Defined benefit (DB) pension plans outshine 401k and similar defined contribution (DC) accounts, at least with cost, according to a new report from the National Institute on Retirement Security (NIRS).
The analysis finds that a typical pension has a 49% cost advantage when compared with a typical DC account, with the cost advantages stemming from longevity risk pooling, higher investment returns, and optimally balanced investment portfolios.
NIRS claims 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Once retired, individuals typically experience substantially higher fees when retirement assets are withdrawn from a workplace retirement plan.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, the report, A Better Bang for the Buck 3.0: Post-Retirement Experience Drives the Pension Cost Advantage, revealed.
“Pensions have economies of scale and risk pooling that just can’t be replicated by individual savings accounts,” co-author Dan Doonan, NIRS executive director, said in a statement. “This means pensions can provide retirement benefits at a much lower cost. At the same time, 401ks 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 401k account.”
The cost differences are a key consideration for employers and policymakers, given that most Americans are apprehensive about retirement, and retirement savings levels, he said, are dangerously low.
Specifically, the analysis indicates that to achieve roughly the same target retirement benefit to replace 54% of final salary, a DB pension plan requires contributions equal to 16.5% of payroll. In contrast, an individually directed DC account requires contributions almost twice as high as the DB plan, at 32.3% of payroll.
Key findings include:
- A typical DB plan has a 49% 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% of the cost savings, a more diversified portfolio drives another 12% of the cost savings, and superior net investment returns from lower fees and professional asset management generate a 30% cost reduction.
- A DB pension plan costs 27% 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.
THE FULL REPORT IS FOUND HERE
With more than 20 years serving financial markets, John Sullivan is the former editor-in-chief of Investment Advisor magazine and retirement editor of ThinkAdvisor.com. Sullivan is also the former editor of Boomer Market Advisor and Bank Advisor magazines, and has a background in the insurance and investment industries in addition to his journalism roots.