Replace a pension with a 401(k)? Tradeoffs may impact employers as well as workers

Defined benefit plans offer distinct advantages over defined contribution 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.

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They said that in the private sector, companies began introducing 401 (k) plans in the 1980s and early in the 21st Century, they began to close or freeze Defined Benefit plans.

The researchers questioned the wisdom of doing that.

For their research, the two used a model based on a group of newly hired female teachers who are 30 years old on the starting date of employment. They work for 30 years, after taking two years off and retire at age 62.

The researchers found that while either type of plan can offer generous benefits, defined benefit plans have a clear cost advantage over defined contribution plans.

As a result, they reported, shifting from a defined benefit plan to a defined contribution plan would result in significant cuts in 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 shifting to a defined contribution plan could reduce the investment risks for employers and taxpayers, there are tradeoffs—either increased benefit costs or significantly reduced retirement benefits that do not offset the savings.

Their analysis found that a typical defined benefit plan that has the advantages of longevity risk-pooling, asset allocation, low fees and professional managementand  has a 49% cost advantage over Defined Contribution plans. The researchers found that the longevity risk pooling accounts for 7% of the savings, the plan’s ability to maintain a more diversified portfolio results in another 12% in cost savings and lower fees and professional management generates an additional 30% 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 postretirement,” 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 depend on benefit structure, they said.