DB Plans Retain Cost Advantage Over DC Plans

Defined benefit (DB) pension plans remain superior to individually directed defined contribution (DC) plans, particularly for providing predictable lifetime income to post-retirees, according to new research from the National Institute on Retirement Security (NIRS)

Researchers Dan Doonan, executive director of the NIRS, and William Fornia, president at Pension Trustee Advisors, examined the costs—as a level percent of payroll over a retirement plan participant’s career—of achieving a target benefit in a typical DB plan and compared that with the cost of providing the same target benefit in a DC plan.

The results show that DB plans provide a greater given level of retirement benefits at about half the cost of a 401(k), according to the new research, “A Better Bang for the Buck 3.0.” The new report follows similar research NIRS conducted in 2008 and 2014.

“On average, a dollar invested in a DB plan will generate more retirement income than a DC plan,” the paper states. “DB plans are more efficient.”

The researchers compared a typical large public sector DB pension with two DC plans: an “ideal” DC plan with a typical target-date fund (TDF) asset allocation pattern, fees below industry average and asset class investment performance as strong as that managed by professionals; and an individually directed DC plan with industry average fees and reduced investment returns based on typical individual investor behavior. 

The study finds that the cost to fund the target retirement benefit under the DB plan comes to 16.5% of payroll each year. The analysis finds that the cost to provide the same target retirement benefit is 32.3% under the individually directed DC plan and 22.6% of payroll under the ideal DC plan. Additionally, the DB plan can provide the same benefit at a cost that is 49% lower than the individually directed DC plan and 27% lower than the ideal DC plan, according to the research.

The researchers say the typical DB plan is likely to provide a given level of retirement benefits at about half the cost of a 401(k)-style plan because of three advantages over DC plans: longevity risk pooling, higher investment returns and optimally balanced investment portfolios.

“A typical DB plan, with advantages based on longevity risk pooling, asset allocation, low fees and professional management, has a 49% cost advantage compared to a typical individually directed DC plan,” the paper states.

Longevity risk pooling accounts for 7% of cost savings; the DB plan’s ability to maintain a more diversified portfolio drives another 12% of cost savings; and greater net investment returns, lower fees and professional management generate an additional 30% cost reduction.

DB plans’ superiority is clearest for retirees, the research shows.

“Roughly four-fifths of the difference in costs between the DB plan and the individually directed DC plan occurs during the post-retirement period, as retirees move from an environment that benefits from a long investment horizon and fiduciary protections to one where they manage their spend-down on a short-term individual basis without the benefits associated with longevity-risk pooling,” the paper states.

Some of the disadvantages for DC plans when it comes to cost efficiency are baked in because pensions provide retirees with a predictable monthly benefit, while DC plan participants accumulate a lump sum that must be converted into lifetime income.

The Setting Every Community Up for Retirement Enhancement (SECURE) Act aimed to simplify this tricky calculation and help participants determine how much to withdraw per month or whether to convert a lump sum into lifetime annuity payments.

However, the NIRS research finds that participants may still fall short with annuities.

“Using private annuities to convert DC account balances at retirement into a lifetime income stream does not close this gap because such annuities are expensive, especially when they include the kind of inflation protection offered by public DB plans,” the paper states.

Despite many employers moving from DB plans to DC arrangements for employees, West Virginia did the reverse and reopened a closed pension. In 2008, the conversion proposal was passed by a state panel that voted to close the state teachers’ DC program to new enrollees. In its place, the shuttered Teachers’ Retirement System (TRS) DB plan was reopened.