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Is your pension secure?

Probably, but it could be smaller than you expect

Last reviewed: July 2009

American workers have great expectations of traditional defined-benefit pension plans, the kind of pensions that promise a set income stream or a lump-sum benefit in retirement. A 2007 survey of 1,000 workers conducted by the Employee Benefits Research Institute found that more than 60 percent of them expected to collect some money from a traditional pension plan once they retire.

Yet the percentage of American workers covered by defined-benefit pension plans has been shrinking steadily in recent years. Since the early 1990s, emphasis has shifted steadily to defined-contribution plans, such as 401(k)s, which allow employees to divert part of their income to a tax-deferred account. Employers often match a percentage of an employee's contribution. With these plans, employees decide how much they put in each year and how the money is invested. Unlike traditional pensions, defined-contribution plans do not promise a specific annual income or lump-sum payout upon retirement.

Unfortunately, some workers covered by private corporate pensions might end up receiving less in retirement than they're banking on. Cutbacks will most likely have the biggest effect on midcareer employees and high-income earners.

At the same time, the Social Security system is facing a funding shortfall projected at $4.7 trillion, according to the Government Accountability Office. That funding gap could eventually require cuts in those benefits as well.

Safety nets in place

About the only workers who need not lose sleep over their pension benefits, say experts, are state and local government employees covered by public-sector pension plans. That's because most public pension benefits are protected by state laws and constitutional provisions. New hires in state and local government might have to accept a pension that's less generous than existing plans, but public-sector workers who are already rooted to a job and pension generally will be all right.

Benefit cuts might loom for many, but pension experts say that private defined-benefit plans are essentially safe. Among defined benefit private pensions, asset-to-liability funding ratios are in the range of 85 percent funded today, even after the fall 2008 financial crisis, according to a November 2008 research paper by the Boston College Center for Retirement Research.

And despite its funding gap, Social Security "doesn't face an immediate crisis," David Walker, then U.S. comptroller general told us in a 2008 interview. He contended that the program's funding deficit is more easily solvable the sooner politicians deal with it, however.

The Pension Benefit Guaranty Corp. is a safety net for many private-sector pensions when sponsoring companies go bust. PBGC protects the retirement income of nearly 44 million American workers in 29,000 defined-benefit pension plans. In fiscal year 2008, which ended on Sept. 30, 2008, just as the world-wide economic crisis was beginning, the PBGC reported that it had an $11 billion shortfall in assets used to pay claims from pensions that have been terminated or that are considered to be "probable" terminations. That deficit was a considerable improvement from its 2004 balance sheet, when it was $24 billion under water.

Five possible hazards

Even with these safeguards, your expectations for retirement income can still be upset mightily. Here's what can go wrong if you work in the private sector, and how you can protect yourself. Also check our steps you can take to protect your retirement income.

Pension freezes

Although workers may not realize it, defined-benefit pensions are a promise, not a guarantee. As such, the employer is free to change the rules at any time. In recent years, more companies have been doing just that, even companies that are fiscally sound. "Freezing" the pension is one way to accomplish that.

A freeze stops the clock that ticks off credit for each year of service a worker racks up at a company. So if you have 20 years of service when the pension is frozen, that's what will be counted when your final benefit is calculated. That calculation typically is some percentage of your final compensation multiplied by years of service. If the old rule allowed you to tote up to 30 years of service, freezing the clock at 20 will significantly reduce your final benefit.

Some freezes shut out all employees, some keep out only new hires, and some close the door to all except older workers nearing retirement. A "hard" freeze stops benefit accruals based on both job tenure and compensation growth, while a "soft" freeze stops tenure growth but allows accruals for salary increases. Freezes only affect benefits going forward; vested benefits already earned up to the point of the freeze can't be taken away.

About 4,200, or 14 percent, of all private pensions insured by the PBGC were frozen as of 2005, the latest year for which data are available. Smaller plans with fewer than 1,000 participants and those in the manufacturing and retail industries were more likely to have been frozen. But dozens of big Standard & Poor's 500 companies have also frozen pensions in recent years, including Citigroup, General Motors, IBM, Lockheed Martin, and Verizon.

