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Pensions Deliver Benefits More Efficiently than 401(k)s, NIRS Study Finds
Defined benefit pensions continue to offer significant economic efficiencies that individual defined contribution accounts can't replicate, a new analysis by the National Institute on Retirement Security has found.
Pensions Deliver Benefits More Efficiently than 401(k)s, NIRS Study Finds
Defined benefit pensions continue to offer significant economic efficiencies that individual defined contribution accounts can't replicate, a new analysis by the National Institute on Retirement Security has found.
A typical pension has a 49% cost advantage as compared to a typical 401(k) plan or similar account because of features such as longevity risk pooling, higher investment returns, and optimally balanced investment portfolios, NIRS reported.
“DB plans should remain a centerpiece of retirement income policy and practice, given the persistent advantages in economic efficiency,” NIRS concluded.
The report, titled A Better Bang for the Buck 3.0: Post-Retirement Experience Drives the Pension Cost Advantage, is based on a comparison of defined benefit and defined contribution plans, and follows previous analyses conducted in 2008 and 2014. NIRS constructed a model that looks at the cost of achieving a target retirement benefit in a typical public sector pension plan. It then compares the cost of providing the same benefit via an “ideal” defined contribution based on generous assumptions and a typical individually directed plan.
NIRS broke down the elements of the 49% cost advantage of a typical defined benefit plan versus a typical defined contribution plan, which puts the burden on an individual worker to manage their portfolio.
- Longevity risk pooling accounts for 7% of the cost savings. NIRS noted that pooling risk enables pension funds to fund benefits based on average life expectancy, while paying each worker monthly income no matter how long they live. Workers with defined contribution plans, on the other hand, have to self-insure against the possibility of living longer and outlasting their financial resources by making excess contributions.
- A more diversified portfolio makes up 12% of the cost savings. Pensions are “ageless” and therefore “can perpetually maintain an optimally balanced investment portfolio rather than the typical individual strategy of downshifting over time to a lower risk/return asset allocation,” the report said. The upshot is that over a lifetime, pensions earn higher investment returns as compared to defined contribution accounts.
- Superior investment returns from lower fees and professional asset management accounts for 30% of the cost savings. Pensions realize higher net investment returns due to professional management and lower fees from economies of scale, the report said.
Pensions maintained their advantage even when compared to an “ideal” defined contribution account. A defined benefit pension plan costs 27% than such a plan, which would be generously modeled to include the same fees and investor skill as a pension plan.
Stated another way, the report found that a defined contribution plan would require contributions equal to 16.5% of payroll to achieve a target retirement benefit that will replace 54% of final salary. An individually directed defined contribution almost twice as much—32.3% of payroll. And even an “ideal” plan would need 22.6% of payroll to provide the targeted benefits.
NIRS said that four-fifths of the difference in costs between pensions and defined contribution accounts occurs during the post-retirement period. “Retirees typically move from an environment that benefits from a long investment horizon and fiduciary protections to one where individuals manage their spend-down on a short-term basis without the benefits associated with longevity risk pooling,” the report said.
The report also tackles two new topics: The impact of the current low interest rate environment on portfolios, and how saving mid-career rather than early in a career reduces total retirement savings.
You may also like: NIRS Report: Rising Risks and Costs Threaten Americans' Retirement Security; The Case for Public Pensions.
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