Are Pensions Dead? Comparing Defined Benefit Plans to Defined Contribution Plans

Whether you have a pension or a 401(k), your retirement faces risks…

Pensions, also known as “defined benefit” or “DB” plans, are a dying breed of retirement plans.

In the 1970s, over 60 percent of private-sector retirement plan participants had a pension. Fast forward to the 2020s and that fraction dropped to fewer than one in eight participants. 

This is because Congress created ‘defined contribution’ or DC plans, such as the 401(k), in 1978.

Defined Contribution Plans vs. Defined Benefit Plans

If you have a pension, your employer guarantees a certain retirement income based on your wages and tenure. In these plans, the employer bears the risk that the plan’s investments may not perform well enough. You, on the other hand, bear no market risk.

In addition, if you live to 100 or longer, your employer is on the hook to keep paying out your benefits.

Once Congress allowed it, employers were only too happy to shift both market and longevity risk from themselves to you, the employee, by implementing DC plans. Here, you get to contribute to the plan up to a limit set by the IRS that gets updated (more or less) annually. Your employer may, but is not required to, match your contribution.

From that point on, your employer bears no market risk and no longevity risk. 

If you contribute enough and are lucky and/or good enough to pick winning investments within your 401(k), your retirement will be comfortable or better; and if your longevity is likely to be shorter, you can increase your spending. 

If you don’t contribute enough and/or choose the wrong investments (e.g., if you invest solely in money market funds that take next to zero risk but, as a result, don’t have high returns) and/or pick riskier investments that happen to tank when you’re about to retire, your account will be far short of what’s needed to fund your retirement, especially if your retirement is longer than average.

In brief, you have far more control over how your retirement contributions are invested and drawn down in retirement, but you alone bear the market risk of your choices and the longevity risk of your genetics and behavioral choices.

On the flip side, pensions require a far longer time with the employers to provide significant benefits, and many plans may not let the employee bequeath their benefits to their surviving spouse and/or kids.

If you have a pension, your employer could decide to sell the plan, including its assets and liabilities, to an insurance company. This could remove federal protections that prevent lawsuits from pursuing your pension benefits. Also, if the insurer goes belly up, the federal Pension Benefit Guaranty Corp. (PBGC) won’t make you whole, though there may be some state-level protection.

Who Still Has a Pension? Survey Offers Insights

If you have a pension, you’re most likely a unionized worker, whether in the public sector (e.g., government employees at the federal, state, or local level) or the private sector (e.g., longshoremen, auto workers, etc.). Government employees here include teachers and long-term active-duty military.

According to the Investment Company Institute (ICI) 2024 factbook, “Employer-sponsored retirement plans and IRAs, which complement Social Security benefits and are important resources for households regardless of income or wealth, increase in importance for households for which Social Security replaces a smaller share of earnings [i.e., those with higher earnings]. In 2022, more than three-quarters of near-retiree households had accrued benefits in employer-sponsored retirement plans—DB and DC plans sponsored by private-sector and government employers—or IRAs.”

Across all income levels, the factbook reports nine percent of pre-retirees have DB plans only and nearly 29 percent have both DB and other plans. Forty percent have no DB plan (and 23 percent have no retirement plan whatsoever).

Breaking things down by income quintiles (i.e., segments of 20 percent each), we find pre-retirees with only a DB plan aren’t likely to be in the top-earning quintile (just one percent) vs. nine to 15 percent in the other four quintiles. 

Those with both a DB and other retirement plans comprise six percent of the lowest-earning quintile, 18 percent of the second-lowest, 38 percent of the middle quintile, 46 percent of the second-highest quintile, and 35 percent of the top quintile.

Those having solely non-DB retirement plans comprise 28 percent of the first quintile, 37 percent of the second, 33 percent of the middle or third, 40 percent of the fourth, and a full 62 percent of the top quintile. 

As for those with no retirement plan whatsoever, unsurprisingly, they comprise the largest fraction in the lowest quintile and gradually fewer as we move up in income – 58 percent of the first quintile, 35 percent of the second, 15 percent of the third, five percent of the fourth, and just two percent of the top-earning quintile.

Division of Value Between DB and Other Plans

Employer retirement plans, IRAs, and annuities intended to fund retirement comprise nearly a third of US household investments. At $38.4 trillion at the end of 2023, the division of value was:

• IRAs (including rollovers): $13.6 trillion
• 401(k) plans: $7.4 trillion
• State and local government DB plans: $6.0 trillion
• Private-sector DB plans: $3.2 trillion
• DC plans other than 401(k) and IRAs: $3.1 trillion
• Federal government DB plans: $2.7 trillion
• Annuities: $2.4 trillion

How Retirement Plan Asset Allocation Changes with Age

Appropriately, nearly all retirement plan participants invest at least some of their money in equities (e.g., stock funds, stock ETFs, target-date funds, other balanced funds, and/or company stock). Target-date funds are especially popular, with 68 percent of 401(k) plan participants investing in them.

Also appropriately, younger and older employees allocate different fractions of their money between equities and other asset classes, with 71.8 percent of assets invested in equity funds, target-date funds, and other balanced funds for participants in their 60s, compared to 93.6 percent for those in their 20s. Looking at the overall equity allocation, participants in their 60s have just 57 percent invested directly or indirectly in stocks compared to an 89.5 percent stock allocation for younger participants in their 20s.

