Defined contribution plans have outstripped defined benefit plans in number of accounts, assets, employers offering them and participants. But a recent study that examines the cost of both kinds of plans challenges the notion that bigger is synonymous with better.
In “A Better Bang for the Buck 3.0: Post-Retirement Experience Drives Pension Cost Advantage,” National Institute for Retirement Security (NIRS) Executive Director Dan Doonan and Pension Trustee Advisors President William Fornia examine whether DC plans are better than the DB plans that they are in many cases supplanting. They zero in on the relative costs of DB plans versus those of DC accounts in their study.
Setting the table, Doonan and Fornia note that over the past four decades, private-sector employers have shifted from DB plans that provide employees with a steady retirement income stream to DC plans in which individual workers manage their own investments and bear the risks.
Doonan and Fornia constructed a model that calculates the cost of achieving a target retirement benefit in a typical public-sector DB plan. They considered this cost as a level percentage of payroll over a career; then they calculated the cost of providing the same benefit through a DC plan modeled with generous assumptions and a DC plan that is individually directed.
Previous Studies
Previous studies by the NIRS found that DB plans are “substantially more economically efficient” than individual retirement accounts, such as DC accounts, in providing retirement income. Their studies in 2008 and 2014 found that DB plans “feature critical efficiencies that make them significantly less expensive to provide a given level of retirement benefit compared to DC plans,” Doonan and Fornia say.
Both studies found that a typical large DB plan provides a given level of retirement benefit at about half the cost of a 401(k)-style plan. They cite three factors for this finding:
1. Longevity risk pooling, which they found enables DB plans to fund benefits based on average life expectancy, and yet pay each worker monthly income regardless of lifespan, whereas DC plans must receive excess contributions to enable each worker to self-insure themselves against the possibility of a lifespan beyond normal life expectancy.
2. Higher investment returns; they say that because DB plans are professionally managed and have lower fees from economies of scale, they realize higher net investment returns.
3. Optimally balanced investment portfolios. The NIRS calls DB plans “ageless,” and says that they “therefore can perpetually maintain an optimally balanced investment portfolio rather than the typical individual strategy of downshifting over time to a lower risk/return asset allocation.” This means, they say, that over a lifetime, DB accounts earn higher investment returns than their DC counterparts.
Findings
Doonan and Fornia report that the facts are basically the same as those underlying the first two studies. What has changed, they say, is the development of different assumptions for pre- and post-retirement years in DC plans.
Despite those changed assumptions, Doonan and Fornia found that DB plans still “offer substantial cost advantages” over 401(k)-style DC plans. They found that a typical pension costs less than a typical DC account, and cite the same three factors: longevity risk pooling, higher investment returns and optimally balanced investment portfolios.
The key findings include the following.
Costs
A DB plan costs 27% less than an “ideal” DC plan, the study says. Further, a typical DB plan has a 49% cost advantage over a typical individually directed DC plan. Longevity risk pooling accounts for 7% of the savings; a more diversified portfolio, 12%; and superior net investment returns resulting from lower fees and professional asset management, 30%.
The cost of either a DB plan or DC plan depends first of all on how generous the benefits are, say Doonan and Fornia. However, they continue, a DC plan will be more expensive than a DB plan for any given benefit level. On average, they say, money invested in a DB plan will generate higher retirement income than a DC plan. “In other words,” Doonan and Fornia say, “DB plans are more efficient.”
The new research found that the cost to fund the target retirement benefit under a DB plan amounts to 16.5% of payroll each year, while funding an ideal DC plan takes 22.6% of payroll and individually directed DC plan takes 32.3%. In short, a DB plan can provide the same benefit as an ideal DC plan at a 27% lower cost and at almost half the cost entailed in providing an individually directed DC plan. “The bottom line appears to be that they’re twice as expensive,” said Fornia of DC plans in the Jan. 13 NIRS webinar.
After Retiring
Four-fifths of the difference in costs between the DB plan and an individually directed DC plan occurs during retirement. This, they say, is because after retiring, individuals usually move from an environment that benefits from a long investment horizon and fiduciary protections while they are working to one in which they manage decumulation on a short-term basis without the benefits derived from longevity risk pooling.
Fornia elaborated on concern over post-retirement years. In a Jan. 13 NIRS webinar on the study, he remarked that “DC plans are getting pretty good” at accumulating revenue and that “the industry has really fixed a lot of the problems uncovered since 2008.” The problem, he said, is with “what happens when you are 63” and what to do with the money that accumulated.
The Bottom Line
The bottom line, Doonan and Fornia say, is that even if the transition from DB plan prevalence to DC plan prevalence meant that employer costs were reduced (or simply shifted to workers along with the risks), it wasn’t due to DC retirement accounts being less costly than a DB plan per dollar of benefit.
In fact, Doonan and Fornia say, the substantial economic efficiencies that typify DB plans that had been found continue, and individual DC accounts cannot replicate them. There is one way that making a transition from a DB plan to a DC plan can save an employer money, they say: substantially cutting employee benefits.
The study “shows the responsibility that plans have to invest funds well,” said Doonan on Jan. 13. And participants share responsibility too, he indicated, remarking that retirement saving “becomes less efficient if you start late.”
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