Defined benefit pension plans offer substantial cost advantages over 401(k)-style defined contribution plans, according to a new report by the National Institute on Retirement Security.
The U.S. report found a typical DB pension — with advantages based on longevity risk pooling, asset allocation, low fees and professional management — has a 49 per cent cost advantage compared to a typical DC plan.
Longevity risk pooling enables DB plans to fund benefits based on average life expectancy, while paying each worker a monthly income no matter how long they live. In contrast, DC plans must receive excess contributions to enable each employee to self-insure against the possibility of living longer than average. DB plans’ longevity risk pooling accounts for seven per cent in cost savings, according to the report.
In addition, the report noted that DB plans realize higher net investment returns due to professional management and lower fees from economies of scale. It found a DB pension costs 27 per cent less than an “ideal” DC plan with below-average fees and no individual investor deficiencies, while the plans’ ability to maintain a more diversified portfolio accounts for 12 per cent in cost savings and superior net investment returns, due to lower fees and professional management, generate an additional 30 per cent reduction in cost.
“In summary, when it comes to providing retirement income, DB pensions are substantially more economically efficient than individual retirement accounts because of risk pooling across a large number of individuals, a longer investment time horizon and lower expenses and higher returns.”
The report also found about four-fifths of the cost difference between DB and DC plans occurs during post-retirement years. Once retired, individuals typically experience substantially higher fees when retirement assets are withdrawn from a DC-style retirement plan. Also, retired individuals often shift their savings to lower risk, lower return asset classes, which is further complicated by today’s historically low interest rate environment.
“Specifically, it would be 96 per cent and 37 per cent more expensive for a typical DC plan and an ideal DC plan, respectively, to deliver the same level of retirement income as a typical DB plan,” stated the report. “Thus, DB pensions continue to offer significant cost advantage.
“While shifting from a DB pension to a DC plan offers a way to reduce the investment risk borne by employers and taxpayers, this comes with an unavoidable tradeoff — either increased benefit costs or, more likely, significant retirement benefit cuts that are larger than the savings realized by the employer.”