The Vanishing Safety Net

Pension checks may one day be relegated to museum exhibits along with buggy whips, telegrams and other artifacts of days gone by. The number of employers offering so-called defined-benefit plans peaked in the mid 1980s, when pensions covered one out of three private-sector workers in the U.S. By the end of 2003, pension coverage had slipped to less than one in five.

In recent years, most of the hand-wringing over pensions has been directed at corporations -- mainly in the steel, airline and auto-parts industries -- that went bankrupt and turned their pension obligations over to the Pension Benefit Guaranty Corp., the federal agency that insures private pensions. As recently as 2001, the PBGC estimated that it had more than enough assets on hand to cover its expected liabilities. But that is no longer the case. Currently, it has about $23 billion less than it needs if it has to take over several vulnerable plans at the same time. While affected retirees will continue to receive benefits from the PBGC, in some cases the payments they receive will be smaller than if employers had continued to operate the pension plans.

And within the past year, even well-funded pension plans sponsored by healthy, profitable companies have taken a T. rex-size step closer to extinction. Some of the biggest names in corporate America -- many known for offering the richest benefits -- have backed away from making any further pension promises to employees. General Motors, IBM, Lockheed Martin, Motorola, Sprint Nextel and Verizon are among those that have "frozen" their plans. Earlier this year, GM offered cash buyouts to workers with less than 30 years of service in exchange for giving up promised pensions and retiree health benefits. More announcements are expected to follow. (Learn when it makes sense to accept a buyout offer.) Ten years from now, employers will still be paying out benefits to retirees, but few active employees will be accruing them.

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Reasons behind the trend

Companies are getting out of the pension business for a variety of reasons. The sluggish stock market has kept pension-fund assets from growing to expected levels, forcing companies to contribute more. At the same time, low interest rates require employers to set aside more money to pay future benefit obligations. For example, an immediate lifetime annuity paying $1,000 a month to a 65-year-old man cost roughly $110,000 in 2000, according to the Employee Benefit Research Institute. In 2005, the same monthly benefit cost about $145,000.

Looking ahead, tougher pension accounting rules from the Financial Accounting Standards Board and legislation pending in Congress have the potential to make defined-benefit plans even more unpredictable and costly to maintain.

Some firms are shutting down healthy pension plans because of cost-cutting pressure from global competition. Effectively, companies are saying that "it's more important that you have a job than a rich defined-benefit plan," explains Martha Priddy Patterson, of Deloitte Consulting's Human Capital Group. At the same time, the cost of employee health care is rising so fast that it is squeezing out pension benefits.

Finally, many employers believe that their employees don't understand, and therefore don't appreciate, pension plans, particularly if they don't expect to remain with their current employer long enough to accrue a meaningful benefit. By freezing or terminating a pension plan, employers are sending a not-so-subtle message, says Karen Holden, a professor of public affairs and consumer science at the University of Wisconsin: "Your retirement is your responsibility, not the company's responsibility. It's up to you to build up an adequate nest egg."

Frozen in place

Most companies that are altering their pension plans are either implementing a "soft freeze" or a "hard freeze." A soft freeze is what IBM put into place in early 2005 when it closed the plan to all new hires. Existing employees continued to accrue benefits.

In January 2006, IBM turned down the temperature another notch, moving from a soft freeze to a hard freeze. As of 2008, there will be no further benefit accruals in the pension plan, but all benefits earned as of that date will be preserved. IBM's 125,000 current retirees, former employees with vested benefits and employees who retire prior to 2008 will not be affected.

Freezing a pension plan does not relieve a company from making future contributions, but it does mean that its pension liability will gradually melt away. It still has to pay premiums to the PBGC, and benefits are still insured if the company subsequently goes under.

"The good news about a pension freeze is that you haven't lost anything that you've already earned," says Steve Metz, of PricewaterhouseCoopers HR Services. A typical pension plan is designed so the value of benefits grows slowly when you're young and ramps up dramatically as you approach retirement age. A frozen pension is not a big deal for young workers who aren't vested yet or who are accruing benefits at a very low level. It's also not a tragedy for someone who is 64 and has already earned 90% of his or her pension accrual. The biggest losers are those mid-career workers in their fifties with many years of service.

