Pensions provide a guaranteed income stream for retirees, but the company funding them must remain in business. Companies folding and the cost of funding pensions are reasons why employers have abandoned them over the last 20 years.
Pensions are retirement plans offered by private companies, the military, federal, state and local governments, plus a variety of other organizations – including employer associations, trade unions and labor unions. They're a type of defined benefit (DB) retirement plan, in which a worker's retirement fund receives regular contributions over the course of their working life.
A preset formula determines the contributions, and they can come either wholly from the employer or, in some cases, from the employer and the employee. Often, funds are invested in interest-bearing or capital appreciating accounts, in which they grow tax-deferred until withdrawal.
The worker collects from the assembled pool of money at a defined period of time when the employee (or retired employee) is at least age 55. The goal is to provide a retiree with a regular source of post-retirement income that is similar to a salary.
Most pensions also come with insurance guarantees that provide for a continuing stream of income for the life of the retiree, or for a retiree's spouse or survivors, should the employee die before receiving all promised benefits.
History of Pensions
The first known DB plan may have been implemented in ancient Rome. Records indicate that professional soldiers were given a pension after 20 years of service. Military pensions were also common in the 19th century: Many nations, including the United States after the Civil War, awarded lifetime benefits to combat veterans.
Late in the 19th century, the German Empire guaranteed income through a defined benefit to all elderly retirees. Great Britain adopted a similar program early in the 20th century. In 1935, the U.S. government and President Franklin Roosevelt enacted the world's largest defined benefit pension plan for its retired persons over age 65 when it created the Social Security Administration.
The first private-sector pension plan was introduced by American Express in 1875. As time went on, and more and more employers began to recognize their value as worker recruitment and retention tools, a growing number of private companies began offering defined benefit pensions to their employees.
Especially popular were plans in which pension funds were invested in annuities that promised the possibility of lifetime payments to retirees after they left the workforce. In 1974, the Employee Retirement Income Security Act (ERISA) required that all private industry pensions offer annuity benefits.
U.S. private sector pension plans grew enormously popular during the 1930s and 1940s for two reasons: They placated the demands of organized labor, which was at the height of its bargaining powers, and they served as de facto pay raises for workers coping with the federal government's national wartime wage freeze.
Public pensions originated in 1920 when Congress created the Civil Service Retirement System to provide a retirement program for civilian federal employees. State and local governments created pension systems during the Great Depression. These local plans were deemed necessary because the new Social Security system specifically excluded state and city municipal workers.
In addition, many municipalities were unable to offer salaries that were competitive with those in the private sector. They responded by offering generous pension plans with guaranteed cost-of-living adjustments. Forty-five 45 states had retirement systems in place by 1961.
Collecting Your Pension
If you have a company-provided or public pension, you likely will have to make a one-time, irrevocable decision on how you want to receive your benefits once you leave the work force. Three common choices:
- An annuity provides a series of regular payments for life
- A lump-sum payout
- A combination of the two
Your choice will depend on your plan's options, marriage status, retirement needs, current financial situation and life expectancy.
By law, a pension plan must provide a lifetime annuity option that pays benefits until you die or until a surviving beneficiary passes away. Your plan may offer a lump-sum option in lieu of, or in addition to, a life annuity.
Generally, the annuity option provides greater long-term security but with less flexibility on how and when you can use your money. The lump-sum option allows you to invest your benefits any way you want. With a lump-sum payment, you can purchase an annuity contract, open an IRA, invest in the stock market or leave your funds to designated beneficiaries.
Pensions Not as Prevalent Today
For several reasons beginning in the 1980s, defined benefit pension plans in the private sector were increasingly replaced by defined contribution (DC) plans such as IRAs and 401(k)s. One reason: DC plans are generally more cost-effective from an employer's point of view. For example, they are exempt from Cost of Living Adjustment (COLA) provisions and they require smaller contributions.
In addition, even though they don't provide the same level of security associated with pensions, employees are empowered by DC plans because they can control investment decisions.
Another reason for the decline in defined benefit plans is their relative fragility. For example, automobile manufacturer Studebaker went out of business in 1966. Because it no longer existed as a functioning company, its pension plan also disappeared. Realizing that private companies could fail and leave retirees without their promised post-work benefits, Congress created the Pension Benefit Guarantee Corporation (PBGC), a federal agency that partially guarantees private pensions.
Despite the decline of DB plans, about one in three older adult Americans receives some sort of pension from a private, union, federal, state, local, military or veterans pension. Private sector pensions hold more than $2.2 trillion in assets and cover approximately 44 million working Americans.
Federal pensions serve 2.3 million active civilian employees. State and local pensions, with total assets of $2.8 trillion, cover 14.8 million active participants and 4.6 million inactive members.
Pensions in Trouble
All defined benefits plans face two limitations: Inflation and the potential insolvency of the business or organization that sponsors them. In the first case, a defined benefit can lose its purchasing power over time as inflation decreases the value of money. Congress addressed this problem by mandating COLAs that automatically adjust the amount of a defined benefit to keep pace with inflation. Most pensions today have some sort of COLA provision similar to one employed by the Social Security system.
The second threat to pensions is much more difficult to remediate. Even if the PBGC steps in to honor pension costs for companies that can no longer afford them, it will neither cover the full costs, nor will it repay any negotiated COLAs.
