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 overinvest 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 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."