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.