DB Plans Cost Less than DC Plans

August 14, 2008 (PLANSPONSOR.com) - The economic efficiencies inherent in a defined benefit retirement plan makes it a less costly benefit for employers to provide than a defined contribution retirement plan.

So said Beth Almeida, Executive Director of the National Institute on Retirement Security (NIRS), as she concluded an overview of the findings in a new report, “A Better Bang for the Buck: The Economic Efficiencies of Defined Benefit Pension Plans,” during a conference call for the press.

Almeida and William (Flick) Fornia, Aon Consulting Senior Vice President, coauthored the report summarizing the findings of their analysis of the cost of achieving a target retirement benefit in a typical DB plan versus the cost of providing that same benefit under a 401(k)-style defined contribution plan.

Their analysis found that the cost to deliver the same level of retirement income to a group of employees is 46% lower in a DB plan than it is in a DC plan. More specifically, according to the report, “longevity risk pooling in a DB plan saves 15%, maintenance of a balanced portfolio diversification in a DB plan saves 5%, and a DB plan’s superior investment returns save 26% as compared with a typical DC plan.”

Though DB plans typically provide a more generous benefit than DC plans, and more generous benefits are more expensive, DB plans are more efficient and “stretch taxpayer, employer or employee dollars further in achieving any given level of retirement income.”

According to the report, DB plans have three embedded characteristics that drive their economic efficiency:

  • DB Plans Avoid "Over-Saving." We will not all live to be 95 or 100, but in a DC plan, participants want to save enough to last until very old age to avoid the risk of running out of money. However, a DB plan only has to save for the AVERAGE life expectancy, which is much lower and which actuaries can calculate with a high degree of accuracy. By saving for a realistic average life expectancy, the DB plan realizes a 15% cost savingsover the DC plan. In technical terms, this is called "longevity risk pooling."
  • DB Plans Stay Forever Young. - Individuals age. Therefore, those in DC plans must adjust their asset allocations to ensure sufficient cash is on hand to last throughout retirement. Most financial advisers counsel downshifting from higher risk/higher return investments to lower risk/lower return investments as they get older. This protects individuals from the risk of a stock market crash, but progressively reduces the investment returns that can be earned. However, a DB plan exists across generations and therefore can always maintain the most optimal asset allocation. There is not a need to be overly weighted in lower return/risk bonds or cash. This results ina 5% cost savingsover the DC plan.
  • DB Plans Achieve Higher Investment Returns. -The higher returns of DB plans as compared to individual retirement accounts can be attributed a combination of professional asset management and lower fees. A retirement plan that earns greater investment returns will require less money in contributions. Even seemingly small differences in annual returns compound over time. In Almeida and Fornia's model, a 1% difference in annual investment returns resulted ina 26% cost savingsover a career, as compared to the DC plan.

Almeida and Fornia's model is based on a group of 1,000 newly-hired female teachers aged 30 on the starting date of their employment. They work for three years and then take a two-year break from their careers to have and raise children, returning to work at age 35 and continuing to work until age 62. By their final year of work, the model participants' salaries have reached $50,000, a 4% percent each year.

Almeida and Fornia defined a target retirement benefit that, combined with Social Security benefits, allows the 1,000 teachers to achieve an income replacement rate in retirement of 83%. That benefit is $26,684 per year or $2,224 per month. A cost of living adjustment is provided to ensure the benefit maintains its purchasing power during retirement.

After defining certain parameters for life expectancy and investment returns, Almeida and Fornia calculated the contribution required to fund the target retirement benefit through the DB plan over the course of a career and do the same for the DC plan.

The analysis found that the cost to fund the target retirement benefit under the DB plan is 12.5% of payroll each year, and the cost to provide the same target retirement benefit under the DC plan is 22.9% of payroll each year. Almeida said in the press conference she and Fornia are certain the results would have been similar if different employee demographic assumptions had been made.

A copy of the report, as well as other information about the analysis, can be downloaded from here .