Freezing is expected to spread to more plans, partly as an unintended consequence of recent changes to federal pension regulations intended to protect workers, says Mauricio Soto, a research economist at the Boston College Center for Retirement Research. To make sure that the pension benefit liability is sufficiently funded, companies are required to pump more money into underfunded defined-benefit portfolios, especially when stock-market returns and interest rates are low. "That requires money from the company at the worst time," Soto adds.

Defined-contribution plans are less likely to place increased cash demands on employers as a result of volatile market conditions. Many employers use a pension freeze as the first step in phasing out defined-benefit pensions and replacing them with 401(k)-type savings plans.

Cash-balance conversions

Another way for a company to reduce the annual cost and limit the long-term liability of its pension is to convert the pension to a cash-balance plan. This is also considered a defined-benefit plan, but the payout at retirement is determined by the amount of money in your account, not by a multiple of compensation in your final years employed by the company, when it is likely to be highest. A cash-balance pension usually results in a smaller benefit than a traditional defined-benefit plan would have paid, says Dallas Salisbury, president and CEO of the Employee Benefits Research Institute.

When a plan is converted, your starting cash balance usually is whatever vested benefits you've already accrued in the traditional pension. Each year, your employer contributes cash to your account based on that year's pay.

If your pension is converted to a cash-balance plan when you're in your 40s or 50s and you have, say, 15 years with the company, you will lose the value of your long tenure as a multiplier in the pension formula. Your cash balance may not have time to grow through compounding to make up for that loss. "You get the worst part of the traditional plan and the worst part of the cash-balance plan," says David Certner, legislative policy director of AARP. "People have seen fairly dramatic benefit reductions."

From 1999 to 2003, the number of cash-balance plans grew by about 60 percent, to 1,000, and plan assets more than doubled, to $530 billion. Since that time, extensive litigation by employees challenging conversions has virtually halted their growth, according to the Boston College Center for Retirement Research.

Benefit formula changes

You can lose retirement income in a defined-benefit pension without even realizing it when your employer tinkers with the benefit formula. Among the tricks:

  • The "compensation" part of the equation is changed from the final year (usually the highest-paying) to an average of the last three to five years or to a career average.
  • The percentage benefit multiplier is cut from, say, 1.9 percent for each year of service to 1.5 percent.
  • "Compensation" is sliced into two parts: the amount of salary up to the Social Security Wage Base (the maximum salary on which Social Security taxes are levied, $106,800 in 2009) and any salary amounts above that level. Then a lower benefit multiplier is applied to the larger segment of your salary.

PBGC benefit limits

If your employer has not sufficiently funded its pension plan, it could be terminated and taken over by the Pension Benefit Guaranty Corp. That was the case with Bethlehem Steel, United Airlines, and US Airways, which walked away from a total of $13.8 billion in pension liabilities to nearly 280,000 vested participants in 2003 and 2005.

In most cases, you will get the full vested benefit owed to you up to the time the pension plan is terminated. If you earn a high salary, however, you could lose benefits you accrued that exceed the PBGC guarantee limit, which ranges from $12,150 to $54,000 for plans terminated in 2009. How much you'll get depends on your age (45 to 65) and whether you take a straight life annuity or joint annuity with 50 percent survivor benefit.

Plans that were terminated in earlier years guarantee less—for example, $8,698 to $38,659 for terminations in 2000—as coverage limits increase yearly. The PBGC says that only 16 percent of participants lost benefits, according to a 2008 study, but that's a 160 percent increase over benefits lost in 1999, when a study found that only 6 percent lost benefits.

The average benefit reduction has increased significantly, to 28 percent of what high-salary participants earned in 2008 from only 16 percent in 1999. Those losses do not include the loss of future accruals that the workers would have earned if the plan had continued to credit them for tenure and compensation gains.

Social Security cuts

To close Social Security's $4.7 trillion funding gap, benefits might have to be cut. "Most individuals will need to assume more responsibility for their own economic security in the future, especially if they want to retire at a relatively early age," says Walker. About half of all workers now retire and start collecting benefits by age 62.

"It is highly likely that the eligibility ages for Social Security will increase over time," Walker says. What's more, middle- and high-income retirees are more likely than those with low incomes to have their benefits cut, perhaps in the form of income-means testing or taxation of their benefits. In other words, those who voluntarily saved more money to ensure a higher income in retirement could get back less of what they contributed to Social Security.