Defined benefit pensions are not created equal.

I wish they were, mainly because it would make my job of explaining pensions easier, but that simply isn’t the case. Most pensions are designed differently than each other. In some cases, pension design varies significantly, in others only slightly. However, in almost all cases, these variations in pension design produce unique plans.

This fundamental truth is key to understanding the potentially decisive role of a defined benefit pension (DBP) in a pensioner’s retirement outcome. This truth is also vital for understanding a DBP’s influence during an employee’s decision to depart a pensionable job before reaching retirement eligibility. Academics and economists call this departure decision a voluntary turnover decision. However, I call it a Golden Albatross moment for those in a pensionable job. Future pensioners and current pensionable employees must understand their pension design in both the retirement and Golden Albatross scenarios. They can do this by examining their pension’s design elements.

Pension Plan Design Elements

Are you wondering what a pension design element is? It’s an umbrella term I coined while drafting my master’s thesis (about pensions). I used it to describe all of the various pension features, characteristics, provisions, and penalties that pension administrators use to design a specific pension plan. As such, it’s not a universally accepted term. Then again, few terms in the pension industry are! Not only does the pension industry suffer from an extreme amount of design variation from one pension plan to the next, but so too does the language used to describe pension design. Thus, without any agreed-upon vernacular, I created my own.

This post is about which pension design elements I found most commonly offered as I researched the subject for my thesis. This research adds to the research I did for my book and for several of my previous Pension Series articles. As a result, it reflects my latest, academically researched thinking about the types of pension design elements that add to or subtract from a pension’s value. Understanding what those design elements are and what they are meant to do will help you plot a better course for your retirement or a more straightforward path during your Golden Albatross decision.

Non-Standardization

DBPs suffer from an extreme lack of standardization, at least in the US. So much so that it’s even hard to find an agreed-upon definition of DBP. As a result, I settled on the following definition for my thesis:

a type of deferred retirement compensation where a former employer pays a retired worker an annuity for the remainder of their life (US DOL BLS, 2020; US GAO, 2009).

Thus, the only two required design elements for a DBP are deferred compensation and the offer of an annuity at the end of that deferred period. Everything else comes down to the choice of the plan provider, of which there are many.

For example, the US pension industry includes over 52,000 active DBP plans split between Federal, state, and local governments and US corporations (EBSA, 2019; Fore & Hammond, 2005; Mayo & Caskey, 2020; Turner, 2010). In 2017, the breakdown included over 46,600 corporate DBP plans covering 13.1 million active workers and 21.341 million annuitants or awaiting annuitants (EBSA, 2019, pp. 3-4). Additionally, in the fiscal year 2019, over 5,300 DBPs existed at the state and local government levels, covering approximately 14.7 million active workers and 18.2 million annuitants or awaiting annuitants (Mayo & Caskey, 2020; US Census Bureau, 2020).

Pension Design In General

Most US DBP plans evolved independently, which means the type and quality of provisions that compose each plan’s benefit package vary widely (EBSA, 2019; Fore & Hammond, 2005; Turner, 2010). Generally, DBP plans are expensive and risky for organizations to provide because each benefit offered comes at a cost and risk to the plan provider (de Thierry et al., 2014; Geddes et al., 2014; Rajnes, 2002; Secunda & Maher, 2016). As a result, benefits aren’t simply provided as a standard package but tailored to the goals and budgets of the organization providing the pension. Typically the goal is employee retention, which means the types of benefits that entice employees to stay may vary from country to country, state to state, or company to company.

Pension design elements can either be positive or negative from the point of view of the worker. Positive design elements work to the advantage of pensionable employees and retirees, while negative elements work against. The aggregate effect of those negative and positive design elements is known as pension plan generosity. I discuss the design elements and their effect in more detail below. However, it’s worth noting that US pension plan generosity declined significantly after the 2008-09 Great Financial Crisis due to budget constraints at many pension-providing organizations (Beshears et al., 2011; Brainard & Brown, 2020; Copeland & VanDerhei, 2009). Consequently, those reduced DBPs appear less effective in retaining workers (Munnell et al., 2015).

Narrowing the Field of Design Elements

With so much variation in pension design, it should come as no surprise that I had to narrow down the number of pension design elements that I considered within my thesis. The primary method I used to carve the numbers down was to assess the original intent behind the idea of a DBP, worker retention. As a result, I decided to categorize all the design elements I identified during my literature review as either an incentive to stay or a penalty for leaving. It wasn’t always a clear delineation between those two categories, but it got the job done.

