The History of the Pension Plan
In financial advisor and radio personality Ric Edelman's book, The Truth About Retirement Plans and IRAs, he describes a monthly lifetime income benefit that was offered to soldiers during the American Revolution. If a soldier survived the war, the Continental Congress would reward them with income for life. It was called a pension, and it was offered again by the federal government in the Civil War and every U.S. war since.
The structure, however, was not new. Soldiers who served in Ancient Rome were also guaranteed income after they retired. There is also evidence of pensions being offered to public sector workers throughout history.
The First Modern U.S. Pension Plans
The American Express Company established the first corporate pension in the U.S. in 1875. Before that, most companies were small or family-run businesses. The plan applied to workers who had been with the company for 20 years, had reached age 60, had been recommended for retirement by a manager, and had been approved by a committee along with the board of directors. Workers who made it received half of their annual salary in retirement, up to a maximum of $500 per year, according to the Bureau of Labor Statistics.
Banking and railroad companies were among the first to offer pensions to their employees. But by the turn of the 20th century, several large corporations began to grow and offer pensions. These included Standard Oil, U.S. Steel, AT&T, Eastman Kodak, Goodyear, and General Electric, all of which had adopted pension plans before 1930. Manufacturing companies were the last to adopt the new retirement plans. The Internal Revenue Act of 1921 helped to spur growth by exempting contributions made to employee pensions from federal corporate income tax.
In the 1940s, labor unions became interested in pension plans and pushed to increase the benefits offered. By 1950, nearly 10 million Americans, or about 25% of the private sector workforce, had a pension. Ten years later, about half of the private sector workforce had one.
After a few pensions began to fail, the government enacted the Employee Retirement Income Security Act (ERISA), which made pension plans more secure by establishing legal participation, accountability, and disclosure requirements. It also included guidelines for vesting, limiting the vesting schedule to within 10 years or less. With ERISA came the Pension Benefit Guaranty Corporation, which ensures employee benefits should a pension plan fail.
The Rise of Defined Contribution Plans
This type of guaranteed pension came to be known as a defined benefits plan. Workers knew exactly how much they would get in retirement because it was a defined dollar amount or percentage of salary. This was something workers could plan a life around. Workers who wanted to save extra dollars of their own could do so, but private investment accounts were supplemental to pension and Social Security benefits.
Defined benefit plans are very different from what came after: defined contribution plans. In defined contribution plans, which include 401(k) plans, 403(b) plans, 457 plans, and Thrift Savings Plans, the employee makes the bulk of the contributions to the plan and directs the investments within. The employer may (or may not) match a portion of employee contributions.
These plans entered the picture in the early 1980s, a tax-deferred gift to highly compensated employees who wanted to shelter more of their paycheck from taxes. But as they gained popularity, 401(k)s and other defined contribution options quickly surpassed the defined benefit pension as the plan of choice for large private sector companies.