Defined benefit (DB) pension plans are “substantially more economically efficient” than defined contribution (DC) plans, according to a new report from the nonprofit National Institute on Retirement Security (NIRS).
The report calculated the cost of achieving a target benefit in a typical public sector DB plan expressed as a level percent of payroll over a career, and compared that with the cost of providing the same target benefit in a typical DC plan. The research found that a traditional DB pension has a 49% cost advantage over a typical DC account, thanks to benefits from longevity risk pooling, higher investment returns, and optimally balanced investment portfolios.
“DB pensions continue to have substantial economic efficiencies that cannot be replicated by individual DC accounts,” said the report. “Switching from a DB to a DC system saves money only if it involves substantial cuts to employee benefits.”
According to the report, the pooling of longevity risk in DB pensions enables them to fund benefits based on average life expectancy, while still paying each worker monthly income regardless of how long they live. In contrast, DC plans must receive excess contributions for each worker to self-insure against living longer than expected.
DB pensions also tend to have higher net investment returns due to professional management and lower fees from economies of scale, according to the report. The report also called DB pensions “ageless” in that they can perpetually maintain an optimally balanced investment portfolio rather than downshifting over time to a lower risk/return asset allocation as one does with a typical individual strategy.
“Due to the advantages of longevity risk pooling and the maintenance of portfolio diversification, the DB plan costs less than a DC plan, even compared to the ideal DC plan with no disadvantage in terms of fees and investor skill,” said the report, which added that “the cost of the DC plan doubles compared to the DB plan because the DB plan realizes a hefty additional cost advantage due to its low expenses and professional management of assets.”
The report also said using private annuities to convert DC account balances into a lifetime income stream does not close the gap between DB and DC plans because such annuities are expensive, particularly when they include the same inflation protection offered by public DB plans.
“Shifting from a DB plan to a DC plan and maintaining the same contribution rate will generate significant cuts in retirement income,” according to the report. “Considering the magnitude of the DB cost advantage, the consequences of a decision to switch to a DC plan could be dramatic for employees, employers, and taxpayers.”