Defined Benefit Plan Risk: Funding Shortfalls

As mentioned above, participants in DB plans are guaranteed certain retirement benefits, according to formulas based on their income and tenure.

However, not all DB plans are healthy enough to cover all their guarantees. For example, according to the Brookings Institute, “In 2001, the median teacher retirement system was 96% funded, buoyed by the tech bubble in the stock market. But in 2001 the tech bubble melted down, and then in 2008 the housing market melted down and triggered the Great Recession. By 2019, the median teacher pension was only 70% funded.”

The Pew Foundation reported similar problems in state pension plans and retiree health coverage, “Across all 50 states, unfunded pension liabilities increased by 14.4 percentage points as a share of states’ own-source revenue between fiscal years 2007 and 2021, reaching 49.1% in fiscal 2021. Total 50-state unfunded retiree health care liabilities increased by 7.7 percentage points as a share of states’ own-source revenue between fiscal years 2008 and 2019, reaching 45.4% in 2019.”

The Reason Foundation finds similar problems persisted after 2021, “Based on an estimated annual investment return of 7% for public pension plans, Reason Foundation forecasts the 118 state pension systems analyzed have $1.3 trillion in total unfunded liabilities at the end of the 2023 fiscal year.”

In short, despite being promised certain benefits, you may receive lower amounts if your employer’s plan is chronically underfunded.

Financial Pros Offer Advice for Participants of Both Defined Benefit and Defined Contribution Plans

Michael Rosenberg, Founder and Managing Director of Diversified Investment Strategies, cautions pre-retirees who have pensions against making a common mistake, saying, “Many pre-retirees who have a DB pension plan make a mistake by not planning for the survivorship benefit. In a simplified example, if a married worker retires with $1000 of benefits a month, they are asked if they would like to have a survivorship benefit for their spouse, and 99.9% of them elect to take that survivorship benefit. This typically results in a 20% permanent reduction of their benefit, so the $1000 monthly benefit would drop to $800. This then impacts the surviving spouse’s survivor benefits too. Also, as mentioned above, this benefit selection is permanent and can’t be changed. Even if your spouse should die before retirement, you can’t go back to the original $1000 benefit. 

“One strategy to address this, if the client is healthy, is to purchase a life insurance policy to provide the surviving spouse a pool of money from the life insurance contract instead of selecting the survivor benefit. This would mean an increase of 25% in retirement benefits at retirement (the $1000 vs. the $800 in the above scenario). If your spouse should die before you, you can cancel the life insurance policy and receive the cash value. 

“Note, that it is best to implement this strategy earlier rather than later, since the cost of insurance increases as you age. People will usually find that the price of life insurance is lower than the decrease in pension benefits needed to provide the survivor benefit. 

“It is important to understand that you’re buying life insurance one way or the other. In one way you pay for life insurance while you are working, and in the other, you pay for a survivor benefit when you retire. Most people I meet would rather pay while working and have more income at retirement. So, if you have a DB plan, I’d advise planning early.”

Omar Morillo, Founder of Imperio Wealth Advisors, has advice for participants in both DB and DC plans. He says, “Clients with DB plans need to focus on ensuring their pension income aligns with their retirement goals, inflation protection, and asset protection. This predictable income base lets them be more growth-oriented in other investments. 

“Clients with DC plans should emphasize saving strategies, risk management, and maximizing employer matches. Balancing tax advantages and ensuring their investments support long-term retirement goals is also critical. 

“Many pre-retirees overlook income planning, tax diversification, and healthcare costs. People should create strategies to convert savings into steady retirement income, take advantage of catch-up contributions, and plan for inflation and medical expenses that can quickly erode savings. 

“Beyond all that, DB plans, especially cash balance plans, allow far higher contributions and tax deductions, making them ideal for high-income earners. When combined with a DC plan, business owners can maximize tax savings and retirement contributions while protecting assets, creating a powerful strategy for retirement security and wealth building.”

The Bottom Line

American workers’ retirement funding model changed significantly over the past 40-plus years, moving from a situation in the late 1970s where most employees covered by retirement plans had pensions that guaranteed specific benefits (based on salary and tenure) to a completely different situation these days, where an overwhelming majority of employer-sponsored retirement plans are DC plans such as 401(k), 403(b), 457(b), etc.

This change shifted market risk and longevity risk from employers to employees. As a result, employees who don’t save a large enough portion of their pay and/or don’t invest it in assets carrying prudent levels of risk and thus sufficiently high average returns may well find themselves in an unenviable situation when they retire.

Since participants in DC plans don’t automatically get a set monthly benefit, it is up to them to decide how much to draw each year from their retirement accounts. If they draw too heavily early on, they risk running out of money. If they draw too little, their plan balance may continue growing but their lifestyle will be needlessly austere.

Pension plan participants aren’t completely out of the woods either. Many pension systems suffer chronic underfunding, potentially being unable to fulfill their promised benefits in full. Worse yet, if such plans get sold off to insurance companies, participants lose federal protections and guarantees for pensions. Even if your pension system isn’t underfunded, your heirs may not receive anything once you pass away.

Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.