The End of the Defined Benefit

For generations of American employees, the end of a long career meant retiring with a full pension for the rest of their lives.  That pension was usually fully funded by the worker’s former employer, for whom he or she typically worked for an entire career.

A lot has changed for recent retirees.  In the 21^st century, few people spend their entire working lives at one company.  Increasingly  fewer and fewer are retiring with defined benefit pension plans.

Soon, public-sector employees will begin to face the same reality, and it’s just a matter of time before the defined benefit safety-net programs like Social Security and Medicare will also undergo fundamental changes.

Why is this happening?  Social Security, Medicare, and Medicaid, as well as many public- and private-sector pension plans, promise specific benefits to their beneficiaries and have to come up with a way to pay those benefits.  Most government workers still receive this type of pension, whereas most private employers have moved to so-called “defined contribution” plans, under which employers contribute money to their employees’ 401(k) accounts along with the employee’s own contributions.  The money grows and the employee actually has real assets in his or her name, rather than just a claim on a fund someone else is managing.

Private companies migrated to this type of plan because they realized that the assumptions that may have once justified defined benefit plans are becoming obsolete.  The future is simply too unpredictable.  A plan’s success depends on an economy that provides continuous, steady growth.  Unfortunately, as we’ve seen in recent years, the U.S. economy tends to move in boom and bust cycles.  In addition, even if the long-term average outcomes were forecast correctly, specific outcomes for a fund, especially for a specific time frame, can be substantially different than the averages.

The outlook for defined benefit plans dramatically changed not only because of the income assumption, but also because of the huge shift in demographic realities.¹ Social Security and other defined benefit pensions were usually based on the belief that people wouldn’t live very long after retiring at age 65.  That’s no longer the case.

Since Social Security, Medicare, and Medicaid were based on a “pay as you go” model rather than a fully-funded actuarial model, they assumed a certain growth rate for the workforce.  However, that growth has basically slowed to a standstill.  As a result, while there were once nine employees paying Social Security taxes to finance the benefits of one retiree, that ratio has fallen to three-to-one tod... To read the full article, you must be a Trends Magazine Subscriber. To learn more, click here