A basic and increasingly nostalgic assumption
in the private pension world has long been that the financial
payouts of defined benefit plans are much better than those of
defined contribution plans, and its too bad that defined
benefit plans seem to be heading for extinction.
an Employee Benefit Research Institute study has cast doubt
on the conventional wisdom.
The study compared the tens of thousands of 401(k) plans in
EBRIs long-term database with two current defined benefit
plan models a standard three-year, final-average-pay
pension and a cash balance plan. Institute researchers found
that the 401(k) benefits were better for almost every age and
income cohort. The median differences ranged from about even to
44 percent, with higher earners and those with longer tenure
generally doing best with defined contribution plans.
How could that be?
Conventional wisdom always made defined benefit plans
more advantageous than they really are, says Jack
VanDerhei, EBRIs research director and the author of the
Not so fast, retort critics, arguing that the study makes a
lot of assumptions that are biased toward 401(k)s. In its
day, a defined benefit pension was a better way of delivering
benefits, says Alicia Munnell, director of the Center for
Retirement Research at Boston College. What the paper is
doing is looking at the effect of an institution in a world
that no longer exists.
One problem is that the report includes only voluntary
401(k)s, ignoring the automatic enrollment variety even
though the latter constitute more than half of all 401(k)s and
are steadily gaining ground, according to the consulting firm
Aon Hewitt. The study omitted them because researchers say
there was not enough data available on participants who opt out
of certain types.
In some ways, that methodology inherently tilts the
conclusion in favor of defined contributions. Thats
because the average contribution rate in auto-enrolled plans
6.6 percent of salary, according to Aon Hewitt is
lower than the average rate of 7.9 percent in the voluntary
type. (The most common auto-default rate 3 percent
is even worse.) Thus, in the real world, most employees
actually have significantly less money in their 401(k)s than
the samples in this survey, reducing any comparative advantage
against traditional pensions.
But VanDerhei argues that if the numbers are analyzed in
terms of what really matters how much money people are
accumulating for retirement the inclusion of
auto-enrollment plans would actually boost defined
contributions results versus defined benefits because
automatic plans cover more people. Auto-enrollment
increases low-income participation and thus increases their
benefits, he says.
Munnell also points out that the study uses
extraordinarily high assumed rates of return for
equities in 401(k) plans 8.6 percent. VanDerhei
says this is the average historical return for U.S. stocks.
However, rare is the amateur 401(k) investor who consistently
matches the markets historical returns. The paper also
admits that, if the assumed return rate is lowered by 200 basis
points and the purchase price for annuities is raised to
reflect todays bond rates, results show that in many
cases the [voluntary enrollment] 401(k) plans lose their
comparative advantage for lower-paid employees.
Even if all of the financial assumptions were accurate, the
report largely ignores the concept of opportunity costs.
Private pensions are essentially free money for employees, paid
directly by the employer. By contrast, employees have to fork
up most if not all of the contributions that go to build their
401(k) benefits. If they had a defined benefit, even a small
one, they could have used that 401(k) money for something
else, says Alan Glickstein, a senior consultant at Towers
The paper concedes this point as a caveat,
promising that a more nuanced approach to dealing with
this difference will be dealt with in a future EBRI
Ultimately, the biggest controversy revolves around whether
any defined benefitdefined contribution comparison even
makes sense. The paper assumes realistically, in
todays world that people dont stay with the
same employer for their entire career. That is not a problem
for a portable defined contribution plan. However, a
traditional pension doesnt work for frequent job-hoppers.
Employees would have to restart the benefit accrual from zero
at each new job assuming they could keep finding jobs
with defined benefit plans which would diminish the
benefit because the payout is based in part on the
employees longevity at that company.
This might seem to bring the argument back to the
conventional wisdom: Pensions are nice, but they are gone with
the wind. However, VanDerhei says his calculations serve a
valuable purpose in countering part of that nostalgia
the theory that, due to the disappearance of defined benefits,
retirement income has gone down so incredibly much that
GenXers are going to be worse off than Boomers.
Karen Ferguson, director of the Pension Rights Center in
Washington, D.C., says the papers chief value could be to
add to the ongoing debate over designing a better retirement
system that might include the best features of both defined
benefit and defined contribution plans. One solution implied in
the paper is cash balance plans with higher contribution rates.
That may already be happening. Since the passage of the Pension
Protection Act in 2006, says Towers Watsons Glickstein,
many of the ones we work with have more complicated
formulas now, including market-based rates.
VanDerhei says he agrees that cash balance plans with a
higher employer contribution could be a good solution.
You dont have to worry about the number of
employees participating, he points out. You
dont have to worry about the investment risk
falling on employees. But the key question, he says, is
how high would the contribution have to be?