Once done, I concentrated on the design elements that I believed provided the most significant incentive or acted as the harshest penalty. I ultimately came up with a list of 13 design elements, 11 of which were clearly incentives and two of which were clear penalties. Finally, I should point out that my thesis only studied US pensions. Still, many of the points made in this article apply to DBPs in other countries as well.

Penalties

I’ll start with the smaller of the two groups, pension design elements that act as penalties and deter voluntary turnover. As just mentioned, I only identified two clear penalties for my thesis. However, I added a third penalty for this article which didn’t make the cut for the thesis since it isn’t widely applicable to non-military pensionable employees. Therefore, while I discuss it below, it’s not reflected in the frequency analysis towards the end of this post. All penalties are accompanied by an explanation of how they retain pensionable employees and how it impacts the worker or retiree. So, too, are the incentives that follow.

Penalty #1: Non-Portability

Many pensionable employees cannot take their accrued pension’s value with them if they quit, thereby freezing the pension’s value with their former employer (Fore & Hammond, 2005; Foster, 1994). Depending on the pension plan’s rules, some left behind pensions may continue to accrue value based on investment returns and inflation. However, in either case, non-portability penalizes voluntary departure by forcing the employee to restart retirement savings at a new job and creating a loss of years of service (YOS) and seniority. It especially penalizes late-career movers if coupled with the backloaded pension design element (see the incentives section).

In some cases, employees can cash out their pension with their former employer in the form of a present value lump-sum (which is significantly reduced from the future value). Once done, they can roll it into a tax-advantaged retirement savings account. However, the lump-sum design element is not universal. This point makes for a tremendous final reminder for this section. Despite the widespread use of the non-portability pension design element, non-portability rules are truly plan-by-plan specific. So, make sure you research yours before quitting a pensionable job.

Penalty #2: No Social Security (SS)

Approximately 25% of pensionable state government jobs in the US redirect employee SS contributions into their DBP’s trust fund (Quinby et al., 2020). As a result, these plans’ retirees typically will not receive SS payments (Brainard & Brown, 2018). This penalizes late-career leavers with no previous SS qualifying work history. It also concentrates a retiree’s fiscal risk, especially if their public pension fund is not well-run. On the other hand, US law requires that the DBP annuities for these retirees reflect additional compensation equal to, or higher than, the forgone SS payments’ value (Quinby et al., 2020). In some cases, those payments may be more generous than SS, depending on the pension fund.

Penalty #3: Cliff Vesting (not included in the thesis)

As far as my research showed, this design element really only impacts US military members. Thus, I did not include it for study in my thesis. However, I include it here for my military readers and anyone else looking to draw comparisons to a military pension.

Simply put, any pension plan which vests their workers all at once practices cliff vesting. Vesting, in this case, means an employee is tenured enough to qualify for some future amount of pension payments. If a pension plan vests a worker incrementally, that is known as graded vesting (Turner, 2010).

In the US, the Employee Retirement Income Security Act (ERISA) requires that civilian employers who cliff vest must do so by an employee’s fifth year (Warner, 2008; Turner 2010). This means that any US employee who works longer than five years at a pensionable job with cliff vesting is eligible for an annuity. Of course, the ultimate value of that annuity is typically contingent upon total years of service (YOS). In other words, employees who only work five years should not expect a large pension. Also, vesting should not be misconstrued with full vesting, the point at which all defined benefits (like healthcare) are earned.

Interestingly, the US military is exempt from ERISA vesting requirements (Warner, 2008). It cliff vests and fully vests members at 20 years. This means if a military member leaves the service before 20 years, they get no pension or other defined benefits from the Department of Defense (Asch, 2019). That’s a severe penalty, especially for late-career quitters, since military salaries are tilted towards seniority in years of service as well as rank. As Warner (2008) notes (p. 6):

Indeed, the retirement system has been likened to a pair of “golden handcuffs” that prevent personnel from leaving prematurely. As a result of the golden handcuffs, the retirement system exerts an increasingly strong pull effect as personnel approach the 20th year. From the 6th year of service to the 20th, all four services have annual continuation rates in excess of 90 percent. Between the 11th and 19th years of service, they are in excess of 95 percent. 

Although I disagree with using golden handcuffs to describe military members (read my Golden Albatross post or my book to find out why), Warner’s point is well worth considering. The military’s cliff vesting point is an undeniable penalty that motivates military members to stay for the pension. Not only that, its effect grows stronger with each additional year served. So much so that when Warner graphed military voluntary turnover results, it looked like this:

Incentive #1: The Basic Annuity

Every DBP provides an annuity option; it is the defining feature (Secunda & Maher, 2016). Thus, without advanced features like backloading, basic annuities still represent a valuable source of fixed retirement income. This fixed income would be otherwise expensive for individuals to replicate through the private insurance market (Pratt, 2018). For example, in 2018, the US government estimated that building an insurance annuity for the same price as a pension fund’s would require between a 17% and a 41% reduction in annuity payments, depending on age and gender (Pratt, 2018). Thus, a basic annuity and the fixed retirement income it represents act as an incentive for pensionable workers to stay.