Filling the gap

Employers recognize that defined-benefit plans have been an important safety net for past retirees and their survivors. That's why many of the companies that are phasing out their pension plans are beefing up their 401(k) plans at the same time. IBM, for example, boasts that its new 401(k) plan will be one of the richest in the country and will set a standard in the U.S. Among other things, IBM is increasing the match rate from 50 cents to $1 and making additional employer contributions of 1% to 4% of pay.

If you work for a company that has announced a pension freeze or that is likely to, consider this your wake-up call. By starting now, you should be able to patch together a personal retirement safety net that is just as strong. Here's how.

Get with the program. Enroll in your company's 401(k) plan as soon as you are eligible. Although about three out of four workers have gotten that message, it still isn't reaching younger workers in their twenties, who have the most to gain from the power of compounding.

Boost your contributions. Make sure you contribute at least enough to capture your company match. Almost one-fourth of workers who participate in their employer's plan don't, leaving free money on the table. The most common match is 50 cents on the dollar, up to 6% of pay. If you're 50 or older, you have a special opportunity to make a catch-up contribution of $5,000 over and above this year's annual limit of $15,000.

Trim company stock. Financial experts recommend that you allocate no more than 10% of your portfolio to company stock. Just ask some former Enron employees what happens when your job and your retirement investments all depend on a company that collapses like a house of cards.

Protect stay-at-home spouses. Just because one spouse takes a break from the workforce doesn't mean retirement savings should take a holiday. On the contrary, the stay-at-home spouse's future retirement income becomes even more important. Although traditional pensions guaranteed a survivor benefit equal to 50% of the worker's benefit, most retirees choose to take their 401(k) savings as a lump sum. "The risk is that women who live longer will be left with inadequate savings in the end," says Alice Munnell, director of the Center for Retirement Research at Boston College.

Consider a government job. Even though private-sector employers are phasing out their pension plans, federal, state and local government employers will continue to offer them, for the most part. "Government will be the last bastion of defined-benefit pension plans," predicts Metz.

The 401(k) of the future

The demise of defined-benefit pension plans in the private sector could shape how 401(k) plans evolve in the years ahead. "As employers discover that workers aren't progressing in terms of saving and managing on their own the way they need to be, the pendulum is moving back toward giving people more care and protection, " says Syl Schieber, of Watson Wyatt Worldwide.

Someday soon, the automatic 401(k) may become the norm. You'll be automatically enrolled in your plan as soon as you're eligible. Your employer will select an appropriate contribution rate -- usually 1% to 3% of your pay initially -- and increase it each year as your salary grows. And you'll be automatically invested in an age-appropriate diversified portfolio, such as a target-retirement fund. And while it hasn't happened yet, in the future, a portion of your 401(k) account balance might be annuitized at retirement to provide a steady stream of income -- creating a modern-day version of an old-fashioned pension check.

IN SEARCH OF A SOLUTION

Social Security Reform on Hold

It looks as if President Bush has thrown in the towel on his attempt to make Social Security reform part of his legacy. Although the first of the baby-boomers are inching closer to claiming retirement benefits, the nation is no closer to a consensus about how to restore balance to the Social Security program. Starting in 2017, the system is projected to pay out more in benefits than it collects in taxes. And by 2040, the trust fund that is set up to cover the gap will be exhausted. At that point, tax revenues will cover just 70% of promised benefits.

Recent news about companies freezing their pension plans could potentially make it even more difficult to create individual accounts within Social Security -- a key feature of Bush's original proposal. Without defined-benefit plans, says Karen Holden, a professor of public affairs and consumer science at the University of Wisconsin, Social Security becomes the sole source of guaranteed retirement income in a world where there's increasing market volatility.

"The situation with private-sector pensions has really clarified itself, and we should now take the whole discussion about Social Security reform from the top again," adds Alicia Munnell, director of the Center for Retirement Research at Boston College.

The sooner that happens, the better. With each passing day, solvency becomes more difficult and more painful to achieve. As 2017 approaches, the odds grow stronger that reforming the system will require a combination of benefit cuts for higher-income beneficiaries, higher taxes for future generations, and delayed retirement for everyone.

"The Vanishing Safety Net" is from the all-new edition of Kiplinger's Retirement Planning. For more sound planning strategies and carefully researched investment advice, order your copy today.