It has become something of a truism in our industry that defined benefit plans are “better” than defined contribution plans. We’re told that returns are higher[1. In the days following publication of the EBRI Issue Brief, (“Reality Checks: A Comparative Analysis of Future Benefits from Private-Sector, Voluntary-Enrollment 401(k) Plans vs. Stylized, Final-Average-Pay Defined Benefit and Cash Balance Plans,” online here), a number of individuals commented specifically on the chronicled difference in return in DB and DC plans; outside of some exceptions in the public sector, DB investment performance generally has no effect on the benefits paid.] and fees lower in the former; that employees are better served by having the investment decisions made by professionals; and that many individuals don’t save enough on their own to provide the level of retirement income that they could expect from a defined benefit pension plan.
Even the recent (arguably positive) changes in defined contribution design — automatic enrollment, qualified default investment alternatives and the expanding availability of retirement income options[2. A recent EBRI analysis indicates that even in DB plans, the rate of annuitization varies directly with the degree to which plan rules restrict the ability to choose a partial or lump-sum distribution. See “Annuity and Lump-Sum Decisions in Defined Benefit Plans: The Role of Plan Rules,” online here. ] — are often said to represent the “DB-ification” of DC plans.
However, a recent analysis by EBRI reveals that DB is not always “better,” at least not defined as providing financial resources in retirement. In fact, if historical rates of return are assumed, as well as annuity purchase prices reflecting average bond rates over the last 27 years, the median comparisons show a strong outcome advantage for voluntary-enrollment 401(k) plans over both stylized, final-average DB plan and cash balance plan designs.[3. While the DC plans modeled in this analysis draw from the actual design experience of several hundred voluntary-enrollment 401(k) plans, in the interest of clarity it was decided to limit the comparisons for DB plans to only two stylized representative plan designs: a high-three-year, final-average DB plan and a cash balance plan. Median generosity parameters are used for baseline purposes but comparisons are also re-run with more generous provisions (the 75th percentile) as part of the sensitivity analysis.]
Admittedly, those findings are based on a number of assumptions, not the least of which include the specific benefit formulae of the DB plans, and the performance of the markets. Indeed, the analysis in the June EBRI Issue Brief takes pains not only to outline and explain those assumptions,[4. The report notes that a multitude of factors affect the ultimate outcome: interest rates and investment returns; the level and length of participation; an individual’s age, job tenure and remaining length of time in the work force; and the purchase price of an annuity, among other things.] but, using EBRI’s unique Retirement Security Projection Model® (RSPM) to produce a wide range of simulations, provides a direct comparison of the likely benefits in a number of possible scenarios, some of which provide different comparative outcomes. While the results do reflect the projected cumulative effects of job changes and things like loans, as well as the real-life 401(k) plan design parameters in several hundred different plans, they do not yet incorporate the potentially positive impact that automatic enrollment might have, particularly for lower-income individuals.
Significantly, the EBRI report does take into account another real-world factor that is frequently overlooked in the DB-to-DC comparisons: the actual job tenure experience of those in the private sector. In fact, as a recent EBRI Notes article points out,[5. The EBRI report highlights several implications of these tenure trends: the effect on DB accruals (even for workers still covered by those programs), the impact of the lump-sum distributions that often accompany job change, and the implications for social programs and workplace stability. See “Employee Tenure Trends, 1983–2012,” online here.] the data on employee tenure (the amount of time an individual has been with his or her current employer) show that so-called “career jobs” never existed for most workers.
Indeed, over the past nearly 30 years, the median tenure of all wage and salary workers age 20 or older has held steady at approximately five years. Even with today’s accelerated vesting schedules, that kind of turnover represents a kind of tenure “leakage” that can have a significant impact on pension benefits — even when they work for an employer that offers that benefit, they simply don’t work for one employer long enough to qualify for a meaningful benefit.
So, which type of retirement plan is “better”? As advisors know — and as the EBRI analysis illustrates — there is no single right answer. But the data do suggest that ignoring how often people actually change employers can be as misleading as ignoring how much they actually save.
Footnotes
