A pension is a retirement savings vehicle that is tied in with your employer. During your working life, you and your employer contribute to a pension plan. After you retire, the pension plan pays you either a lump-sum benefit or an annuity. (With a lump-sum benefit, you get all of your benefits at once, and then it is up to you to spread out your spending over the course of your retirement.)
Fifty years ago, people believed in lifetime employment. The thinking was that if you went to work for a major corporation, nonprofit institution, or government agency, you would stay there until you retire. The concept of lifetime employment meant that a single worker would have one employer over his (this was before the women's movement) lifetime. Whether or not this thinking was valid then, it certainly is not valid now.
The combination of the myth of lifetime employment and the reality that many people change employers several times over the course of their working lives makes a hash out of the pension system.
Many pension plans pay benefits based on length of employment. If you work less than a minimum number of years, say 5, you may not receive any benefits at all. When you work long enough to receive at least some benefits, you are said to be "partially vested." When you work long enough to receive full benefits, you are said to be "fully vested."
Over the course of your career, you may become vested in several pension plans. They may have different characteristics. It can be quite difficult to predict what your financial situation will be when you retire.
Broadly speaking, there are two types of pension plans. In a defined-contribution plan, the contributions that are made by you and on your behalf to the pension plan are managed by the pension plan managers. Based on the size of contributions and the performance of their investments, your pension balance grows until you retire and start do draw it down. At that point, your pension income is based on this balance.
In contrast, with a defined-benefit plan, your benefits are based on a formula that is not directly tied to your contributions. The formula may include your length of service, your highest salary, the salary in your last three years, or other factors. The benefits under a defined-benefit plan could turn out to be higher, lower, or the same as those in a defined-contribution plan.
With a defined-benefit plan, the company stands to gain or lose, based on how well it manages the pension money. If the returns are high, then the plan's assets may exceed what is necessary to pay benefits, and the firm earns a windfall. Conversely, if the pension plan is mismanaged, the benefits must still be paid. In this situation, if the firm goes bankrupt, it might be unable to pay benefits. In the United States, the government has set up a pension insurance fund, called the Pension Benefit Guaranty Corporation, that charges companies a fee (defined-benefit plans pay the largest fees) and in return pays the pension obligations of defined-benefit pension plans that succumb to bankruptcy.
Suppose that this year's contributions from you and your employer to your pension plan are $4000, and that this is fully vested. You quit in order to start your own business, with ten years left until retirement. If the pension plan invests the money at 5 percent per year, how much will be available for you as a lump some in ten years? If the company has a defined-benefit plan that pays out $6500 instead of a defined-contribution plan, who comes out ahead--you or the company?
Defined-benefit plans sometimes use a formula that is based on the salary in the year before you leave a company. If you left a company twenty years ago, this salary is likely to be low relative to salaries today, and a defined-benefit plan would be worth little. On the other hand a defined-contribution plan with that same company might be worth a lot, if your contributions were invested in securities that grew in value over the past twenty years.On the other hand, suppose that you change firms a few years before you retire. If the new firm uses a defined-benefit plan and you are vested, you will do very well. If it has only a defined-contribution plan, then you will not have time to accumulate very much in terms of wealth.
In other words, if you are early in your career and you are likely to change jobs before you retire, a defined-contribution plan probably will be to your advantage. If you are late in your career, then a defined-benefit plan will be more to your advantage.
A possible reform for pension legislation would be to try to make pensions more "portable," so that you can change jobs without distorting benefits. However, the most portable pensions are those that individuals fund themselves, rather than using their employer as an intermediary.
Social Security is a defined-benefit pension plan managed by the government. The government collects "contributions" in the form of social security taxes. It pays benefits according to formulas set by Congress. As with any defined-benefit plan, there is no assurance that the value of what you pay in will equal, exceed, or fall short of what you could have obtained had you taken your contributions and saved them. On average over the history of Social Security, the benefits have been greater than they would have been under a defined-contribution allocation. That is a political decision made by Congress, not an economic result.
At any one point in time, Social Security transfers money between two groups of individuals. Taxpayers pay into the system, and beneficiaries take money out of the system. Social security's financial condition depends on the balance between these two groups.
In 1950, when the system was relatively new, there were 16 workers per retiree. Even now, the ratio of taxpayers to beneficiaries is 4.0, which is relatively high. This gives Congress the option of collecting more in taxes than it pays in benefits, with the surplus going to fund other government spending or to pay down government debt.
As the Baby Boomers age, however, the ratio of taxpayers to beneficiaries will fall. According to a report on global aging by Maureen Culhane of Goldman Sachs (my link to it is broken, but you may be able to Google it), this ratio will fall to 3.4 by 2015 and to 2.3 by the year 2050. (In fact, it is likely that the low point for the ratio will come somewhere in between 2030 and 2040, when it may fall below 2.0) Other things equal, if the ratio is 3.0 instead of 4.0, in order to maintain benefits, each taxpayer must pay 4/3 of what he or she would have paid had the ratio remained at 4.0.
As longevity increases relative to the statutory retirement age, people remain Social Security beneficiaries for more and more of their lives. Thus, the outlays for Social Security tend to grow faster than the economy. In 1960, social security outlays were 2.2 percent of GDP. In 2000, they were 4.1 percent of GDP.