Now Is The Time To Re-Think Retirement Plan Design

Retirement plan design can make or break an employee’s ability to maintain their standard of living in retirement. Over the past several decades, many private sector companies implemented a complete overhaul in retirement plan design, shifting from defined benefit pensions to 401(k)-style defined contribution accounts. 

Originally designed to supplement rather than replace pensions, 401(k) plans have become the primary employer-sponsored plan for many U.S. workers. This transition meant sacrificing a number of important features of pension plans and economic efficiencies. Lost were key attributes unique to pensions that strengthen retirement security: lifetime income, longevity risk pooling, mandatory participation, pooled investments managed by professionals, disability and survivor protections, and targeted income replacement. These inherent advantages of pensions mean that these retirement plans can deliver nearly double the retirement benefits at the same cost as compared to a 401(k)-style defined contribution plan.

As a result of the shift from pensions to 401(k) accounts, more and more Americans are far off-track in terms of saving enough on their own to ensure a secure retirement. According to the Boston College Center for Retirement Research, half of today’s households will not have enough retirement income to maintain their pre-retirement standard of living, even if they work to age 65 and annuitize all their financial assets. And, Americans understand their precarious retirement position. Recent national polling finds that more than two-thirds of Americans (67 percent) say the nation faces a retirement crisis, while 68 percent say the average worker cannot save enough on their own to guarantee a secure retirement.

Financial risk often was the reason companies gave for the dramatic change in benefit structure. Unfortunately, moving employees from pensions to individual 401(k) accounts shifted both risks and costs to workers who typically lack access to the professional expertise available to pension systems.

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But even by closing a pension plan and ending future accruals, private sector employers still had to pay accrued benefits, meaning that employers must manage legacy benefits in pension plans with greater negative cashflows over time, which generally makes it more difficult to rebound from down markets.

In stark contrast to private sector employers, state and local governments have taken a different approach to retirement plan design. In many cases, state and local governments took the long view on their retirement plan design, finding ways to balance the retirement needs of employees while also mitigating risks, managing costs, and offering benefits that will attract and retain qualified workers to deliver essential taxpayer services.

In doing so, nearly all state and local employers continue to offer pensions as the core retirement plan for their workforce with some offering supplemental defined contributions plans. Many state and local employers have made tweaks to their retirement offering to address specific issues or to meet workforce goals. 

The regulatory structure that governs defined benefit plans allows for a broad range of plan designs. For example, South Dakota’s public employee retirement system has managed to keep pension costs steady for decades. Colorado PERA provides strong retirement benefits for younger, shorter tenured workers than pensions typically provide by allowing even non-vested members to leave contributions in the system through retirement (preventing leakage) and offering annuitization at retirement. Thus, workers continue to have access to predictable retirement income. Meanwhile, both Colorado and South Dakota public employers benefit because strong retirement benefits are a proven tool for attracting and retaining workers.

In fact, a recent report from the actuarial firm Chieron and the National Institute on Retirement Security provides a comprehensive overview of the many aspects of public sector hybrid retirement plan designs. The Hybrid Handbook provides a deep dive on many of these non-standard plan design elements that have been used to customize their benefit offerings.

Looking back, it’s unfortunate that more private employers didn’t look to be more creative within the pension framework in their retirement plan redesigns. If they had kept a modified pension structure, their current workforce likely would be better positioned for the same level of retirement security as today’s retirees. In addition, employers would have avoided the difficulties associated with managing a closed pension plan, including aging demographics and large negative cashflows that are challenging with volatile investment markets. As a result, the inefficiencies surface on both sides: companies are facing substantial costs to pay their legacy pension plans costs with expensive annuity purchases while employees are unable to access life income in an economically efficient manner. 

There is a possible win-win approach. The retirement challenge is only growing more difficult for younger generations. At the same time, many U.S. employers face challenges recruiting and retaining qualified workers. Offering pensions is a proven tool for employers to attract and retain a qualified workforce. In fact, Americans have highly favorable views about pensions, viewing these plans as better than 401(k) accounts. Seventy-six percent of Americans have a favorable view of defined benefit pensions, while 65 percent agree that pensions are better than 401(k) accounts for providing retirement security.

Now may be the time for private sector companies with closed pension plans to take a strategic look at their retirement plan design options. Instead of buying expensive annuities that are made even more expensive by historically low interest rates, there could be ways to redesign their retirement plan offerings in a way that meets both employer and employee goals.