Report: Pensions Succeed at Half the Cost of 401(k)s
In these uncertain times, a new report evaluating the cost-effectiveness of retirement plans is sure to interest workers who rely on them to maintain a decent standard of living in their golden years.
The study recently published by the nonprofit National Institute on Retirement Security, “A Better Bang for the Buck: The Economic Efficiencies of Defined Benefit Pension Plans,” breaks with the conventional wisdom by demonstrating the superiority of traditional defined benefit pensions, as compared with 401(k)-type defined contribution plans.
Using ‘apples to apples’ comparisons of both investment strategies to achieve the same retirement benefit, the report touts aspects of defined benefit plans – particularly, the pooling of risks and assets – that fuel their economic efficiency.
According to the “Better Bang for the Buck” report, the traditional defined benefit plan provides the same retirement income at nearly half the cost - 46 % less than an individual 401(k)-type defined contribution account. In fact, the report states that the defined benefit plan is the most fiscally efficient means of providing a modest but stable retirement income that cannot be outlived.
This report will provide important new information for policy makers, employers, unions and workers, who are all struggling to ensure adequate retirement income with the fewest dollars. According to the report, defined benefit plans should be considered the “gold standard”, especially in light of current fiscal constraints facing corporate and government retirement plan sponsors.
Under a model defined benefit plan described in the report, contributions equal to 12.5% of annual wages are required to fund an adequate retirement benefit, setting aside $355,000 by the time a worker turns 62. In contrast, a defined contribution plan would require contributions of 22.9% of wages each year with $550,000 set aside by age 62. In this example, the defined benefit plan can “do more with less,” providing the same benefit for nearly $200,000 less.
How? Because defined benefit plans work differently and have certain embedded characteristics that make them more efficient in providing retirement security. According to the “Better Bang for the Buck” analysis, defined benefit pension plans:
• Avoid the problem of “over-saving” by pooling the longevity risks of large numbers of individuals – resulting in a 15% cost savings.
• Are ongoing and “ageless” plans and therefore can perpetually maintain an optimally balanced investment portfolio, rather than the typical individual strategy of downshifting over time to a lower risk/return asset allocation – resulting in a 5% cost savings.
• Achieve higher investment returns as compared to individual investors because of professional asset management and lower fees – resulting in a 26% cost savings.
Defying the Myth of the 401(k)
Unions and workers can use the report findings to make informed decisions about retirement plans and also to evaluate claims by employers that 401(K)-type defined contribution plans save money. Many employers have cited the ‘financial burden’ of defined benefit plans as their main reason for shifting to a defined contribution, or 401(k) plan.
However, research shows that when employers move out of defined benefit and into defined contribution plans, they almost always cut the average employer pension contribution too. During the period from 1981 to 1989, for example, while pension contributions to defined contribution plans rose from 23% to 68%, the average employer contribution declined 66%, from $4,140 to $1,403, per employee.
Retirement Cost Shifts to Workers
According to US Department of Labor, in 1974 employers were contributing 89 percent of retirement funds, with employees contributing a share of 11 percent. Following the rise of the 401(k) that formula had shifted and by 2000 workers were putting in 51% of the contributions and employers only 49%.
Originally introduced as supplemental plans to encourage individual savings, defined contribution plans were not intended to replace traditional pensions, the report states.
Most retirement experts liken the ideal design of retirement income sources to a “three-legged stool” consisting of Social Security, a defined benefit plan, and a supplemental defined contribution savings plan. Indeed, researchers have found that workers who have access to all three sources of retirement income are in the best position to achieve a secure retirement.
To adequately fund retirement, experts suggest funds from all income sources should equal approximately 80 percent of preretirement income, more if individuals must factor in health care costs.
Research shows that low wage workers, in particular, fair poorly in 401(k) plans, realizing lower yields than highly paid workers who can afford to contribute more and, hence, realize compounded returns on their investments earlier in their careers. Participation rates and contribution levels tend to be lower among low wage workers who are also more likely to make early withdrawals, using their funds as a rainy day account.
Workers in defined contribution plans are also likely to struggle with deciding how much they need to contribute to achieve a secure retirement, how to make the best investments, and how quickly to draw the money out after retirement to assure lifetime financial security.
The report concludes that defined contribution plans are still important to the retirement security equation, but they were not designed to stand very well on their own.
The full report can be accessed at http://www.nirsonline.org/.