What is a pension? How defined benefit plans work and who gets them

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Hint: It’s not a 401(k).

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Defined benefit plans were once a mainstay of many companies’ employee benefit plans, driven largely by the industrialization of the United States in the early 20th century. Known more commonly as pension plans, the programs pay regular income throughout retirement, ensuring retirees never run out of money.

Although the number of defined benefit plans has declined—largely thanks to the cost of administering them and the introduction of 401(k) plans—millions of workers still have a pension plan available to them. About 11% of private sector employees and 19% of all civilian workers, including state and local government employees, participate in a defined benefit plan, according to March 2023 data from the Bureau of Labor Statistics.

In a defined benefit plan, employers agree to pay workers money in retirement based on years worked, earnings during that time, and any cost-of-living adjustments. Pension plans were the norm until changes in federal law following the passage of the Employee Retirement Income Security Act (ERISA) of 1974. ERISA set standards for funding private sector pension plans to help ensure participants would receive the funds they earned. The law also established the Pension Benefit Guaranty Corporation (PBGC) to protect participants’ retirement benefits should their pension plans fail.

ERISA gave workers increased confidence in their ability to collect a pension, but it also raised costs for employers offering a defined benefit plan. When 401(k) and similar defined contribution plans became available in the 1980s, most nonunion, private sector employers dropped their pension plans in favor of defined contribution plans, which were cheaper and simpler. But in doing so, the burden of ensuring adequate retirement savings was shifted to workers.

About 27.6 million workers were covered by a defined benefit plan in March 2023, according to calculations based on BLS data. Participants generally fell into one of two categories:

Church plans. Another group of workers who participate in pension plans are those employed by churches or church-affiliated organizations, such as hospitals and schools. So-called church plans trace their roots to 1916, when J.P. Morgan sought to launch a pension program for clergy in the Episcopal Church. It became a model for many other denominations, which to this day often include a defined benefit plan as part of their benefits. Unlike most private employer pension plans, church plans are not covered by ERISA and are exempt from its funding and reporting requirements. In 2019, about 589,000 workers belonged to a church plan, excluding those working at hospitals and schools, according to an analysis by the Government Accountability Office (GAO) of income tax returns from some 33,000 church employers.

Pension plans are costly and complicated to offer because they must have enough funds on hand to pay retiree benefits today and in the future. The funds put into pension plans don’t just sit there; they’re invested in the hope of generating returns that can help fund pension payments. Some plans haven’t been able to keep up, and their funded status—that is, the difference between the plan’s value and the amount needed to pay retirees—has sunk to dangerously low levels.

Some employers have had an optimistic bias, giving generous pension benefits under the impression that it wouldn’t cost much. Before ERISA was passed, some retirees would discover that there wasn’t enough money in their pension plan to cover their benefits.

ERISA made it clear that pensions legally belong to their beneficiaries. It set investment and accounting standards for the liability created by employees covered by the plans. In addition, the Pension Benefit Guaranty Corporation (PBGC) was created to insure defined benefit plans and take over benefit payments should a pension plan become insolvent. The PBGC’s goal is to make sure that beneficiaries of private sector pension plans receive the benefits due them.

Federal law permits the PBGC to guarantee only plans offered by private companies. State and local government plans aren’t covered, which presents a problem. Many state and local pension plans are underfunded, leaving policymakers in those localities to consider raising taxes or cutting promised benefits.

Many workers prize defined benefit plans because they offer regular income in retirement that can’t run out, unlike contributions to a 401(k) plan. But pension plans are expensive and complex, which is why few employers offer them today.

If you’re among the two-thirds of private sector workers with access to a 401(k) or other defined contribution plan, you will likely need to save much more to provide yourself the same retirement income you’d receive under a defined benefit plan. Planning helps, but so does budgeting wisely. Annuities can provide security and mimic the steady payments offered by a pension plan, but high fees and commissions, complicated contracts, and limited returns are some of the reasons why many consumers feel annuities just aren’t worth the cost.