Tradeoffs for Employers in Replacing a Pension with a 401(k)

Defined-benefit (DB) plans offer distinct advantages over defined-contribution (DC) plans, and employers should carefully examine any claims that dispute that, according to new research from the National Institute on Retirement Security.

“This study finds that due to the effects of longevity risk pooling, maintenance of portfolio diversification, and greater investment returns over the lifecycle, a DB plan can provide the same level of retirement benefits at about 27 percent lower cost than an ideal DC plan and about 49 percent lower cost than an individually directed DC plan,” William B. Fornia, president of Pension Trustee Advisors and Dan Doonan, the executive director of the National Institute on Retirement Security, wrote in a research paper.

Private-sector companies began introducing 401(k) plans in the 1980s, and they began to close or freeze their defined-benefit plans early in the 21st century. The researchers question the wisdom of doing that.

Fornia and Doonan modeled the retirement prospects for a group of female teachers who were 30 years old on the starting date of employment. The teachers worked for 30 years, after taking two years off, and retired at age 62. The researchers found that while either type of plan would offer generous benefits for these teachers, a defined-benefit plan would have a clear cost advantage over a defined-contribution plan. As a result, the researchers reported, shifting from a defined-benefit plan to a defined-contribution plan would result in significant cuts to the teachers’ retirement income.

“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,” they wrote.

The researchers said that while moving to a defined-contribution plan could reduce the investment risks for employers and taxpayers, there are tradeoffs—either increased costs or significantly reduced retirement benefits—that do not fully offset those benefits.

Their analysis found that a typical defined-benefit plan that has the advantages of longevity-risk pooling, asset allocation, low fees, and professional management—and has a 49 percent cost advantage over defined-contribution plans. The researchers found that the longevity-risk pooling accounts for about 14 percent of the cost savings, the plan’s ability to maintain a more diversified portfolio accounts for about 24 percent, and lower fees and professional management accounts for about 60 percent of the overall reduction in costs.

“In other words, a typical DC plan costs nearly twice as much to provide the same level of retirement benefit as a DB plan, with four-fifths of the difference occurring post-retirement,” they concluded.

Policymakers are trying to address many of the problems with 401(k) plans, according to the report. Those problems include investment fees, investment options, investor behavior ,and retirement income outcomes.

There also is renewed interest in hybrid retirement benefits that combine some of the features of the two types of plans. The costs of those plans vary depending on benefit structure, they said.

From: BenefitsPRO