Defined Benefit vs. Defined Contribution: Understanding the Costs of Each

There are instances where a DB plan is the more cost-effective option, but experts say the trend of lower DC plan fees could be a game-changer.

Among the most commonly cited reasons for the ongoing shift from defined benefit (DB) to defined contribution (DC) retirement plans has been the perception that the latter is a more cost-efficient way to provide retirement benefits to employees.

But comparing the expenses between a DB plan and a DC plan is a difficult task for a plan sponsor, given all the variables that impact a plan. Plan size and participation rates, market performance, contribution levels and interest rates, for example, can all affect the costs of DB or DC plans.

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“The problem, of course, is that not all DB plans have the same generosity or parameters, and not all DC plans are the same,” says Jack VanDerhei, research director for the Employee Benefit Research Institute (EBRI). “To really compare the costs, you have to make so many assumptions across all different kinds of plan formulas and across all different kinds of employees.”

The Bureau of Labor Statistics (BLS) finds, for civilian workers, the employer cost for defined benefit plans amounts to 3.2% of total compensation paid, while employer costs for defined contribution plans are 2% of total compensation.

Still, experts note there are instances where the DB plan is the more cost-effective option, and some studies find that defined benefit plans cost less overall for employers. A 2019 study by the National Institute on Retirement Security (NIRS) found retirement costs actually went up in four states when they closed their existing pension plans. One state, West Virginia, even reopened its pension plan after a failed attempt at switching to a DC plan.

DB Plan Efficiencies

A 2014 NIRS study found that DB plans, modeled with the typical fees and asset allocation of a large public plan, generated a 48% cost savings over a DC plan due to longevity risk pooling, lower fees and professional management.

Industry experts say that defined benefit plans can invest more aggressively on behalf of a group, including those who are young or will die early. Individuals in a DC plan, on the other hand, must invest on their own behalf, making more conservative investments as they approach or enter retirement and lowering their potential returns.

While the benefits of longevity pooling and professional management that come with a DB plan remain, Dan Doonan, executive director of NIRS, says DB plans may no longer have much of an advantage when it comes to fees, since DC plan fees have come down substantially in recent years.

However, while the NIRS study compared the overall costs of the DB and DC plans, it did not account for share of costs borne by employers versus employees. Many DC plans cost less for the employer because they’re able to offload the expense to participants.

Plan Size Impacts Costs

In general, regardless of the plan type, larger plans have lower costs, on a per-participant basis, than smaller plans, since they can take advantage of economies of scale. Researchers at the University of Oregon found that small DB plans, in particular, have to spend more in order to achieve the same level of benefits as small DC plans.

“When you think about retirement infrastructure, size does matter,” Doonan says. “And size can be very helpful in providing more value to participants.”

In addition to administration fees, DC plan providers must consider the cost of regulatory filings, hiring advisers and the cost of financial wellness or other educational programs aimed at boosting participation and engagement with the plan. Defined benefit plan providers must factor in hiring an actuary and insurance payments to the Pension Benefit Guaranty Corporation (PBGC).

Contributions: The Largest Cost

For many plan sponsors, the largest expense associated with retirement plans is the cost of contributions. It’s an expense that varies for plan sponsors with defined contribution plans (if they offer a match), depending on how much employees contribute in a given year.

“On the DC side, you’re never going to have the same level of certitude with respect to that component of the cost as you do under a defined benefit plan, unless you simply do an employer contribution that’s not a match,” VanDerhei says.

On the DB side, plan sponsors may face additional expenses, depending on their funding status.

“If you’ve been doing a good job funding your plan, your costs are going to be in line with the value you’re providing,” Doonan says. “But if you’ve fallen behind, some of those costs are going to be catching up on past underfunding.”

However, record stock market performance over the past 10 years has helped lift the funding status of many DB plans. After relatively flat returns for the first decade of the 2000s, the S&P 500 returned an annual 13.6% from 2010 to 2020, says Deba Sahoo, senior vice president and head of product for customer journeys at Fidelity Investments.

