Pension plans cheaper overall than 401(k)s, researchers find

A pension research group has a message for employers: The switch from defined-benefit plans to 401(k)s has made retirement saving more expensive.

That conclusion takes into account the costs borne by both employers and employees. Switching to a defined-contribution plan can of course save companies money, but the overall cost of the benefit increases, according to the National Institute on Retirement Security. The nonprofit this month published its third iteration of a paper on the topic, with the new research factoring in the current low-interest-rate environment and the effects of starting to save for retirement mid-career.

“Switching from a DB to a DC system saves money only if it involves substantial cuts to employee benefits,” authors William Fornia and Dan Doonan wrote. “A typical DB plan, with advantages based on longevity risk pooling, asset allocation, low fees and professional management, has a 49% cost advantage compared to a typical individually directed DC plan.”

That difference is due to a 7% cost savings due to longevity risk pooling for DB plans, a 12% savings from having a more diversified portfolio and a 30% savings from higher net investment returns, according to the report.

Compared to an “ideal” DC plan, in which participants are automatically placed into appropriate all-in-one investment options that have low fees, the savings difference is smaller, at 27%. However, that analysis, like the comparison between DB plans and average DC plans, doesn't take into account the tendency of 401(k) participants to take loans against their accounts or cash out early, the authors noted.

Employers increasingly have switched to DC plans over the past several decades, with the liability of providing pension payments to retired workers being a major concern, one that has been exacerbated by longer life expectancies. While pension plans were not the norm in 2008, the financial crisis further strained the system, the authors noted.

As of 2020, assets in U.S. pension plans totaled roughly $10.5 trillion, representing about 30% of the total $34.9 trillion in overall retirement assets in the country, according to data from the Investment Company Institute. By comparison, pension assets were about $6 trillion in 2005, accounting for nearly 42% of all U.S. retirement savings, or $14.4 trillion.

“While shifting from a DB pension to a DC plan offers a way to reduce the investment risk borne by employers and taxpayers, this comes with an unavoidable tradeoff — either increased benefit costs or, more likely, significant retirement benefit cuts that are larger than the savings realized by the employer,” the recent NIRS paper read.

About 80% of the difference in cost is seen during the retirement years, when DB plans have the benefits of risk pooling and higher returns, while participants in DC plans are generally on their own when it comes to buying annuities or deciding how to optimally spend down their savings, according to the report.

“Research suggests that many individuals struggle with this task, either drawing down funds too quickly and running out of money, or holding on to funds too tightly and enjoying a lower standard of living as a result,” the authors wrote. “In theory, employers that offer DC plans could provide annuity payout options, but in practice they rarely do.”

The SECURE Act could eventually change that, and there have been a number of in-plan annuity products appearing on the market. Employers have not been quick to include those, particularly as part of their plans’ default options. Policy makers should continue to focus on ways to help include lifetime income options in DC plans, the authors wrote.

“[Annuities] tend to be expensive due to today’s low interest environment, insurer profit objectives, marketing and administrative costs and adverse selection,” they noted. “But, as … the greatest potential for improving the DC plan experience for participants lies in figuring out a safe and economically efficient means of generating post-retirement income.”

The researchers based the comparison on savings for a hypothetical group of 1,000 newly hired employees, all 30-year-old female teachers. Those workers took a two-year break from their careers to raise children, resumed work at age 35 and retired at 62 with a final salary of $60,000. The target retirement benefit for those teachers was just over $32,000 a year, with an annual cost-of-living adjustment. Combined with Social Security, that would yield retirement income of about 83% of their pre-retirement levels, according to the report.

To reach that level, a DB plan would need to accumulate $520,000 per worker, while a DC account would need to reach $600,000 in order to minimize the risk of running out of money, the authors noted.