Must You Work Until You Drop?
By Janet Novack, Forbes.com - Aug. 30, 2006
 
Will you have enough pension income to stop laboring some day? It's a timely question, and not just because of the upcoming Labor Day holiday.
Earlier this month, President George W. Bush signed a rewrite of the nation's pension laws that will likely hasten the disappearance of traditional defined-benefit pension plans--the kind that are funded entirely by the company and promise retirees a fixed stipend each month for life. And this week DuPont (nyse: DD - news - people ) announced it will cut by two-thirds its contributions to its traditional pension plan, close off the plan to new employees and boost contributions to employees' 401(k) accounts.

It's clear workers are going to have to save more, stay on the job longer and pay more attention to the investment of their own pension funds if they want a comfortable retirement. "People have got to get out of their mindset that they can get out of their office at 55, get in their Winnebago and drive around for the rest of their days. They can't afford it, and their employers can't afford it," says retirement policy guru Sylvester Schieber, director of North America benefits consulting at Watson Wyatt Worldwide.

The majority of workers needn't panic, however. They should be able, with some savings discipline and help from their employers, to build up substantial retirement kitties. (The 71 million workers, mostly at smaller businesses, who aren't offered any employer-sponsored pensions or retirement savings programs have a bigger challenge.)

A little historical perspective: Companies first embraced pensions because they wanted older workers to be able to quit when their productivity fell. To ease workers out even earlier, they piled on early retirement incentives. But with longer life expectancies and more competitive markets, those old promises began to seem unaffordable, or at least too risky. Corporations don't want to be bogged down by legacy costs. "They don't want to be the next auto or airline industry," says benefits lawyer John A. Nixon, a partner with Blank Rome in Philadelphia.

The result: Only 39% of covered workers still have defined benefit plans, down from 83% in 1980. The rest have only defined contribution plans, such as profit-sharing plans and 401(k)s.

The movement away from defined benefits won't be reversed by the new law. In fact, the law's stiffer funding requirements for defined-benefit plans will likely push companies with underfunded plans to freeze them, says Jack VanDerhei, a Temple University professor and fellow at the Employee Benefit Research Institute. Moreover, if the Financial Accounting Standards Board adopts proposed pension accounting changes, even companies with well-funded plans may bow out, he warns. (Right now, projected pension liabilities are reported as a footnote. Under the proposal, companies would have to include them on their balance sheet,)

But just because a company has frozen or cut its defined benefit plan doesn't mean it is leaving workers to fend entirely for themselves. A decent pension plan is still valuable as a recruiting tool and to induce the departure of older workers. "Employers are not social welfare institutions, but they're worried that people will get to retirement age and won't have accumulated enough assets to be able to leave," Schieber observes. (Remember, because of laws against age discrimination, a company can't just boot the old coots.)

DuPont will contribute 3% of each employee's pay to a 401(k) account, and it will then match an employee's contributions, dollar for dollar, up to 6% of pay. A worker who socks away 6% of his salary, for example, gets an additional 9% from DuPont.

Yes, DuPont will be spending less on pensions. But some employees--for example, young folks who leave DuPont for another job well before retirement--could end up better off than under the old scheme. And workers who stay can build substantial retirement funds.

If a 30-year-old employee consistently socks away 15% in a 401(k) plan, gets a 4% raise each year and earns 6% a year on his investments, at age 65, his 401(k) balance will equal 7.3 times his final year's pay. With that wad, a male worker could buy a lifetime annuity equal to 63% of his final year's pay; a female retiree, with her longer life expectancy, could buy an annuity worth 59% of her final pay. A worker who begins the 15% savings regimen at 40 would have a sum equal to 4.7 times his final year's pay at 65; one who starts saving at 50 would end up with 2.6 times his final year's pay.

What's to say workers will actually get around to saving, or that they'll invest what they save wisely? Significantly, the new pension law allows employers to automatically enroll employees in their 401(k) plans and to direct workers' savings into a default portfolio of balanced (and presumably sound) investments. (Workers can still opt out of the plan or actively pick funds themselves. But the idea is that inertia will work on the side of savings.)

Now, here's the bad news for workers: A little-noticed provision in the new law allows employers who use automatic enrollment to contribute less to their workers' 401(k)s and still get out of something called "nondiscrimination testing." These tests limit what highly paid workers can put in a tax-deferred retirement plan if rank-and-file workers don't also save. It sounds like sour grapes, but the point is to give the bosses an incentive to get lower-paid workers into the plan.

Under the old law, if a worker contributed 5% of his pay to a 401(k), the company had to kick in 4% to get out of the nondiscrimination test. And that 4% had to be immediately vested--meaning if an employee left, it was his to keep.

Under the new law, if a company uses automatic enrollment and wants to get out of the nondiscrimination test, it need only give a 3% contribution to a worker who saves 5%. Moreover, that 3% doesn't have to be fully vested until an employee has been with the company two years. Happy Labor Day from Congress.

 

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