In recent years, traditional retirement plans, also called pension funds, have been gradually disappearing from the private sector. Today, public sector employees, such as civil servants, are the largest group with active and growing pension funds. This article explains how other traditional pension plans work.
Key points to remember
- Traditional defined-benefit pension plans are disappearing from the retirement landscape, especially among private employers, but many still exist.
- The pension plans are financed by contributions from employers and occasionally from employees.
- Pension plans for public employees tend to be more generous than those of private employers.
- Private pension plans are federally regulated and eligible for Pension Benefit Guaranty Corporation coverage.
How pension funds work
The most common type of traditional pension is a defined benefit plan. After retirement, employees receive monthly benefits from the plan, based on a percentage of their average salary during their last years of employment. The formula also takes into account the number of years of work for this company. Employers, and sometimes employees, contribute to fund these benefits.
For example, a pension plan could pay 1% for each year of service of the person multiplied by his average salary for the last five years of employment. Thus, an employee with 35 years of service in this company and an average salary of $50,000 at the end of his career would receive $17,500 per year.
Private pension plans offered by corporations or other employers rarely have cost-of-living indexation to adjust for inflation, so the benefits they pay may decline in terms of purchasing power. over the years.
Public employee pension plans tend to be more generous than private plans. For example, the nation’s largest retirement plan, the California Public Employees’ Retirement System (CalPERS), pays out 2% per year in many cases. In this case, an employee with 35 years of service and an average salary of $50,000 could receive $35,000 annually.
In addition, public pension plans generally have a cost-of-living escalator.
How pension plans are regulated and insured
There are two types of private pension plans: single-employer plans and multi-employer plans. These generally cover unionized workers who may work for more than one employer.
Both types of private plans are subject to the Employees Retirement Income Security Act (ERISA) of 1974. It aimed to put pensions on a sounder financial footing and also created the Pension Benefit Guaranty Corporation (PBGC) .
The PBGC acts as a pension insurance fund: employers pay the PBGC an annual premium for each participant, and the PBGC guarantees that employees will receive a pension and other benefits if the employer goes bankrupt or decides to terminate his retirement plan.
The PBGC will not necessarily pay out the full amount retirees would have received had their plans continued to operate. Instead, it pays up to certain maximums, which can change from year to year.
In 2021, the maximum guaranteed amount for a 65-year-old retiree in a single-employer plan who takes their benefits as a single life annuity is $6,034.09 per month. Multi-employer plan benefits are calculated differently, guaranteeing, for example, up to $12,780 per year to a person with 30 years of service.
ERISA does not cover public pension funds, which instead follow rules set by state governments and sometimes state constitutions. PBGC also does not insure public plans. In most states, taxpayers are responsible for footing the bill if a public employee plan is unable to meet its obligations.
How pension funds invest their money
ERISA does not dictate the specific investments of a retirement plan. However, ERISA requires plan sponsors to act as trustees. This means that they must put the interests of their clients (future retirees) before their own.
By law, the investments they make are supposed to be both prudent and diversified so as to avoid large losses.
The traditional investment strategy of a pension fund is to spread its assets between bonds, stocks and commercial real estate. Many pension funds have moved away from actively managing equity portfolios and only invest in index funds.
An emerging trend is to invest money in alternative investments, in search of higher returns and greater diversity. These investments include private equity, hedge funds, commodities, derivatives and high yield bonds.
The American Rescue Plan Act of 2021 includes provisions to help the PBGC strengthen financially distressed multi-employer plans through 2051.
The state of pension funds today
While some pension funds are healthy today, many others are not. For private pension schemes, these figures are reflected in the financial obligations assumed by their insurer, the PBGC.
At the end of its 2020 fiscal year, the PBGC had a net deficit of $48.2 billion. This consisted of a $15.5 billion surplus in its single-employer program, but a $63.7 billion deficit in its multi-employer program.
The Congressional Research Service reported that “PBGC expects the financial position of the single-employer program to continue to improve, but the financial condition of the multi-employer program is expected to deteriorate significantly over the next 10 years.”
However, this assessment was written before the passage of the American Rescue Plan Act of 2021 in March 2021. It includes provisions intended to help the PBGC strengthen multi-employer plans. Plans facing serious financial hardship can apply for special assistance in the form of a one-time lump sum payment calculated to cover plan obligations through 2051. Rather than insurance premiums, the money to fund this program must come from the general tax revenues of the US Treasury.
National and local pension schemes also present a mixed picture. While a handful of state plans have 100% of the funding they need to pay their estimated future benefits, most have considerably less. The Equable Institute recently predicted that “the average capitalization ratio will fall from 72.9% in 2019 to 69.4% in 2020”.