Also, the PBGC doesn't cover public pensions at all, and these plans now are in the most jeopardy. In many instances, governments that offered these pensions lack the money to fund them. All too often, state and local jurisdictions simply hoped that future revenues would meet those needs when required.
In Detroit, the largest American city ever to file for bankruptcy, public service pension boards are fighting to keep their accrued, vested pension amounts from being undercut as the bankruptcy court judge initiates the process of repaying the city's many creditors.
On the federal level, the U.S. Postal Service (USPS) carried a $16 billion deficit in 2012 in large part because of a Congressional mandate that forced the agency to pay $11.1 billion of last year's revenues into future retirees' pensions.
Pensions for Veterans
Today, those who serve in the military and meet certain qualifications may qualify for the Veterans Pension, which is a need-based, monthly monetary benefit that is tax-free.
Those minimum requirements include at least 90 days of active duty during a wartime period (WWI, WWII, Korean War, Vietnam War or the Gulf War) or at least 24 months if you entered active duty after Sept. 7, 1980.
Applicants also must be:
- Age 65 or older, or
- Completely and permanently disabled, or
- A nursing home patient receiving skilled nursing care, or
- Receiving Social Security Disability Insurance (SSDI), or
- Receiving Social Security Income (SSI)
Pensions for Survivors of War Veterans
Also available to families of veterans is the Survivors Pension. This program is available for low-income, unmarried surviving spouses or unmarried children of deceased veterans.
In order for the unmarried spouse of the survivor to qualify, the deceased veteran must have met the following requirements:
- Been in service on or before Sept. 7, 1980, served at least 90 days of active service, with at least one day during a wartime period.
- If service began after Sept. 7, 1980, the veteran must have served at least 24 months or the full term of duty with at least one day of wartime service.
The requirements for the child of the deceased veteran applying for benefits include:
- Must be under 18, or
- Under age 23 if enrolled in a school approved by the VA, or
- Permanently disabled and incapable of self-support as a result of a disability before age 18
Income requirements must be less than amount set by Congress.
Supplemental Pension Benefits for Veterans
Veterans and survivors with additional needs, who require assistance or must remain at home, can apply for supplemental income such as Aid & Attendance (AA) and Housebound plans.
AA benefits are added to monthly pension if applicant:
- Needs the help of another person to perform daily duties like bathing, feeding, dressing, adjusting a prosthetic device
- Remains bedridden
- Is a patient in nursing home and suffering from mental or physical incapacity
- Eyesight limited to a corrected 5/200 or less in both eyes or concentric contraction of the visual field to 5 degrees or less
An increased monthly pension amount for housebound applicants is determined if applicant is "substantially confined" to the immediate area because of a permanent disability.
Future of Pensions in America
Despite widespread public support, the future of pensions in America is unclear. There are no trends that show more pensions are being created. Most private employers have abandoned them in favor of DC plans.
Between 1977 and 2007, the number of participants in defined contribution plans rose from 14.6 million workers to 66.9 million, while the number of people enrolling in defined benefit plans dropped from 28.1 million workers to 19.4 million.
But today's workers prefer the security of a pension. According to a recent study by the National Institute on Retirement Security (NIRS), some 83 percent of Americans favor pensions and believe all retirees should have access to one during retirement. More than 90 percent of respondents said they would favor a new type of universal pension plan that is available to everyone, is portable from job to job and provides a monthly payment for anyone who contributes to it.
In addition, 73 percent of Americans support pension benefits for public employees for a variety of reasons, including the fact that public employees have contributed to their accounts, and that some of them work at high-risk jobs for low pay.
While many public pensions remain, they are under attack in many quarters for being too generous to participants and too wasteful for employers.
The NIRS study also consulted a cohort of the nation's Millennials – those born between the early 1980s and the early 2000s. Although these workers are still far away from the time they can collect a pension, 84 percent are supportive of a new pension system. They also believe lawmakers need to make retirement a higher priority than they currently do.
Selling Your Pension
Because many pensions are funded by annuity accounts, they are similar to the kinds of structured settlements received by personal injury plaintiffs, workers' compensation recipients, and lottery winners. As such, they attract the attention of structured settlement buying companies interested in purchasing the rights to future payments in exchange for lump-sum buyouts.
Unlike the sale of other types of structured settlements, the sale of part or all of someone's future pension payment rights may be illegal or unenforceable, according to some legal experts and a growing number of judges. In fact, federal law already prohibits the assigning of military and civil service pensions to another party and the Internal Revenue Service (IRS) code has language prohibiting the sale of private pensions.
Getting around these prohibitions has proven to be a tricky maneuver for both the buying companies, as well as those who wish to sell their pension payment rights. Various strategies have been attempted in order to prevent these transactions from having to be approved in court, as is necessary for all other types of structured settlement and annuity transfers.
In some cases, the buyout is termed a "pension loan", "pension advance" or a "mirrored pension," rather than an outright sale. In other cases, pensioners are required to route their checks into a bank account owned jointly with the buying company.
State and federal policy makers recently launched investigations into the pension-buying industry, and an increasing number of court cases resulted in the invalidation of "under the radar" pension sales. Both the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) alerted pensioners to be wary about accepting cash buyouts.
At the same time, retail investors have been warned that portfolios of bundled pensions they may have purchased from buying companies could be at risk.
If you are contacted by a buying company wishing to purchase your future pension payment rights, make sure that you contact your plan administrator or a knowledgeable attorney before agreeing to a transfer agreement.
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