The golden years for most Americans appear increasingly threatened by the global financial crisis. Retirement accounts have lost from $2 trillion to $4 trillion as stocks have tumbled nearly 50% from their peak in 2007. For Americans facing retirement, the details of how these plans work may be fuzzy, but the big picture is clear: Whatever comfortable cushion they may have had is now gone, and the process of building it back up will be arduous and long — perhaps too long for employees who are nearing retirement age.

The pain isn’t limited to individuals with plummeting 401(k)s. Sponsors of private and public pensions — which typically invest between 60% and 70% in equities — are also finding their accounts billions of dollars below minimum requirements. The financial crisis “is affecting all types of retirement plans very similarly because they’re all invested in the same assets — stocks and bonds,” says Peter J. Brady, senior economist at the Investment Company Institute (ICI), a Washington, D.C.-based association of investment companies and mutual funds. “People have a lot less in their accounts than they had a short period ago.”

The ripple effect of shrinking retirement accounts and under-funded pensions threatens to undermine the broader economy as older Americans delay retirement, local governments raise taxes, and companies challenged with withering pension balances lay off workers in response to the shortfall.

Wharton professor Olivia Mitchell discusses evaluating Retirement Risk Management

The crisis has many retirement experts calling for change — some for tweaks to the existing system, others for full-blown retirement reform. To supplement Social Security, American workers have a choice of two types of employer-sponsored retirement plans: defined benefit plans, in which an employer promises to take care of employees when they retire; and defined contribution plans, in which employers help employees accumulate their own retirement funds.

Since Congress amended the tax code in 1978 to accommodate defined contribution plans, the bulk of private employers have shifted to them, with plans such as the 401(k), and away from traditional pensions. Most public employees, however, are still covered by traditional pensions. “Thirty years ago, half the workforce had a pension plan, and it was a [defined benefit] plan,” notes Olivia S. Mitchell, executive director of the Pension Research Council and a professor of insurance and risk management at Wharton. Today, about half of the American workforce is covered by an employer-sponsored retirement plan, but the majority of them are defined contribution plans, Mitchell says.

About 22 million workers are covered by defined benefit plans today, while about 66 million are covered by defined contribution plans, according to the Employee Benefit Research Institute (EBRI), a nonprofit research organization in Washington, D.C.

Trouble All Around

Both groups have been hit hard by the crisis, but in different ways.

Employers offering defined benefit plans — commonly known as traditional pension plans — must set aside money over time in order to pay employees a promised amount upon retirement. This “defined benefit” is often based on a formula using the number of years worked and level of salary earned. Employees covered by a defined benefit plan may not feel terribly worried about the current economic crisis, because their retirement benefits are supposedly guaranteed. But employers behind those pensions are now struggling to fund the long-term promises they have made.

Employers offering defined contribution plans — which include 401(k)s, 403(b)s, 457s, and a few others — shift the responsibility of accumulating retirement income from the employer to the employee. Employers pay administrative costs and often offer to match employee contributions, but no law or regulation forces them to do so. Worker participation in most defined contribution plans is voluntary, and many workers choose not to save any money at all. Employees who have been trying to build a nest egg have seen account balances drop precipitously in the current financial crisis, a situation made worse in some cases by employers opting to scale back or eliminate their 401(k) contributions.

So far, there has been no definitive response to the financial crisis from the millions of workers enrolled in defined contribution plans, says Wharton’s Mitchell. “We find some people have pulled entirely out of the stock market, some have gone into lifestyle funds, and some think this is a buying opportunity.”

Still, the crisis brought into focus one of the drawbacks of the do-it-yourself defined contribution plans: Many participants did not adequately diversify their investments, leaving themselves more vulnerable than they should be to market risk. “Even before the financial crisis, we have been concerned about the ability of 401(k) plans to provide secure retirement income,” Alicia H. Munnell, director of the Center for Retirement Research at Boston College, testified to Congress in February. “Workers continue to have almost complete discretion over whether to participate, how much to contribute, how to invest, and how and when to withdraw the funds. Evidence indicates that people make mistakes at every step along the way. They don’t join the plan, they don’t contribute enough, they don’t diversify their holdings, they over invest in company stock, they take out money when they switch jobs and they don’t annuitize at retirement.”

