Defined Benefit Plans - A Better Bang for the Buck

An updated study by the National Institute on Retirement Security ( https://www.nirsonline.org/ ) again concluded that when compared to many Defined Contribution (DC) plans a Defined Benefit (DB) plan does a better job of providing needed retirement income. This is the third study the Institute has performed on this topic (previously 2008 and 2014). The current study, called “A Better Bang for the Buck 3.0” was written by the Institute’s Executive Director (Dan Doonan) and William Fornia, FSA, President of Pension Trustee Advisors.

The research paper concludes that DB plans provide significant cost advantages over 401(k)-style DC accounts. It’s important to note that the study focused on the total funding costs (combined employer and participant contributions) rather than just the employer’s funding costs. With this in mind, the results were that a DB plan has almost a 50% cost advantage as compared to a typical DC account, with the cost advantages resulting from the following: longevity risk pooling; higher investment returns; and optimally balanced investment portfolios. It’s also important to note that the study, for the most part, looked at plans where the member makes the investment elections on their account. For many of the plans that Zenith administers, the Trustees, rather than the members are responsible for making the investment choices. For these Trustee directed investment plans, it’s reasonable to assume the 49% cost differential noted in the study would be less.

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 for a typical DB plan (with a focus on public sector pay-based plans). These plans tend to design the retirement benefit as a percentage of what a member is being paid before retiring. For example, a full service retiree would receive a lifetime annuity of (say) 60% of what they were earning at retirement. Consequently, a member earning $50,000 would receive a lifetime pension of $30,000 per year ($2,500 per month). These plans tend to develop costs as a percentage of each year’s pay while the member is working rather than as a dollar amount per hour worked. For this study, the model DB plan’s annual cost worked out to 16.5% of the member’s annual salary.

As a next step they used this same cost in two types of DC plans; a typical individually directed DC plan (for example, a 401(k) plan) and an “ideal” DC plan modeled with what the study referred to as generous assumptions. The “ideal” plan design removed some of the performance drag and fee costs that they tend to see in participant directed plans. Therefore, the “ideal” plan could be viewed somewhat similar to the Trustee directed plans many of our clients offer.

The results were that both DC plans came up short versus the model DB plan and, therefore, could not provide the same level of lifetime income. As a next step, the study identified the causes of this shortfall in retirement income as follows:

·         Longevity risk pooling -The pooling of longevity risk in DB pensions enables them to fund benefits based on average life expectancy, and yet pay each worker monthly income no matter how long they live. In contrast, DC plans must receive excess contributions to enable each worker to self-insure against the possibility of living longer than average.

·         Higher investment returns - DB pensions realize higher net investment returns due to professional management and lower fees from economies of scale.

·         Optimally balanced investment portfolios - DB pensions are “ageless” 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. This means that over a lifetime, DB pensions earn higher investment returns as compared to DC accounts.

The following graph summarizes the results. The DB’s cost of 16.5% of annual payroll is 51% of the 32.3% for the “typical” participant directed DC plans, for a 49% savings. The 49% breaks down as:

·         7% savings from longevity pooling

·         12% savings from portfolio balancing (generally during retirement)

·         30% savings from better returns and lower fees

When compared to what the study calls an “ideal” DC plan, the savings is 27% (16.5% of payroll versus 22.6%).

As we’ve previously discussed in a different article that was about Variable Annuity Pension Plans (VAPPs) and Supplemental Income Plans (SIPs) https://zenith-american-blog.squarespace.com/blog/sips-and-vapps-what-are-they, VAPPs and SIPs try and retain some of the favorable DB plan features noted in the Institute’s study while minimizing the year over year cost fluctuations that’s viewed as a significant negative with traditional DB plans.

The Department of Labor is aware of these potential shortcomings in many DC plans and is looking for ways to help create better income results for DC plan participants. One recent step is to require DC plans to annually illustrate the annuity income the plan may generate for its participants. Please refer to https://zenith-american-blog.squarespace.com/blog/dc-plan-income-disclosures-are-coming for more on this new requirement. In addition, the American Academy of Actuaries Lifetime Income Risk Committee (which I am on) researches and advocates for ways to help all types of retirement plans become more cost efficient vehicles for providing quality lifetime income.

The full study is available directly from the National Institute on Retirement Security on their website at https://www.nirsonline.org/reports/betterbang3/. As always, if you have questions about this study please reach out to your Client Services Executive or other contacts at Zenith-American Solutions. In addition, feel free to reach out to your Plan’s Actuary or Fund Counsel.