpayers).

The "cost" of a defined benefit plan is not easily calculated, and requires an actuary or actuarial software. However, even with the best of tools, the cost of a defined benefit plan will always be an estimate based on economic and financial assumptions. These assumptions include the average retirement age and lifespan of the employees, the returns to be earned by the pension plan's investments and any additional taxes or levies, such as those required by the Pension Benefit Guaranty Corporation. So, for this arrangement, the benefit is relatively secure but the contribution is uncertain even when estimated by a professional.

Current challenges.

A growing challenge for many pension plans is population aging. As birth rates drop and life expectancy increases an ever-larger portion of the population is elderly. This leaves fewer workers for each retired person. This means that government and public sector pensions could collapse their economies unless pension systems are reformed or taxes are increased. Two methods of reforming the defined benefit system is to increase the retirement age and reduce current benefits. Both of these methods have been taking place over the past few years.

Another growing challenge is the recent trend of purposely under-funding their pension schemes in order to push the costs onto the federal government. For example, in 2009, the majority of states have unfunded pension liabilities exceeding all reported state debt. Bradley Belt, former executive director of the PBGC (the Pension Benefit Guaranty Corporation, the federal agency that insures private-sector defined-benefit pension plans in the event of bankruptcy), testified before a congressional hearing in October 2004, “I am particularly concerned with the temptation, and indeed, growing tendency, to use the pension insurance fund as a means to obtain an interest-free and risk-free loan to enable companies to restructure. Unfortunately, the current calculation appears to be that shifting pension liabilities onto other premium payers or potentially taxpayers is the path of least resistance rather than a last resort.”