Math For Lost Pensions
Albert B. Crenshaw
Sunday, March 12, 2006
As company after company across the country freezes or
terminates traditional pensions, typically at the same time
shifting to new or sweetened 401(k) plans, workers face a
new and very important question:
How much do I need to save to make up for pension benefits I
was expecting and now won't get?
The answer, for tens of thousands of mid-career workers, is
Exactly how much depends on so vast a number of variables --
including the worker's age, the generosity of the original
plan, the rate of return achieved under the 401(k) -- that
no rule of thumb can be reliable.
But a study by pension expert Jack L. VanDerhei of Temple
University and the nonprofit Employee Benefit Research
Institute (EBRI) finds that middle-age workers who had
generous pensions and who don't get particularly high 401(k)
returns, would have to sock away 20 percent of pay to save
enough to buy an annuity to replace lost pension benefits.
The money doesn't all have to come from workers. It could
be contributed by employers or could come from a combination
of employee contributions and employer match, as is common
today. But, since the cost of traditional pensions is
commonly borne entirely by employers, whatever additional
money a worker has to put in represents a pay cut.
That cut can come today, if the worker ponies up to have
more retirement income, or later in the form of reduced
retirement income. But either way, it's a cut.
Let's look at a specific example that VanDerhei worked out.
Assume a worker joined a company as he turned 30, expecting
to work to age 65. Assume further that the company has a
"final-average defined benefit" pension plan, a common type
for middle managers, and that the plan promised a benefit
calculated by multiplying the number of years worked times
the average of the three highest years of pay times 1
Now assume that the worker reaches age 50 this year and is
earning $70,000. If his pay goes up 3 percent every year,
at 64 he will make $105,881, and the average of his "high
three" years will be $102,827.
If the pension plan remained in place, his annual benefit
would work out to:
$102,827 x 35 x 0.01 = $35,989
But look what happens if the plan is frozen this year,
making his high-three average $67,980 and his years of
service 20. His annual benefit, beginning at age 65, would
$67,980 x 20 x 0.01 = $13,596.
This would leave him with $22,393 a year to make up out of
his 401(k). VanDerhei figured that the worker would have to
accumulate $299,536 in his 401(k) to buy an annuity "to fill
in the gap created by the pension freeze."
To get there, assuming the asset allocation common for
someone his age -- about 63 percent stocks at age 50 and
declining to about 55 percent at retirement -- and a 10.5
percent return on stock and 5.5 percent on bonds, he (and/or
his employer) would have to contribute 12.87 percent of his
pay for each of the succeeding 15 years.
If he gets only 8 percent return on his stocks, though, the
required contribution rises to 14.3 percent of his pay.
Looking at hundreds of plans for his study, which was
published last week by EBRI, VanDerhei found that to make up
for a frozen final-average plan -- and such plans vary
widely in their generosity -- the additional share of pay
that workers and/or employers in the median plan would have
to contribute to make up for lost benefits, would be 8.1
percent if their 401(k)s were assumed to earn an 8 percent
return. To make participants in three-quarters of all final
average plans whole, the contribution rate on average would
have to be 16 percent of pay.
If their 401(k) plans earned only 4 percent, however, a
contribution rate of 13.5 percent would be necessary to
cover participants in the median plan, and 21 percent to
cover workers in three-quarters of such plans.
Other types of pension plans with less-generous benefit
formulas would require lower contributions. Cash-balance
plans, in which workers have a hypothetical account that is
credited with a percentage of pay each year along with
interest, would under some scenarios require new 401(k)
contributions as low as 2.7 percent of pay to offset a
The good news, if you want to call it that, is that younger
workers could, in theory, make up for their lost pension
benefits with fairly modest 401(k) contributions. That is
because they would have many years for their k-plan balances
But even those workers would have lost something: risk
In a defined-benefit plan, the investment risks are borne by
the employer, which is given tax benefits to pre-fund its
pension obligations but is required to make up for deficit
if the investment returns fall short.
When a company shifts to a 401(k), the risks don't
disappear; they are simply shifted to the worker. General
Motors Chairman Rick Wagoner acknowledged as much as the
company announced the freezing of its pension plans for
white-collar workers. "These changes will reduce financial
risks ... for GM," he said.
Further, there is no guarantee that the improved 401(k)
matches that have accompanied pension freezes at GM,
International Business Machines and elsewhere, will continue
through an employee's career. Generally, companies are free
to raise, lower or eliminate their matching programs as they
And finally, the increased limits that allow workers to
contribute as much as $15,000 to their 401(k) plans this
year -- plus $5,000 for workers 50 or older -- are scheduled
to expire at the end of 2010. At that point, unless
Congress acts, the limit would revert to $10,500 plus
inflation adjustments, meaning that to contribute the
amounts VanDerhei's study indicates are needed, workers
would have to make a portion of their payment in after-tax
Today, the private pension system provides about $120
billion to retirees and their families each year, the fruit
of years of contributions and investments by employers.
Some big pension plans are in trouble, but most are not.
Nonetheless, companies, including healthy ones, are shedding
such plans wherever they can to rid themselves of the risk
and expense. So workers are left to cast about for a system
that decades from now will provide the equivalent of $120
billion a year, or see their living standards slide toward
What's it gonna be, folks?