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Study Stirs Pension Debate by Touting DC Plans’ Performance

Manhattan Institute paper contends that defined contribution plans have narrowed the performance gap with defined benefit plans, and that top DC plans beat their DB peers.

Those who dare to enter the bitter debate over whether U.S. employers should offer defined benefit or defined contribution retirement plans have often assumed that DB plans are better for employees, even as they acknowledge that companies have good reasons to move to a DC world, to offload pension liabilities and the earnings volatility that comes with them. But a new paper seeks to dispel some of that conventional wisdom, arguing that DC plans can offer advantages to employees as well as employers.

Well-designed defined contribution pension plans “address some of the most significant flaws of the predominant defined-benefit model,” argues a new paper from the Manhattan Institute for Policy Research, a conservative think tank. The paper, “Defined-Contribution Pensions Are Cost-Effective,” was written by Josh McGee, a Houston-based senior fellow at the institute and vice president of public accountability at the Laura and John Arnold Foundation, a leading advocate of pension reforms that often favors DC solutions.

McGee goes over some well-worn ground, noting that DB plans tend to skew benefits toward long-serving employees. In today’s economy, in which workers frequently change jobs rather than spending their career with one firm, DC plans offer a better deal for many workers, he argues.

The author enters more provocative territory when it comes to performance, though, arguing that DC plans can offer returns that are nearly as good as, if not better than, DB alternatives.

A median U.S. defined benefit plan, in performance terms, posted average annual investment returns that were 0.45 percentage points higher than a comparable DC plan between 1990 and 2012.(These figures are for all private sector schemes above a certain very small size that present Form 5500 to the government.) McGee contends that this performance edge is smaller than many DB advocates suggest, although many institutional investors would regard such sustained outperformance as substantial. McGee says the DB edge dropped to 0.29 percentage points from 2003 to 2012, suggesting the performance gap may have narrowed.

The report also finds that the best DC schemes have a better record than their DB counterparts. A 90th-percentile DC scheme, in performance terms, showed an annual return 1.8 percentage points better than a 90th-percentile DB plan between 1990 and 2012.

The paper also suggests that defined benefit schemes tend to be loaded with debt, distorting their true cost. McGee writes that, since 2001, annual state and local government contributions to pension plans have nearly tripled, from 6.7 percent to 18.6 percent of payroll, to bring plans into the black.

“Claims of the superior efficiency of DB plans — underpinned by false assumptions and a neglect of pension debt as a significant cost driver — are not supported by empirical evidence,” McGee contends.

Other pension experts take issue with his findings.

Diane Oakley, executive director of the National Institute on Retirement Security, a nonprofit institute based in Washington, disputes McGee’s assertion that defined benefit plans were less cost-effective than defined contribution ones. “A defined contribution plan will cost you [the employer] 29 percent more than if you provided the same benefit in a defined benefit plan,” she says. Oakley attributes the cost difference largely to the return penalty that defined contribution scheme members face in the years before they retire, when they invest in safer, lower-return assets — a problem not faced by defined benefit schemes.

U.S. companies have increasingly moved from defined benefit plans — by which they provide a fixed pension to former employees depending on years of service and pay — to defined contribution schemes, in which employees pay fixed contributions and receive a pension based on the investment returns of these contributions. In the public sector, however, defined benefit schemes remain common because labor unions have campaigned to keep them on the ground that the employer, rather than the employee, should bear the investment risk. In theory, the actual return of funds invested in a defined benefit plan is irrelevant to an employee, since the benefits are fixed. The better the defined benefit return, however, the less likely the employer is in the long term to curtail or close schemes or to cut employees’ compensation in other ways.

In conversation with Institutional Investor, McGee says public DB plans have some notable drawbacks, including a tendency to overinvest in-state, to support the local economy. “Defined-benefit-scheme institutional investors are susceptible to a lot of the behavioral quirks that individuals are susceptible to, plus politics,” he says. His report also takes issue with another common argument in favor of defined benefit schemes: that they are more cost-efficient because fees are lower. The paper refers to recent analysis from diverse sources, including Boston College’s Center for Retirement Research, finding that average costs for DB schemes are about 40 basis points or slightly higher. This is greater than the average for large DC schemes with more than $1 billion in assets, according to research by McGee, though small DC schemes have much greater costs than the DB average.

Some in the sector dispute that claim, however. “If you’re the employer and your goal is to reward your long-service employees and help prepare them for retirement, a defined benefit plan is the most effective way of delivering those benefits, hands down,” says Scott Kropf, a New York–based managing director at Buck Consultants, a human resources advisory arm of Xerox Corp. DB plans are cost effective because of their ability to pool risk, and because most are structured to offer proportionately greater benefits to long-serving employees, he argues.

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