Your Financial World:  The Changing Nature of Pension Systems                  

The pension world is changing. Many of the people who are already retired have defined-benefit pensions. That is, their employers promised them a lifetime income based on the number of years they worked and their final salary.  The press is filled with reports of companies announcing that they are shifting from defined-benefit to defined-contribution pension plans such as 401ks, where workers put a portion of their salary into tax-deferred investment accounts (and many employers add a matching contribution).   IBM made this announcement in early 2006.  Today, workers and their employers make contributions into a savings plan that will ultimately be used to buy a lifetime annuity from an insurance company.  (A lifetime annuity is a contract that makes a fixed monthly payment for as long as you live.[1]) The shift from defined-benefit to defined-contribution pensions has been prompted by the desire to protect workers, since  poorly performing firms have tended to loot the funds in the defined-benefit systems, leaving individuals with little in the way of pension savings.

In thinking about the move from defined-benefit to defined-contribution pensions, there are two important things you need to understand. First, for each $100 in monthly payments that a lifetime annuity is going to pay, the accumulated principal at retirement must be the same, regardless of the type of plan. Someone somewhere has accumulated the funds to pay for it.

Second, the two types of plans involve a different distribution of risks.  For an individual, the risk in a defined-contribution pension is that they will not receive adequate income during old age.  This happens when the accumulation, including the investment returns, is insufficient to purchase the appropriate life annuity.  Since we can control the deposits into the fund, the risk is that investment returns will be low. And the individual bears this risk, in addition to the risk that they will make poor investment decisions.   In contrast, in the defined-benefit pension, the firm’s owners guarantee the worker’s pension payments, so it bears the risk. 

So, while we may feel that the shift of control of pensions from companies to workers is a good thing, it does come with some costs.  To make sure that they have an adequate pension when they retire, it is now up to workers to invest their savings in a way that controls the risks they face.

Make sure you learn how to manage risk in your pension future.  It is especially important that you diversify your investments. Don’t buy stock in the company you work for (see the In the News story of Enron employees on pages 110-111).  Do hold mutual funds, especially index funds that include all the stocks in the S&P 500 (see Your Financial World about stocks on page 195).  And reduce the risk of your retirement investments as you get older by shifting away from stocks and toward bonds and bond mutual funds.[2]