Although most financial planners recommend that investors shift retirement assets away from equities and into fixed-income investments as they age, many 401(k) investors approaching retirement were still heavily invested in stocks before the market downturn. Nearly one in four workers between the ages of 56 and 65 had more than 90% of their account balances in equities at the end of 2007, EBRI found, and more than two out of five held more than 70% in equities. (In contrast, the average target-date fund — which automatically reallocates investments as a person gets closer to retirement — would have allocated just 51.2% to equities for investors aged 56 to 65 at the end of 2007, according to EBRI.) In January, Boston-based Fidelity, the nation’s largest 401(k) provider, surveyed its 17,095 corporate 401(k) plans and found the average workplace savings account balance had dropped 27% between 2007 and 2008 — from $69,200 to $50,200.

Many older workers have been left with little choice but to keep working to make up the sudden shortfall. That’s bad news not only for workers, but also for companies trying to stay competitive. “If all of your older workers are feeling the pinch, they might not retire. So there is an HR aspect,” says Mitchell. “Baby boomers think they’re never going to retire [and many] are quite morose…. There are those who are saying the defined contribution approach has failed, and are calling for permanent restructuring.”

It could take two to five years (assuming a 5% equity rate of return) for 401(k) balances to return to January 1, 2008, levels, according to EBRI estimates. If the equity return rate drops to zero for the next few years, recovery could take anywhere from two-and-a-half to nine years, EBRI says. “What we know from past economic cycles is that if the economy turns around, then much of this will reverse,” says EBRI CEO Dallas Salisbury. “But we don’t know when it’s going to turn around.”

Cutting Contributions

Making it even harder for defined contribution plan participants to recoup, a number of employers are scaling back or eliminating matching contributions in the face of a slowing economy.

In March, a survey of employers by WorldatWork, an association of human resource managers, and the American Benefits Council, representing companies that provide benefits to their employees, found that 3% of the 505 responding companies had eliminated their 401(k) match, and 8% had either decreased the match or were considering a decrease. The Pension Rights Center, a Washington, D.C.-based consumer organization focused on retirement security, lists on its web site more than 150 companies that have either changed or suspended 401(k) matches.

The fact that companies can scale back on their match during tough economic times could be positive, some argue. “Unlike a freeze in a pension plan, a freeze in a [defined contribution] plan is not usually permanent,” says Jan Jacobson, senior counsel for retirement policy at the American Benefits Council. “To the extent that a company is choosing between laying off workers or stopping their match for a while, some companies will choose to stop the match. And I think I’d rather work for the company that stops the match.” Brady, of the ICI, notes that “this flexibility is actually a strength of the 401(k). It might be a way [for companies to save money] that doesn’t have a short-term cost to employees. And I assume they’ll resume contributions when the economy recovers…. I’m sure people would rather lose their 401(k) match than lose their job.”

Participants in defined benefit plans at private companies face a different set of problems. Companies that offer pension plans are being squeezed by a sudden decline in assets, an increase in liabilities and changes in the law that force them to make up the shortfall faster than in the past. “Many companies might have to lay workers off, walk away from their pensions, shut down a plant,” says Alan Glickstein, senior consultant at the Washington, D.C.-based human resources and financial management consultancy, Watson Wyatt. “Companies [have] to make very difficult decisions.”

The nation’s top 100 pension plan sponsors saw their pension funds drop by $303 billion in 2008, going from an $86 billion surplus — relative to the minimum amount required by pension regulations — at the end of 2007 to a $217 billion deficit at the end of 2008, an analysis by Watson Wyatt found in March. Aggregate funding decreased by 30 percentage points, from 109% funded — meaning they held 9% more than the minimum-required funding — at the end of 2007 to 79% funded at the end of 2008. A different survey by Mercer, a New York-based human resources consulting company, found that aggregate funding of pension plans of S&P 1500 companies fell to 74% at the end of February, with an aggregate deficit of $373 billion. Year-end figures, which are what plan sponsors generally use to calculate pension expenses and contribution requirements for the coming year, showed an aggregate deficit of $409 billion at the end of December, with funding at 75%.

The shortfall stems not only from a decline in equity values, but also from falling interest rates, which have forced companies to increase the amount they set aside for future benefit payments. As a result, money that could have been spent on growing the business is being funneled into pension obligations. Mercer estimates that pension expenses for S&P 1500 companies will jump to $70 billion in 2009, compared to $10 billion in 2008 and $35 billion in 2007. “Companies need to put these assets and liabilities on their financial statements,” says Adrian Hartshorn, a principal in Mercer’s financial strategy group. “It affects their balance sheets and it affects the profits they report, and clearly it also affects the amount of cash they have to put into the plan.”

