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Abstract
The shifting pension landscape raises questions about the financial security of future retirees. About one-half of private-sector workers are not covered by employer-sponsored pension plans on their current job. Many private-sector employers have replaced traditional pensions with 401(k)-type plans, which protect benefits for workers who change jobs frequently but expose participants to investment risks. This primer describes pensions, workers with coverage, and related policy issues.
Introduction
What Are Pensions?
Pension plans are benefits offered by many employers that provide workers with cash payments in retirement. In 2006, about 24 percent of Americans age 65 and older received pension benefits from past private-sector employers, and about 11 percent received benefits from past public-sector employers (Purcell 2007a). Median annual benefits in 2006 were about $7,200 among older adults receiving private pensions and $14,400 for those receiving pensions from government employers.
There are two basic types of employer-sponsored pension plans. Defined benefit (DB) plans, once the most common type, promise specific monthly retirement benefits that usually last until death. Defined contribution (DC) plans, which now dominate, function essentially as individual tax-deferred retirement savings accounts into which both employers and employees usually contribute. Cash balance plans are hybrids that combine features of DB and DC plans. Each plan type affects individual retirement incomes and employer costs differently and raises distinct public policy issues
How Do Benefits Accumulate?
DB plans base payments on formulas that usually depend on earnings and service years. A typical formula in the private sector sets annual benefits equal to 1 percent of average annual salary for each year of service. Most public-sector plan formulas are more generous, with typical multipliers of around 1.5 percent. Sometimes the earnings base includes all years that the participant worked at the employer, but more commonly it includes only the most recent years, such as the last five. A few plans set benefit payments equal to some fixed annual amount per year of service, regardless of earnings.
DC plans do not promise specific retirement benefits. Instead, employers that provide 401(k)-type plans—the most common type of DC plan—contribute to a retirement account in the participant's name, usually as a specific percentage of salary.1 Employees can also contribute to their retirement accounts and defer taxes on their contributions until they withdraw funds from their accounts. Employer contributions sometimes depend on how much the participant contributes. Some employers, for example, match worker contributions up to a specific amount, providing few benefits to employees who contribute little to their retirement plans. Account balances grow over time with contributions and investment returns.
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