When given the choice between a traditional defined benefit pension or a defined contribution savings plan, the vast majority of public employees chose the traditional pension plan, according to a study by the National Institute for Retirement Security and consulting firm Milliman Inc.
The study found that defined benefit plans are more cost efficient that defined contribution plans. The study also surfaced significant differences in the return stream in each type of plan. Over a 30-year period, defined benefit plans delivered an almost 25 percent greater return to participants than defined contribution plans. On an annual basis, the research found that the DB plans outperformed the DC by between 80 to 270 basis points.
These results are important because in the private sector many employers have frozen their traditional pensions to new hires and replaced them with 401(k) or similar plans that formerly were supplemental savings plans. The corporate sponsors thinking was that DC plans off load all the investment risk to employees and reduce costs to the corporations.
A number of the biggest public pensions plans have given employees a choice between the two kinds of retirement plans, rather than forcing them out of one into the other, enabling NIRS and Milliman to crunch the data and arrive at their findings.
Seven public pension systems that offered employees a choice between DB and DC plans were analyzed. The employers included:
The Colorado Public Employees Retirement Association; Florida Retirement System; Montana Public Employee Retirement Administration; North Dakota Public Employees Retirement System; Ohio Public Employees Retirement System; State Teachers Retirement System of Ohio; and South Carolina Retirement Systems.
The DB uptake rate ranged from 98 to 75 percent of employees. The percentage of new employees choosing a DC plan ranged from 2 to 25 percent for the plans studied.
Several other plans were studied. Beyond the seven states analyzed that offer DB-DC choice, the experiences of Nebraska and West Virginia offer additional insight, said report co-author Mark Olleman, consulting actuary and principal with Milliman. Both states chose to put new hires in a DC plan, and then later changed to DB. Nebraska offered some employees hired between 1964 and 2003 only a DC plan, but also maintained a DB plan for other employees. Over 20 years, the average investment return in the DB plan was 11 percent, and the average return in the DC plans was between 6 and 7 percent.
West Virginia closed their Teachers DB plan to new hires in 1991 in response to funding problems and put all new hires in a DC plan. Unfortunately this did not solve the funding problem, and many teachers found it difficult to retire when relying only on the DC plan. West Virginia performed a study, found a given level of benefits could be funded for a lower cost through a DB plan, and put all teachers hired after July 1, 2005, in the DB plan as a cost-saving measure. So both Nebraska and West Virginia found a DC plan did not achieve their goals and changed from DC to DB.
Olleman stressed that DB plans are lower cost for two main reasons. One, because of their higher investment returns and two, due to longevity risk pooling, meaning participants of different ages are pooled in one big fund versus participants bearing their own longevity risk alone in an individual plan.
While corporate pension sponsors might not be ready to shift employees back to their defined benefit plans just yet, there may be hope with hybrid plans. New hybrid plans incorporate elements of both DB and DC plans and can spread the risks between employer and employees. The State of Utah has developed just such a plan that caps the DB funding risk to employers, shifting the rest to employees.