Incentive #2: Backloaded Annuity

Annuity formulas tied to late-career salaries provide considerably higher annuity value potential since the highest-paid years of a pensionable worker’s career are often their final years (Grefer et al., 2016; Haverstick et al., 2010; Taylor, 2000). For example, suppose the pension formula includes an average of the final three years’ salary (or highest-paid three-years). In that case, pension value increases significantly for those who get paid more towards the end of their career, like public servants (Beshear, 2011; Maximus, 2020). On the other hand, if the formula calls for an average of the highest-paid 10 years or the final 10 years, there is a chance that those 10 years would include significantly lower-paid years than the final three, bringing the average annuity value down.

In some ways, the term backloaded annuity is a misnomer. The salaries or earnings of pensionable workers are backloaded towards the end of their careers. The annuities simply reflect the effect of the backloading. Regardless, backloading incentivizes the employee to stay with the same employer late in their career through the potential for a demonstrably larger annuity check each month. Of course, that’s a dual-edge sword. The reliance on significant increases in salaries towards the end of the career to increase annuity value expose pensionable employees to the risks of age discrimination, late-career layoffs, and/or pension plan freezes (Zelinsky, 2004). Thus, this rather lucrative design element that incentivizes staying can also act as a rather harsh penalty if circumstances do not play out as expected.

Incentive #3: Immediate Annuities

Some DBPs have no starting age restrictions, meaning annuity payments begin immediately upon retirement (Asch, 2019; US DOL BLS, 2020). For instance, the US military’s active-duty pension only requires 20 YOS, contrasted by 20 YOS and reaching age 62 for career reservists (Asch, 2019; Warner, 2008). The math here isn’t hard to figure out. All other circumstances (like life expectancy) being equal, a retiree whose annuity starts immediately at age 45 will collect more money over their ‘retired years’ than one who retires at 45 but must wait 18 years to reach age 62. Thus, immediate start annuities act as incentives by providing more payments over longer retirement spans (Benartzi et al., 2011). They’re lucrative for pensionable retirees but expensive for employers to offer (Enns et al., 1984). As a result, such a generous design element is somewhat rare to find in modern pension plan design.

Incentive #4: Pension Subsidized Healthcare

Widespread federally subsidized US healthcare coverage does not start until 65 (Fronstin et al., 2011). In 2016, the average hospitalization cost US $11,700 (Liang et al., 2020). On average, household healthcare spending rises as they age, from 8.8% for 55-year-old to 15.6% for 75-year-old led households (Foster, 2016). Medical costs in the US increased 639% between 1979 and 2019 (Liang et al., 2020), while the overall inflation rate only rose 285% between 1979 and 2021 (Webster, 2021).

Thus, pension subsidized healthcare acts as an incentive to many pensionable workers. Ironically, though, most pension subsidized healthcare isn’t actually funded through the DBP trust fund, but a separate fund set aside for healthcare. However, the bundling of healthcare coverage into the defined benefit package and synchronization of coverage start with normal retirement age makes the distinction irrelevant for most plan participants.

Incentive #5: Cost of Living Adjustments (COLAs)

COLAs fight inflation and are a powerful tool for maintaining the purchasing power of an annuity over a retiree’s lifespan (Brainard & Brown, 2020). I discuss COLAs and inflation extensively in my book and my Pension Series Part 3, Part 4 and Part 7 articles. For instance, in those articles and the book, I point out that even a 1% annual inflation rate decreases purchasing power by 22% over 25 years (Maximus, 2020). Thus, COLAs incentivize staying. If you haven’t read those articles or my book, don’t discount the importance of a COLA; simply go and read what I’ve already written. Once you do, you’ll have a much greater appreciation for the threat that inflation poses and just how generous of a design element that a fully-inflation indexed COLA is.

Incentive #6: Noncontributory Plans

Although rare, some DBPs do not require worker contributions, meaning only the employer contributes to the trust fund (Brainard & Brown, 2018; US DOL BLS, 2021). Theoretically, the trade-off is that employers pay pensionable employees fewer upfront wages than their non-pensionable counterparts, but whether salaries reflect this reduction is debatable (Ippolito, 1994; Montgomery et al., 1992). Thus, pensionable employees in non-contribution DBPs who are paid full labor market rates should be incentivized to stay by this feature.