Changes under the Pension Protection Act (PPA) of 2006, many of which took effect in 2008, are also making it more difficult for companies to ride out the storm. Actuaries calculate annual shortfalls in pension funds using a method called “smoothing,” which averages investment gains and losses over several years. “Under the old law, we had the ability to spread ups and downs over a four- to five-year period,” says Glickstein. “So we could sort of calm the ups and downs to make sure it’s not just noise in the market.”

The new law limits smoothing to just 24 months, meaning the dramatic losses of 2008 will have a proportionately larger impact on the calculated shortfalls. In essence, the new accounting rules are forcing companies to act now to make up for a huge financial gap, even though a quick turn-around in the economy could ultimately negate the deficit. “The challenge is, what is the real number?” asks Glickstein. “What is the right posture [for companies] to take in the face of a temporary phenomenon that has created a huge amount of pressure?”

The pressure has spurred some companies to reconsider their pension offerings. “Continuing to operate a [defined benefit] plan is a risk and a cost that they are no longer willing to bear,” says Hartshorn. Some companies are freezing their defined plans voluntarily, meaning they stop making contributions and employees stop earning benefits. (Under the PPA, a plan is automatically frozen if it is less than 60% funded.)  Phone maker Motorola, newspaper publisher McClatchy, aerospace company GenCorp, insurer Aon and apparel retailer Talbots are among the nearly 100 companies that have frozen pension plans in the last few months, according to the Pension Rights Center.

Freezing a plan can save money on contributions but does not remove the long-term risk and volatility for the employer, notes Hartshorn. Companies will still have to pay out on promises that have already been made and benefits that employees have already earned.

Drastic Solutions

That fact has some companies contemplating even more drastic solutions. “Many corporations are thinking about whether they should file for bankruptcy in order to unload their retiree promises,” says Mitchell.

If a company goes bankrupt, the plan would be taken over by the Pension Benefit Guaranty Corporation (PBGC), a federal agency that insures private-sector pensions. Created under the Employee Retirement Income Security Act of 1974, the PBCG guarantees payment of basic pension benefits for 44 million American workers and retirees in more than 29,000 private-sector defined benefit plans. The PBGC paid out $4.29 billion in benefits to more than 640,000 people in 2008, and collected $1.49 billion in insurance premiums from pension plan sponsors, which are its main source of funding.

But there is a limit to how much the PBGC will pay in benefits. The maximum guaranteed pension for participants in plans that terminated in 2008 was $51,750 per year at age 65, and lower for couples or early retirees. Workers who were promised more than that would be out of luck if their company declared bankruptcy. “It’s important to understand what is actually guaranteed,” Mitchell says.

In addition to taking over pensions from distressed companies, the PBGC also takes over fully funded plans that employers voluntarily terminate. (Companies cannot choose to terminate a plan unless it is fully funded.)

The problem, Mitchell points out, is that the PBGC itself is $11.15 billion in the hole. PBGC’s annual report for 2008 notes: “The Corporation has sufficient liquidity to meet its obligations for a number of years; however, neither of its insurance programs at present has the resources to fully satisfy PBGC’s long-term obligation to plan participants.” Says Mitchell: “There is a big concern about that insurance guarantor. And if any one of the big auto companies goes bust, that could double or triple the PBGC’s under-funded status.”

PBGC spokesman Gary Pastorius says the PBGC has run a deficit for most of its history — in fact, its deficit shrunk in 2008 — and has a healthy enough cash flow to keep things going. “On a cash flow basis, we’re pretty strong,” Pastorius says. “The assets are on hand now. The liabilities, we pay out into the future. Not everybody’s ready to retire yet.”

At least the PBGC doesn’t have to worry about funding pensions for public employees. “There is not a PBGC for state and local government pension plans,” says Keith Brainard, research director at the National Association of State Retirement Administrators (NASRA), which represents 82 statewide public retirement systems for about 22 million working and retired employees of state and local governments. “By and large, the taxpayers are the backstop.”

Like 401(k) accounts and private-sector pensions, public pension funds have watched assets fall during the financial crisis. According to the most recent figures from the Center for Retirement Research at Boston College, aggregate assets for state and local pensions have dropped $1.3 trillion since the peak of the market on October 9, 2007. NASRA estimates that its members are now about 85% funded, on average.

Cities and towns throughout the U.S. are juggling tightening budgets with pension shortfalls, straining to find a way to make ends meet without raising taxes and causing more economic strife. “So the question is, what happens if they go broke?” asks Mitchell. “And it’s really unclear.”

