Are DB plans really more cost-effective than DC plans?

It is assumed in some circles that defined benefit plans are more economical to run than defined contribution plans, and that participants are better off because plan assets are managed by professional investment managers.

Not so, concludes a study titled, “Defined-Contribution Plans Are Cost-Effective,” issued today by the Manhattan Institute for Policy Research.

Author Josh B. McGee, Ph.D., a senior fellow at the think tank, drew the following conclusions:

DC plans achieve similar investment returns,

• DB plans are not structurally more cost-effective than DC plans,
• Pension debt is a significant cost driver for DB plans, and
• DC plans are a good option for providing retirement security.

DB plans remain a mainstay of public employers, but some are beginning to think seriously about following the lead of private sector employers and make a DC plan the primary retirement funding vehicle. According to McGee, so far only Michigan and Alaska have done so, “as well as a handful of cities.”

When state and local governments have considered adopting a DC plan for new employees, “they have encountered significant opposition from organized labor, managers of current public-retirement systems, and the cottage industry of consultants that supports public DB plans,” McGee writes.

In examining the common assumption that DB plans deliver superior investment performance, McGee points to the trend towards DC plan participants’ utilization of institutionally managed funds including target-date funds. Few DC plan participants are actively managing stock and bond portfolios, so the fact that they would fare poorly against professionals in such a contest is becoming a moot point, according to McGee.

After adjusting published investment return data for plan size and averaging different starting year periods, McGee found that while DB plans still deliver superior investment returns, the distinction was “only .18-.28 percentage points, an order of magnitude smaller than the difference that DC plan critics typically use in their analyses.”

Research from the National Institute for Retirement Security, meanwhile, maintains that DB plans are more cost-efficient than DC plans. In its report, "Still a Better Bang for the Buck: Update on the Economic Efficiencies of Pensions," NIRS calculated that DB plans deliver the same retirement income at a 48% lower cost than 401(k)-type DC plans.

Length of service variable

McGee also pointed out that the ultimate benefit an employee gains from a DB plan is heavily dependent upon length of service. Thus the effective investment return of an employee who changes jobs, leaving a DB plan behind, would be lower than that of a similarly situated DC plan participant. The reverse is also true, however: The long-tenure DB plan participant typically comes out ahead of the typical DC plan participant.

Regarding the cost of DB plans, McGee notes that prior analyses of plan cost “do not include the cost of carrying pension debt”— the effect of rampant under-funding of pension liabilities. He notes that “debt service payments to pay off the accumulated pension debt are now larger than the annual cost of benefits earned by workers in most jurisdictions.”

By McGee’s calculations, a DB plan that maintains a 90% funded ratio (which is more than many plans do), assuming the median rate of return and ratio of liabilities to payroll “would result in additional debt-service cost of approximately 4.48% of payroll.” For funding ratios of 80% and 70%, estimated added debt service cost would be 8.96% and 13.44%, respectively.

Also, the increasing availability of private annuity contracts is making it easier for DC plan participants to gain protection from depleting their retirement savings too rapidly — an essential feature of the DB plan design.

“In theory and in practice, DC plans can be designed to offer retirement benefits efficiently while solving many of the political-economy and benefit-design problems presented by DB plans,” McGee concludes. “By moving beyond the current, largely misinformed, DB vs. DC debate, policymakers can better focus on placing all workers on the path to retirement security.”

The Manhattan Institute has a free-market orientation, with its website stating that it “has been an important force in shaping American political culture and developing ideas that foster economic choice and individual responsibility.”

Source: Employee Benefit News