A defined benefit (DB) plan, modeled with the typical fees and asset allocation of a large public plan, has a 48% cost advantage compared to a typical individually directed defined contribution (DC) plan, the National Institute on Retirement Security (NIRS) concludes in a recent analysis.
Further, the DB pension costs 29% less than an “ideal” DC plan that features the same low fees and no individual investor deficiencies. According to the NIRS, annuitizing DC account balances does not erase the DB pension cost advantage. Annuities offered by private insurance companies would only modestly decrease DC funding requirements at historical average interest rates, and would increase costs at 2014 interest rates.
In this updated comparison of its DB and DC plan costs, the NIRS says it takes into account key developments in the retirement benefits landscape with regard to fees, investment strategies, and annuities, while building an “apples to apples” comparison through a uniform set of demographic and economic assumptions.
In its report, “Still a Better Bang for the Buck: An Update on the Economic Efficiencies of Defined Benefit Pensions,” the NIRS explains that DB plans have three structural cost advantages compared to DC plans: longevity risk pooling, the ability to maintain a well-diversified portfolio over a long investment horizon, and low fees and professional management.
In order to provide lifelong income to each and every retiree, DB plans only have to fund benefits to last to average life expectancy. In a DC plan, an individual must accumulate extra funds in order to self-insure against the possibility of living longer than average. They can also buy a life annuity from an insurance company, but this comes at a cost, the report notes.
DB plans are able to maintain portfolio diversification—specifically, stay invested in equities—over time, while DC participants must shift to lower-risk, lower-return investments as they age. Thus, over a lifetime, DB pensions earn higher gross investment returns than do DC accounts, the NIRS says.
Due to economies of scale, DB plans feature low investment and administrative expenses as well as management of investments by professionals. According to the NIRS, an “ideal” DC plan can theoretically achieve the same fees and investment returns, for a given asset allocation, by removing individual choice. When it uses more realistic assumptions—industry average fees and a modest “behavioral drag” on investment returns resulting from well-documented tendencies in individual investor behavior—the NIRS finds that the DB plan has a large advantage in net investment returns.
The Institute suggests that employers and policymakers should continue to carefully evaluate claims that “DC plans will save money.”
The NIRS’ recent report is here.
In a previous analysis, the Institute found the $476.8 billion in public and private defined benefit (DB) pension plan payments in 2012 supported $943.3 billion dollars in overall economic output in the national economy.