A New Life for Pension Plans
Don't ring the death knell for defined-benefit pensions just yet. A new effort is under way to rehabilitate these plans.
For workers struggling to manage their 401(k)s, employers' decades-long shift away from traditional, professionally managed pensions seems relentless -- and potentially disastrous. But now, one plan administrator is bucking the trend, backing away from a 401(k) that wasn't working for participants and adopting a new type of defined-benefit plan designed to reduce risks for both employers and workers.
At the start of this year, roughly 4,500 Boston-area hospitality workers belonging to the Unite Here Local 26 union became participants in a new defined-benefit pension plan. This "Adjustable Pension Plan," designed by actuarial firm Cheiron, divides investment risk between employers and employees. Workers get pooled, professional money management rather than the individual accounts found in 401(k)s. At retirement, Local 26 workers are promised an annual base benefit of at least $300 to $400 for each year of service, no matter how the plan's investments perform. But workers can also earn a higher annual benefit if the plan's investments beat a relatively conservative return hurdle.
This bold experiment illustrates one possible solution to many problems plaguing both 401(k)s and traditional pension plans. The new plan's risk-sharing approach avoids placing all the investment risk on employers, as in traditional pension plans, or on workers, as in 401(k)s. Amid market upheaval and low interest rates, many employers have frozen or terminated traditional pension plans. Just 15% of private-sector workers participated in a defined-benefit plan in 2008, down from nearly 40% in 1979, according to the Employee Benefit Research Institute. Many workers have been left to fend for themselves in 401(k)s, which burden participants not just with the risk of market downturns but also with the risk that a long lifespan could cause them to burn through their retirement savings.
The Adjustable Pension Plan "is a really promising compromise between the 401(k) world, which we know doesn't work for lots of people, and the traditional defined-benefit world," which comes with hefty potential liabilities for employers, says Norman Stein, a law professor at Drexel University and senior policy adviser for the Pension Rights Center.
The Local 26 union arrived at its trailblazing plan by following a path now familiar to many American workers. The union had a traditional defined-benefit plan in the 1960s and '70s, says Joey Mokos, executive director and chief compliance officer of Local 26 Benefits Administration, which administers the union's retirement plans. Workers in the 1980s were switched to a defined-contribution plan -- first in the form of a money-purchase plan, and ultimately in the '90s, a 401(k) plan. But many workers didn't participate in the 401(k). And thanks to two major market downturns, 401(k) participants on the brink of retirement "realized they didn't have the money they were counting on," Mokos says. With defined-benefit plans also struggling in the wake of the financial crisis, he says, a return to a traditional pension plan didn't seem a viable alternative.
The union's solution, the Adjustable plan design, was born from an effort to analyze the weaknesses of traditional pensions and develop a new plan that mitigates their risks, says Richard Hudson, Cheiron's principal consulting actuary. One key remedy for traditional pension woes lies in the Adjustable pension's relatively conservative return assumption of roughly 5%. Traditional pensions have taken on considerable investment risk in an effort to meet return assumptions that critics say are unrealistically high, and many of these plans are severely underfunded. But the Adjustable pension can invest mostly in bonds and still have a good chance of beating its return target -- and adding a nice bonus to workers' "floor" retirement benefit, Hudson says.
"We're not looking for big returns," Mokos says. "We're taking the turtle's approach, slow and steady, and that keeps us fully funded."
Given its conservative return assumptions, the plan "should be far less battered by unpredictable financial storms" than traditional pensions, Stein says.
Employees don't contribute to the Adjustable plan. In the Local 26 plan, employers contribute 75 cents for every hour a participant works. And while a floor benefit of $400 per year of service may not sound like much, it allows workers over a 30-year career to build up a guaranteed annual benefit of $12,000, which combined with Social Security should replace a substantial portion of preretirement income for these participants, Hudson says. And any benefit will be better than what many of these workers were saving in the 401(k) -- which was nothing, Hudson notes.
While workers in the plan know they'll at least receive the floor benefit, the possibility of receiving a higher adjustable benefit leaves some uncertainty about their exact level of retirement income. Most communications to participants "will be talking about the floor benefit," Hudson says, though the hope is "that the plan should provide for a nice surprise in retirement."
Cheiron is currently working with a couple of employers who have traditional pension plans and are considering a move to the Adjustable Pension Plan, Hudson says. Many firms with traditional pensions are inclined "to abandon ship and jump to a defined-contribution plan, so what this does is give you a balance between the two. Participants need more retirement security than what a defined contribution plan can provide," he says. At Local 26, the 401(k) plan will continue, but new workers enrolling in the plan will no longer receive an employer matching contribution, Mokos says.
A successful implementation of the Adjustable Pension Plan would offer some hope for the future of defined-benefit plans, pension experts say. If the plan works in practice, Stein says, "other people will take note that there are creative things people can do to control costs in these kinds of plans and still harvest the advantages of defined-benefit plans."