Benefits and Challenges: From DB to DC Plans, Part 1

July 2024

The landscape of retirement planning in the United States has undergone significant transformation over the past several decades. In Part 1 of this two-part article, we will cover the transition from defined benefit (DB) plans to defined contribution (DC) plans, which reflects broader economic, regulatory and demographic changes. While DB plans once played a more dominant role in providing retirement security, they were not without their limitations. Understanding the rise of DC plans and how they have evolved to serve a broader spectrum of workers is important during a time of heated debate on the issue.

The DB Plan Era

DB plans were the cornerstone of retirement security for many American workers during the mid-20th century. Under these plans, employers guaranteed a specified monthly benefit upon retirement, often based on factors such as salary history and years of service. This promise of a stable, predictable income in retirement made DB plans very attractive.

At their peak in the mid-1980s, DB plans covered about one-third of American workers. Despite their appeal, these plans were far from universal. Many small businesses did not offer DB plans, leaving significant portions of the workforce uncovered. Additionally, even among those who had access, not all employees stayed with a single employer long enough to vest fully in their pension benefits.

Moreover, the average annual payout from DB plans was modest. According to recent research, the median private pension benefit was approximately $11,000 annually in 2022. This amount, while helpful, is likely insufficient to cover all retirement expenses, particularly as healthcare costs continue to rise.

The Shift to DC Plans

Workers in DB plans had security in part because their employer assumed the investment risk and usually worked with professional investment managers. Most analyses suggest that DB plans are more efficient than DC plans at producing retirement income per dollar applied. This system was not sustainable, though, and several factors contributed to the decline of DB plans and the rise of DC plans:

Cost and Risk Management: For employers, DB plans became increasingly expensive and unpredictable. The responsibility of funding future liabilities, managing investments and ensuring the solvency of pension funds created significant financial risks.

Regulatory Changes: The passage of the Employee Retirement Income Security Act (ERISA) in 1974 set new standards for retirement plan funding, benefit protections and fiduciary responsibilities. While ERISA primarily aimed to protect participants in existing pension plans, it also created a more favorable environment for DC plans. The Revenue Act of 1978 further facilitated this shift by introducing Section 401(k), allowing employees to defer compensation into retirement accounts on a tax-advantaged basis.

Workforce Mobility: According to the Bureau of Labor Statistics (BLS), the median tenure for all wage and salary workers was approximately 4.1 years as of January 2022. DB plans, which often require long vesting periods, seem less suited to a mobile workforce. DC plans offer portability, allowing employees to roll over their savings to new employers or individual retirement accounts (IRAs).

Issues and Challenges

Most would agree that the employer-based retirement system is designed to provide a structured and effective way for employees to save for retirement. One challenge is that stakeholders do not all share the same expectations of retirement plans. Who assumes the cost and risk? Is the emphasis on access or equity? Advocates of different systems and plans defend their preferred system using different data and proof points. It would be helpful to have a standard set of measures to gauge the effectiveness of plans.

Critics of the DC system point out that low-income workers may not benefit as much as other workers. Low-income workers often have less disposable income, making it harder for them to contribute significant amounts. This results in smaller retirement savings compared to higher-income workers. (There are annual plan contribution limits.) Additionally, many low-income workers have to prioritize immediate financial needs, such as housing, healthcare and education, over long-term retirement savings.

Income challenges are a structural issue, and the retirement system reflects that. Social Security was initially created to provide financial assistance to retired workers aged 65 and older, ensuring they had a source of income after leaving the workforce. This was important at a time when the elderly were often living in poverty from a lack of retirement savings and pensions. Shoring up Social Security will help address some of the issues lower-income workers will face in retirement.

DC plans, particularly 401(k) plans, have become the predominant form of employer-sponsored retirement plans in the United States. At the end of 2023, 401(k) plans held approximately $7.4 trillion in assets, serving around 70 million active participants and millions of retirees. LIMRA research found the majority of people believe that workers have a responsibility to save for their own retirement.

DC plans were not intended to be the main or only vehicle to save for retirement. Since their inception, though, these plans have evolved to better meet needs, incorporating innovations designed to facilitate saving and expand access to plans. These innovations, which will be covered in Part 2 of this article and published in August, include things like automatic features, investment advice, target date funds, managed accounts, catch-up contributions and income options within plans. While the DC system is not without its flaws, it remains a valuable tool for many workers to build their retirement savings.

The DB plan, then, has mostly given way to the DC plan. Both types of retirement plans have pros and cons. The good news is that DC plan innovations, combined with Social Security, can offer employees a solid footing during their retirement years.