Economic Efficiencies Unique to Pensions Enable Plans to Deliver Retirement Benefits at Half the Cost of 401(k) Accounts, With Four-Fifths of the Cost Differential Occurring Post-Retirement
A new analysis finds that defined benefit (DB) pension plans offer substantial cost advantages over 401(k)-style defined contribution (DC) accounts. A typical pension has a 49 percent cost advantage as compared to a typical DC account, with the cost advantages stemming from longevity risk pooling, higher investment returns, and optimally balanced investment portfolios.
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The analysis also indicates that about four-fifths of the cost difference occurs during post-retirement years. Once retired, individuals typically experience substantially higher fees when retirement assets are withdrawn from a workplace retirement plan.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.
These findings are contained in a new research report from the National Institute on Retirement Security (NIRS), A Better Bang for the Buck 3.0: Post-Retirement Experience Drives the Pension Cost Advantage. The research is co-authored by Dan Doonan, NIRS executive director, and William Fornia, FSA, Pension Trustee Advisors president.
“Pensions have economies of scale and risk pooling that just can’t be replicated by individual savings accounts,” Doonan said. “This means pensions can provide retirement benefits at a much lower cost. At the same time, 401(k)s have made significant progress in recent years when it comes to reducing costs and making investing easier for individuals. But the post-retirement period remains difficult to navigate for those in a 401(k) account. Retirees are transitioning from saving to spending down their retirement income at the right rate so they don’t outlive their savings. Also, post-retirement is the source of most of the cost difference between pensions and 401(k) accounts.”
“These cost differences are a key consideration for employers and policymakers given that most Americans are deeply worried about retirement and retirement savings levels are dangerously low for the typical U.S. household. Policymakers are wise to protect existing pensions while also fostering innovation in DC plans to improve the financial security of those relying on 401(k) accounts,” Doonan explained.
The analysis indicates that to achieve roughly the same target retirement benefit to replace 54 percent of final salary, a DB pension plan requires contributions equal to 16.5 percent of payroll. In contrast, an individually directed DC account requires contributions almost twice as high as the DB plan, at 32.3 percent of payroll.
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This report follows two previous analyses conducted in 2008 and 2014 comparing DB plans and DC accounts, and it includes two new elements not included in the previous studies: 1) the impact of the current low interest rate environment; and 2) how saving mid-career rather than early career reduces total retirement savings.
The research’s key findings are as follows:
- A typical DB plan has a 49 percent cost advantage compared to a typical individually directed DC plan because of longevity risk pooling, asset allocation, low fees, and professional management. Longevity risk pooling accounts for seven percent of the cost savings, a more diversified portfolio drives another 12 percent of the cost savings, and superior net investment returns from lower fees and professional asset management generate a 30 percent cost reduction.
- A DB pension plan costs 27 percent less than an “ideal” DC plan, with below-average fees and no individual investor deficiencies.
- Four-fifths of the difference in costs between the DB plan and an individually directed DC plan occurs during the post-retirement period. Retirees typically move from an environment that benefits from a long investment horizon and fiduciary protections to one where individuals manage their spend-down on a short-term basis without the benefits associated with longevity risk pooling.
In terms of the methodology, this research compares the relative costs of DB plans and DC accounts by constructing a model that first calculates the cost of achieving a target retirement benefit in a typical public sector DB plan. This includes calculating this cost as a level percent of payroll over a career, then calculating the cost of providing the same retirement benefit under two different types of DC plans: an “ideal” DC plan modeled with generous assumptions and a typical individually directed DC plan. Additional details on the methodology that account for the impact of alternative economic and demographic assumptions can be found in the report’s Technical Appendix.
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