Defined benefit (DB) plan sponsors looking to save money by switching to defined contribution (DC) plans take note: despite commonly held beliefs, DB plans are capable of delivering retirement benefits at a lower cost than DC plans, according to a report.
The National Institute on Retirement Security’s (NIRS) report, A Better Bang for the Buck: The Economic Efficiencies of Defined Benefit Pension Plans, found that it required 12.5% of contributions per year to pay for a simulated DB plan versus 23% of contributions for a simulated DC plan. The report outlines three reasons why DB plans, if administered correctly, are more cost-effective than DC plans.
DB plans better manage longevity risk, or the chance of running out of money in retirement, according to William Fornia, senior vice-president at Aon Consulting, and co-author of the report. He says the study identified an additional cost to DC plans, which is a result of plan members dying prematurely.
“With our study we can see that as they die, there is a significant amount of money that goes to their estates,” explains Fornia. “This excess amount is what we call the over-savings dilemma, which reflects an additional cost for a DC plan.”
The report suggests that by pooling the longevity risks of large numbers of individuals, DB plans avoid the over-savings dilemma—saving more than people need on average to avoid running out of cash—that is inherent in DC plans.
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The second case for DB plans is that, unlike the individuals in them, they do not age and are able to take advantage of the enhanced investment returns that come from a balanced portfolio throughout an individual’s lifetime. Beth Almeida, executive director of NIRS, explains that to protect against market shocks, individuals in DC plans are advised to shift toward more conservative investments as they age, sacrificing some expected return.
“As individuals move to a lower risk portfolio allocation, there is some return that’s sacrificed as a result,” Almeida says. She adds that lower investment returns means that more money must be contributed on the front end in order to deliver the same level of benefits.
NIRS’s final case for DB plans rests on the argument that they are pooled, professionally-managed assets that achieve greater investment returns than DC plans. “Despite their best efforts, individuals tend to under perform when it comes to investing in DC plans,” explains Almeida. She adds that pooled investments in DB plans can lower expenses through large group pricing negotiation and avoiding expenses of individual recordkeeping, investment education, and investment transactions.
Together, NIRS estimates that DB plans can reduce costs by nearly half compared to DC plans. Twenty-six percent of savings can come from superior investment returns, 5% from maintenance of portfolio diversification, and 15% from longevity risk pooling.
The National Institute on Retirement Security was founded in 2007 by the Council of Institutional Investors, the National Association of State Retirement Administrators, and the National Council on Teacher Retirement.
To read the NIRS report, click here.
To comment on this story, email jody.white@rci.rogers.com.