Employer-sponsored retirement plans can basically be divided into two categories: defined benefit vs defined contribution.
In a traditional defined benefit pension plan, an employee receives a set monthly amount once they reach retirement. The amount they receive is based upon the participant’s salary and length of service with the company. They continue to receive that amount (plus cost of living increases) every month for the rest of their lives.
In contrast to traditional pensions where the amount of the benefit is defined, most workers today participate in defined contribution plans like the 401(k). DC plans get their name because it is the amount of the contribution that is defined instead of the benefit. Employees contribute a portion of their salary into a retirement account where it can be invested in stock, bonds, mutual funds, etc. Some companies make a matching contribution up to a certain percentage. The account grows through contributions and investment earnings until retirement. In a DC plan, there are no guarantees how much (if any) of your money will be left when you retire. If you make poor investment choices you might not have anything at all.
Today defined benefit plans are practically extinct in the private sector. Most companies that do have a traditional pension plan only keep them open for long-time employees who were grandfathered in. New hires are enrolled into a defined contribution plan instead.
Why the switch from defined benefit to defined contribution?
In a word…sustainability. As more and more workers retired and began collecting benefits, companies had to devote more and more resources to pay for those promised benefits. Before long they were crippled by the enormous payments they had to make to fund the pension plan.
And it’s not just the private sector that is affected, government pension plans are now being targeted for reform. New Jersey governor Chris Christie is one of the loudest proponents for pension reform:
“I know these reforms will not be popular with everyone,” said Christie. “I also know that failure to follow through with dramatic pension reform will imperil the system for everyone, and that failure to control and share costs of health care benefits will continue to eat away at our state and local budgets. We must reverse the damage caused by fairy tale promises that have fattened benefits and pensions to unsustainable levels while ballooning unfunded liabilities to breathtaking levels.”
Those are strong words and only time will tell how successful Christie will be in implementing reforms. But I have to give him credit for trying to tackle the issue instead of sweeping it under the rug and leaving it for “the next guy” to worry about.