In response to a budget crisis, the City of Philadelphia recently announced it would suspend contributions to the city employees’ pension fund and extend amortization of the shortfall from 20 to 40 years, Mitchell notes. “They can’t fill the potholes and police the crime. So what it means is that we’re consuming the services today, but we’re going to make our grandchildren pay for them.”

The other looming question, says Mitchell, is: What would happen if a state pension got into big trouble? Most states’ employee pension plans are guaranteed by a combination of the state constitution and state law. That could make it difficult for states to scale back on pension contributions, because the only way to cut the pension would be to amend the constitution, Mitchell notes.

Brainard calls the doomsday scenarios for state and local pensions “a distant and unlikely event…. States and cities don’t typically declare bankruptcy, they’re not acquired and they don’t go out of business. Most public pension plans have assets to continue meeting their liabilities indefinitely or for decades.”

Besides, the true impact of the current financial crisis will not show up for most public pensions for at least another year, because there is a lag in reporting, Brainard adds. Since the fiscal year for most state and local governments ends in June rather than December, most of the worst market losses haven’t even been recorded. Also, as public pensions do not fall under the PPA, most are able to smooth gains and losses over a much longer period than their private-sector counterparts — from three to 15 years.

So if the economy rebounds soon, the astounding losses of 2008 could largely fade away. And if the economy continues to sputter, the worst shortfalls for public pensions may be yet to come. “It is really going to take a few years to understand and recognize what effect the market decline has had,” Brainard says.

A New System?

In the meantime, retirement experts are looking at the crisis as an opportunity to point out flaws in the system and suggest change. Indeed, the crisis has highlighted problems with all of America’s current retirement plans, they say. Defined contribution plans place too much burden on the individual; private sector defined benefit plans place too much burden on the employer; and public sector pensions shift the burden to entire communities of taxpayers and threaten to drag down local economies.

“To me, the health of our retirement system [depends on taking] lessons from the financial crisis and applying them correctly, making sure pension law supports the next innovation,” says Watson Wyatt’s Glickstein. “The bloom is off the rose to a large degree on the 401(k), and I think there’s going to be a renewed interest in coming up with a new retirement plan design.”

Glickstein sees room for a hybrid called a cash balance plan, which attempts to incorporate the features of a 401(k) into a defined benefit plan. Others have called for automatic enrollment in the target-date 401(k)s that automatically reallocate investments as an investor nears retirement.

The Pension Rights Center has launched what it calls the Retirement USA Initiative, which is pushing for systematic change. “Even before the current recession, retirement income security had become a major national concern, as companies increasingly shifted away from traditional pensions to do-it-yourself savings plans,” the group’s web site says. “In the past six months, the faltering stock market and dwindling 401(k) accounts have turned a major concern into a crisis…. It is critical to start now to lay the foundation for a new system to supplement Social Security for future retirees — one that is universal, secure and adequate.”

Munnell, of the Center for Retirement Research, has stepped up her calls for a new mandatory, universal savings account that would replace about 20% of pre-retirement income.

“Placing all the financial risk for the second tier of retirement income on either individuals or on firms does not work,” she wrote in a paper published last November. “The private sector is unlikely to revert back to defined benefit plans, where employers bear all the risk. But relying on a system where the individual bears all the risk does not make much sense either. It may be time for the United States to consider other ways of designing a retirement system.”

One of the long-term lessons from the financial crisis is the importance of risk management, says Mitchell. “One thing that many baby boomers are probably aware of is that it is going to take much more money to retire.” As they see their 401(k) account balances plummet, “people now understand risk in a real, visceral way, more than they ever did before.”

In addition, she says, it no longer wise to rely entirely on employers to provide retirement security. “It’s really hard to link retirement benefits to an employer who may or may not be there. And that has been brought to the fore by the discussion of the auto companies’ potential bankruptcy. As a young worker, you often don’t think that this is a promise that may be 100 years long. So it is a real challenge to try to construct both a financial system that can keep long-term promises and a political system to back those promises.”

Going forward, Mitchell sees reforming Social Security as one of the most important issues in retirement planning because it is the base on which the rest of America’s retirement system is built. “I think the biggest problem is the near insolvency of Social Security,” says Mitchell. “The fact that it is running out of money in six or seven years is already putting implicit pressure on retirement plans and everything else. So that’s priority one in my book.”