401(k) Tips

Why did 401k replace pensions?

Most employers have phased out pension plans in favor of defined contribution plans like 401(k). Find out why 401k replaced pension plans.

3 min read

Before the 1980s, pension plans were the most popular retirement plans for workers in the private sector. After years of service, you could expect to be rewarded with periodic checks lasting through your retirement. These checks were solely funded by the employer, with no deductions from the employee’s paycheck. However, the 1978 Revenue Act gave employees a new tax-advantaged way to save for retirement through 401(k)s.

Most companies have replaced pension plans with 401(k) plans due to the high ongoing liabilities involved in managing the plan. Pension plans are fully funded by the employer, and the funding comes from the company’s earnings. By replacing pension plans with 401(k), employers are shifting the burden of saving for retirement to employees. This reduces the company’s ongoing liabilities and boosts its overall earnings.

How defined benefit plans work

Before the 1980s, pension plans were the most popular retirement plans for workers, and a select number of employers still offer these plans to their employees. Typically, employers bear the responsibility of contributing to a pension plan on the employee’s behalf, and these benefits are determined based on the employee’s years of service.

For employees, pension plans allow them to access retirement benefits fully funded by the employer. An employee gets to keep all the pension benefits calculated based on their years of service, and they can predict how much they will receive in the next period's payout.

However, employers consider pension plans a liability to the company since it is funded from the business earnings, which can derail a company’s competitiveness. Typically, the employer must predict how many years the retirees are going to live and tie the pending liabilities to projected company earnings.

Phasing out pensions

Since maintaining pension plans is an ongoing liability for a company, most employers have been freezing defined benefit plans like pension, in favor of defined contribution plans like 401(k). Unlike pension plans, the employer creates a 401(k) plan where its employees can defer a portion of their paycheck up to a specific annual contribution limit for their retirement.

Switching from a pension plan to a 401(k) plan means employers move from a plan where the company pays the entire retirement benefits on behalf of employees, to a system where employees shoulder most of the cost and any risks associated with the 401(k) plan. After the Revenue Act of 1978, most private sector employers started freezing their pension plans by stopping further funding as they shifted to employee-funded defined contribution plans.

Data from Social Security showed that the number of workers in pension plans declined from 38% in 1980 to 20% in 2008. In comparison, defined contribution plans jumped from 8% in 1980 to 31% in 2008. This shows that, in less than two decades, a majority of workers had jumped from a traditional pension plan to a 401(k) plan. Some of the companies that have shifted from pension plans to 401(k) plans include General Electric, IBM, Motorola, and Verizon. 

Why did 401(k) replace pensions?

Here are some of the reasons why companies moved from pension plans to 401(k):

Ongoing liability

Defined benefit plans like pension plans are funded by the employer, and this means the employer must dig into its corporate earnings.

With an increasing number of employees retiring each year, it means employers must continually tap into their earnings to meet their increasing pension obligations. The ongoing liabilities put the company at risk of not being able to meet their pension benefits to retired workers.

Increased life expectancy

With improved healthcare, there has been an increase in life expectancy, with more retirees living longer. This means a company will make pension payments over a longer period to an increasing number of retiring workers. Such liabilities are only feasible if the company maintains consistent growth into the future.

The declining ratio of workers to pensioners

In most developed countries, there are shifting demographics such as a declining ratio of workers to pensioners. This has been contributed by the lower birth rates in these countries, hence decreasing the number of workers relative to the retirees.

The ratio of workers to pensioners has declined from 7.2 people (age 20 to 64) for every person age 65 or older in 1950, to 4.1 in 2010, and it is expected to reach 2.1 by 2050. 

Impacts of Switching from Pension Plans to 401(k)

If your employer moved from traditional pension plans to a 401(k) plan, it means you will be responsible for contributing money for your retirement. Typically, 401(k) plans allow employees to make tax-deferred contributions to the 401(k) plans up to the annual IRS limit. For 2021 and 2022, you can contribute up to $19,500 and $20,500 respectively.

Some employers may offer matching contributions to employees. However, the matching contributions are less than what the employer would have contributed to a pension plan. Usually, the employer may offer a partial or full match of your contributions.

The contributions made to a 401(k) are invested in various investment options provided by the employer. If the markets go up, 401(k) investors will earn investment income on their contributions, and these monies will grow through compounding over the employee’s working life.

However, employees who got laid off as companies downsized their workforce were left to fend for themselves. With no periodic pension checks forthcoming, these employees had to find ways to fend for themselves so that they can afford their daily expenses.