Incentive #7: Low-Risk Retirement Income

Some pensions are considered ultra-safe, like US Federal pensions (Asch, 2019; Poterba et al., 2007) and corporate and public pension plans with 100% funding (AAOA, 2012). However, the average corporate pension fund is underfunded by 13.75% (Lantz et al., 2020; Wadia et al., 2020), while the average public pension is underfunded by 29% (Aubry et al., 2020). This underfunding introduces risk into a supposedly risk-free retirement benefit (Munnell et al., 2006; Zelinsky, 2004). As a result, a DBP’s good fiscal health creates a premium and incentive to stay.

Incentive #8: Lump-Sums

Some DBP plans offer a one-time partial or complete present value lump-sum payment at retirement, replacing a portion or all of an annuity (Purcell, 2009). Just like the Flight of the Conchords’ Sugalumps, lump-sums are popular (Banerjee, 2013), especially among retiring employees with bequest motives, chronic health issues, or access to a spouses’ annuity (Benartzi et al., 2011; Clark et al., 2019; Pratt, 2018). Thus, lump-sums add an incentive to stay for some pensionable workers. That said, lump-sums hold numerous drawbacks, before making a lump-sum decision, readers should read the articles I’ve written about them or my book. Doing so provides you the tools needed to make an informed lump-sum decision.

Incentive #9: Survivorship

US law requires that all DBPs provide a survivor’s benefit option for spouses and/or minor children (Clark et al., 2019). This provision is financed by reducing the pensioner’s monthly annuity like a life insurance premium (Clark et al., 2019). While benefit provision is mandatory, the retiree can decline it for a larger annuity (Clark et al., 2019). Employees with chronic medical issues and families value survivorship provisions (Davis & Fraser, 2012). Survivorship incentivizes pensionable workers to stay due to the comparatively higher cost of an insurance policy with the same features as a DBP annuity. Check out my Pension Series article on survivorship for more details.

Incentive #10: Other Post-Employment Benefits (OPEBs)

Although typically funded from separate trust funds, OPEBs are linked to a DBP’s normal retirement age and bundled into a retirement benefits package (GASB, 2017; Norcross & Gonzalez, 2018; Rezaee, 2006). Examples include long-term care insurance and life insurance (US DOL BLS, 2020), which may incentivize certain types of pensionable workers to stay.

Incentive #11: Disability Insurance

Many DBPs provide disability coverage for employees injured on the job (Brainard & Brown, 2018). Some DBPs supplement Social Security (SS) disability insurance (SSDI), and plans which replace SS also replace SSDI. These plans are sometimes more generous (Belbase & Quinby, 2020). Disability coverage acts as an incentive for many workers in hazardous jobs (Brainard & Brown, 2018).

Design Element Frequency

As I stated at the beginning of this article, almost all US pension plans use different design elements to create their own unique benefits package. Thus, as a part of my master’s thesis, I set out to determine which design elements are used the most. I did this by running a survey and asked respondents to select the design elements applicable to their pension plan. A total of 130 respondents answered this part of the survey, which allowed me to graphically display the results. They looked like this:

Now, there are some things to keep in mind about these results. First, the survey population consisted of pensionable workers in various personal finance Facebook groups and my blog’s email distro. So, the sample of respondents wasn’t completely random, which means there is a certain amount of sample bias inherent to my results. For instance, I know my sample population was composed of a large number of military and teachers. I also know there was a lack of respondents with corporate pensions. Second, this survey relied on the comprehension and memories of the respondents. While I provided definitions of each design element as a reference, respondents’ understanding of those definitions or knowledge about the design elements used in their pension’s design was probably imperfect.

That said, the results are illustrative of my main point for this blog post, that all US DBPs are designed differently. In fact, no two design elements in this survey held the same number of respondents. For example, while 87 of 130 (67%) of respondents had access to pension subsidized healthcare, only 14 of 130 (11%) of them did not have access to social security. The only design element that all respondents had access to was survivorship. In truth, I pre-filled that category because it’s mandated by US law.

What Does This Mean?

Do you remember what I said at the beginning of this post about pension generosity? I noted that the cumulative effect of positive pension design elements versus negative ones in a pension plan equals its overall generosity. These survey results show how some pensionable workers end up with a more generous pension than others.

The bottom line for this article is that some organizations provide more generous plans to achieve their employee retention goals than others. Doing so incentivizes workers to stay by offering them a chance at a potentially more secure, easier, and happier retirement. As either a current pensionable employee or a soon-to-be retiree, it behooves you to examine your pension plan’s design and determine its generosity level. Breaking it down by its design elements will help you make a better informed Golden Albatross decision or build a better retirement plan. So, if you haven’t done so already, then start examining your pension plan’s design elements today!

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