“So, DB employers that invest for a longer time horizon with the entire plan’s assets were investing more in equity [in recent years] and getting all the rewards of that investment,” he says. “A return of 13.6% has could have significantly reduced their costs. Based on the math, that could shift the dynamics more in factor of the DB plan.”

In the second quarter of 2021, corporate defined benefit plans had an average funding ratio of nearly 90%, according to LGIM America. Having a prudent, fully funded plan, however, will not reduce an employer’s contributions, says Paul Swanson, vice president of retirement, Cuna Mutual Group.

“If the company has a consistent contribution strategy, that can help mitigate the impact of the volatile rate and equity market,” he adds. “It won’t necessarily lower the cost, but it’ll smooth the volatility out.”

DB plans have also had to deal with a protracted period of low interest rates, which has increased their liabilities. Discount rates for defined benefit plans now stand at less than 3%, Swanson says, compared with 6% a decade ago and 7% 20 years ago. And he says that for every 1% decline in the discount rate, pension liabilities can increase by more than 10%.

“So a plan design that was affordable for a plan sponsor at a 6% discount rate environment 10 years ago is much less affordable now,” he says. “It’s much more expensive with a 3% discount rate.”

While the costs of DB plans have gone up, increased competition has resulted in fee compression for DC plans, with overall costs falling by about 50%, Swanson says.

“If you really do a per-employee cost comparison, DB plans generally cost more than DC plans, even though they’re also generally more effective and more efficient from an investment perspective,” Sahoo says.

Defined contribution plans also have a cost advantage over defined benefit plans, since, as long as their plan documents allow it, DC plans have more flexibility to decrease their contribution costs in a given year by reducing or suspending their contributions. Sponsors can also more easily shut down the plan, entirely eliminating all the associated costs.

“The bottom line is, if you’re small and don’t have a certain profit stream, do you really want to take on the obligation of funding someone’s retirement plan, as opposed to a 401(k) system, where the only real obligation is to make the contribution for that particular year?” VanDerhei asks.

Of course, while cost is an important factor, it shouldn’t be the only one employers consider when determining the best mechanism for providing retirement savings services to their employees.

“In an ideal world, any decision about a retirement plan should fit into a much more holistic picture as far as what the company is trying to accomplish with respect to all of its employee benefits,” VanDerhei says. “That’s critically important.”

Industry Ripe for Development of Retirement Income Products and Solutions

David Blanchett, QMA’s newest managing director and head of retirement research, talks about the growing importance of retirement income solutions in DC plans and other investment menu considerations for plan sponsors.

David Blanchett

QMA LLC, the quantitative equity and multi-asset solutions specialist of PGIM, announced in early June that it was bringing David Blanchett on board as a managing director and head of retirement research for defined contribution (DC) solutions. (PGIM is the $1.5 trillion global investment management business of Prudential Financial Inc.)

Blanchett is well-known in the DC plan industry for previously heading up retirement research at Morningstar Investment Management. The leadership at PGIM/QMA say his hiring reflects the fact that retirement income solutions are going to be the next big thing that will come to dominate the marketplace.

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Shortly after the announcement, QMA Chief Executive Officer Andrew Dyson told PLANSPONSOR that Blanchett’s hiring “reflects QMA’s vision for our role in the future of retirement income,” adding that “great products will need to be founded on great research, and David will be at the forefront of that.”

Dyson argued the next 10 years will see income solutions come to dominate the DC plan marketplace. In a new interview with PLANSPONSOR, Blanchett leaned into that suggestion, echoing the growing importance of getting DC plan investors not just to, but also through, a successful retirement.

The following is a selection of highlights from the new discussion with Blanchett, now about 10 weeks into the new gig, edited and condensed for clarity:

PLANSPONSOR: We heard previously from your new colleague Andrew Dyson about your anticipated role and responsibilities at QMA. It would be great to hear your thoughts about taking on the new job at a time when the retirement plan industry is experiencing significant change.

Blanchett: As Andrew said, PGIM and QMA definitely believe that retirement income solutions are the next frontier, especially within the DC space, and I’m excited to be working on this challenge. For some time now, there has been a lot of talk about making DC plans more friendly to retirees and to efficient retirement spending, but plan sponsors are now truly starting to push this trend forward in a big way.

