The debate over the relative merits of defined benefit versus defined contribution retirement plans rages on.
A recent study by theEmployee Benefit Research Institute stirred controversy when it came down heavily on the side of 401(k) plans.
Meanwhile, a report by New Yorkbased consulting firm Towers Watson in May finds that defined benefit plans have outperformed defined contribution plans over the last 17 years. In some years, such as 2009, defined contribution plans held a temporary advantage. Further, the performance advantage enjoyed by defined benefit plans has narrowed over the past five years.
In the most recent year included in the study, 2011, defined benefit plans held a 2.96 percentage point advantage, their best performance in the past 17 years. The better DB plan performance was likely due to strong performances in long bond markets coupled with lower equity holdings at a time when equities underperformed, writes the author of the report, Brendan McFarland, a senior research associate at Towers Watson.
Asset-weighted median rates
of return for DB and DC plans
The study found that defined benefit returns averaged 8.01 percent a year and beat by 76 basis points the 7.25 percent average returns reported by defined contribution plans. That difference is meaningful, according to Dave Suchsland, senior retirement consultant at Towers Watson. That reinforces the point that defined benefit plans although they have their accounting challenges are a cheaper way to fund the same benefits, he says. If both kinds of plans are going to provide the same level of benefit, you can get there with less contributions in a defined benefit plan because of the better returns.
Towers Watson also found that size matters for both defined benefit and defined contribution plans. Big plans do better than small plans across the board, says Suchsland. In big plans what you have is access to better investment advisers and bigger pools of assets that allow for better diversification into a lot of asset classes that might not be affordable in small plans or in defined contribution plans for example, private equity or real estate. Larger plans also have better purchasing power and lower costs, he adds, which translate into higher returns.
To demonstrate the effect of plan size on rates of return, Towers Watson compared the largest defined benefit plans to the smallest ones and did the same thing for defined contribution plans. Over the 17-year period, the largest defined benefit plans had a 7.93 percent rate of return, nearly 3 percentage points higher than the 5.04 percent return for the smallest ones. The performance differential was smaller for defined contribution plans: 6.94 percent versus for the largest compared to 6.18 percent for the smallest. Contrary to the broader trends, small defined contribution plans outperformed small defined benefit plans (6.18 percent to 5.04 percent).
Not everyone is ready to concede that defined benefit plans have a permanent advantage that lowers the cost of delivering the same benefit. Richard Hiller, senior vice president for government market at $523 billion financial services firm TIAA-CREF, thinks that such comparisons need a few caveats. When youre looking at defined contribution plans, the corporate 401(k) is almost always used as the definition [of the corporate DC plan world], and thats where really my concern is, he says. Is that an appropriate comparison to a DB plan?
More fundamentally, is it useful to compare overall returns for all defined benefit plans versus all defined contribution plans? Hiller argues that the performance of retirement plans should be evaluated and compared on the basis of the intended objective. If you are talking about income security as the objective, lets look at the plans ability to produce an adequate stream of income in retirement, he says. Obviously defined benefit plans will excel at doing that, which is really what they are designed around.
The defined contribution world contains plans with a variety of savings goals that are not uniform in their objectives, Hiller points out. The 401(k) was originally designed to supplement the defined benefit plan [and not intended] to be a primary retirement plan vehicle in and of itself, he says.
Yet, Hiller believes that a well-designed defined contribution plan can deliver the same level of retirement benefits as a good defined benefit plan. And, he adds, a defined contribution plan that defaults into target date funds can give individuals access to professional management of a large pool of assets with the same range of diversified investments as can be found with large defined benefit plans, and with lower costs.
Indeed, the TIAA (for Teachers Insurance and Annuity Association) part of TIAA-CREF was launched in 1918 by grants from Andrew Carnegie to be a portable defined contribution plan with a fixed annuity designed to deliver good retirement benefits to college professors even as they moved from one college to another during their careers, Hiller notes.
If youre going to compare defined benefit to defined contribution, [the TIAA plan] is the kind of defined contribution plan you should be using and not plans designed to be supplemental savings plans, Hiller contends. And a lot of whats going on in the 401(k) world today is to try to make those plans more of a true retirement plan than a supplemental plan.