Why pensions went away

At least for most people in the private sector

On Sunday, the New York Times Magazine published a special edition all about retirement. For the next few issues of The Whatever Years, I’m going to go through the articles and give some context (and opinions) about the issues raised. Tell your friends!

First up: The 401(k) Problem (NYTimes gift link). These were designed to be tax shelters for highly compensated employees, allowing them to set extra money aside and defer their tax obligations until retirement. They have become the cornerstone of the American retirement system.

So, what happened? Why did the old-fashioned pension (mostly) go away, and is that good or bad?

The key regulation governing corporate retirement plans is the Employee Retirement Income Security Act of 1974, more commonly known as ERISA. The law improved the retirement system by requiring that funds be managed using professional investment techniques for the primary benefit of the pension recipients, not the sponsoring company. Also, companies had to record pension liabilities on their balance sheets so that shareholders understood the true cost of pensions. (Although the accounting method is baroque, so good luck with that.) In exchange, the government agreed to protect pension benefits from insolvency through the Pension Benefit Guarantee Corporation.

Before ERISA, many employers paid pensions out of general funds. They didn’t have a lot of assets backing the pension, and sometimes those assets were mis-managed. People often lost pensions to corporate bankruptcy, which wasn’t good.

After ERISA, pensions were safer, but the cost of offering them went way up.

Under ERISA, the maximum vesting period was 10 years. This meant that full pension benefits were received after no more than 10 years of employment. If you left your job sooner than your full vesting date, you gave up some of your pension benefits. These lost benefits were known as forfeitures, and they helped support the benefits for those who were fully vested. The problem is that women often had shorter tenures in the workplace because of family obligations, and some companies faced age-related litigation when they laid off employees who were nearing their full vesting anniversary.

The Tax Reform Act of 1986 cut the vesting schedule from 10 years to five years. This gave people far more flexibility in their lives and their careers. It also reduced the amount of forfeitures that went into a pension fund, adding to the cost of offering pensions.

The 401(k) solved two problems. It allowed companies to remove pension obligations from their balance sheets, and it gave workers who changed jobs frequently portability. They could take their savings with them. These are both excellent things!

But they don’t make up a win/win.

401(k) plans are portable. For those workers who can set money aside and who have some investment knowledge, they may lead to greater retirement savings than a traditional pension. That’s good.

Workers who have trouble saving (sometimes, but not always, due to low income) and those who make poor investment choices are worse off. That’s not good.

People who entered their peak working years under the 401(k) regime are nearing retirement, and we are likely to find that a lot of people can’t afford to retire. It is likely to get worse as many younger people find it difficult to pay off student loans, cover housing costs, and save for retirement.

Do you have questions or comments? Things you think I should write about? Let me know in the comments.