Increasingly, plan sponsors want to get their people not just to, but also through, a high-quality retirement, and as a result of that, this industry is ripe for the development of new products and solutions that speak to these needs.

On a personal note, why did I make this change now? I can say that there is a lot of potential within QMA and within the broader PGIM and Prudential organization to take on these big, important challenges.

 

PLANSPONSOR: You mentioned that plan sponsors want to get their people through retirement, not just to retirement. Do you have a sense for why that is? Presumably a big part of this is wanting to do the right thing for their people—but is it also to do the right thing for their businesses?

Blanchett: Oh, yes, there are many sides to this trend. For example, there is a growing understanding about the importance of economies of scale, and that midsized and especially larger plans can really take advantage of their scale. There is a growing understanding that the older population in a given retirement plan is going to own the bulk of the assets in that plan, meaning keeping them in the plan is important to maintaining hard-earned scale.

Yes, the plan sponsor knows it will carry marginal additional fiduciary risk by continuing to serve this person in the plan. However, the sponsor also knows that keeping people in the plan will ensure they maintain access to high-quality services and support—much more support than many people would be able to access in the private market. If you are in a DC plan, you are going to have an institutional fiduciary overseeing your assets, and you will have access to best-of-breed investments and administration services. If you go outside of the plan, there is a much wider array of possible outcomes, not all of them good.

Going way back, you might not know this, I actually started out as a financial adviser. I was doing individual personal financial planning, so I don’t mean to sound too skeptical. There are a lot of private wealth advisers who do a great job and who can build just as good of a portfolio and as good a suite of services as you will get in the DC space—but that is not universal. In a DC plan, there is just an extra level of oversight and a promotion and embracing of best practices.

 

PLANSPONSOR: What are some other ways plan sponsors can step up their game? What other points of progress are you hoping to see?

Blanchett:  There is so much to mention. For example, the core menu is not finished. After a lot of time spent refining and rationalizing investment menus in the wake of the Pension Protection Act of 2006 [PPA], I would argue there may be a need to make menus more expansive, so that they can serve new and evolving needs, including retirement income.

If you pause and think about it, the role of the core menu has shifted and evolved so dramatically over the past decade. There was all this research that came out 10 years ago to show that, if you have an overly large core menu, it will scare people away from the plan. Honestly, that was an important discovery, but it is an outdated point of discussion in 2021, given the broad adoption of automatic enrollment and the massive popularity of target-date funds [TDFs].

There has been a massive migration of assets into the default option. If you want to capture significant assets, especially for younger participants, the default investment is central. That being said, for a lot of participants, as they age, the odds of them using the default decrease dramatically. So, there is a chance for us to add other building blocks and evolve the core menu once again.

Let me also add, I am a fan of target-date funds. I think some people have a false impression that I have a negative opinion of TDFs, and I don’t. It is a fact that TDFs are a massive improvement over self-direction. On the other hand, the idea that everyone within the same five-year age band is getting the best possible portfolio is not necessarily true.

Especially as fees for advice and personalization come down, this is an area where further evolution could happen. Also, the growing focus on income and guarantees makes personalization that much more important. Simply put, the amount of assets you own will have a big impact on the recommended approach when it comes to building income guarantees, which is not a fact that is going to be addressed by a target-date fund.

 

PLANSPONSOR: Can you speak to the importance of research and analysis in this discussion? Another way to ask the question: How do we go from good ideas to good solutions?

Blanchett: I have met so many incredibly smart people in this industry, but I have also seen the challenges that come up when you have a very smart team go away and work in isolation. They can go into a room and solve a fancy equation and have an answer to a tough question, but people have to understand what you are doing and why. Successful solutions have to be accessible, and they have to cut through the intellectual biases that exist out there in the market.

Practically speaking, we need to create strategies and solutions that people understand—so that they can appreciate why they need them and why they should want to implement them. This part of the process cannot be overlooked. Even with TDFs, as popular and successful as they have been, some people still don’t totally understand them, and others misuse them.

What I’m saying is that thinking about how participants will react to what we are doing and recommending is really important. If people cannot see why they need something or why it will help them, it won’t be successful.

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