A Better Bang for the Buck: The Economic Efficiencies of Defined Benefit Pension Plans

Reference: National Institute on Retirement Security

By Beth Almeida and William B. Fornia, FSA

August 2008

Introduction

Worries about retirement security abound. Families fear that they won’t have enough to support an adequate retirement income as home values and financial markets plummet. Dwindling profit margins have employers looking to cut costs. And governments are concerned about delivering on the promises that they have made to their citizens and to their employees as tax revenues shrink amid a weakening economy.

In this environment, some have proposed replacing traditional defined benefit (DB) pensions with 401(k)-type defined contribution (DC) retirement savings plans in an effort to save money. But decision makers would be wise to look before they leap. To deliver the same level of retirement benefits, a DB plan can do the job at almost half the cost of a DC plan. Hence, DB plans should remain an integral part of retirement income security in an increasingly uncertain world because they offer employers and employees a better bang for the buck.

The value of traditional DB pensions to employees is generally recognized: they provide a secure, predictable retirement income that cannot be outlived. But less well known is the value of a DB pension to an employer. Due to their group nature, DB plans possess “built-in” savings, which make them highly efficient retirement income vehicles, capable of delivering retirement benefits at a low cost to the employer and employee. These savings derive from three principal sources.

First, DB plans better manage longevity risk, or the chance of running out of money in retirement. By pooling the longevity risks of large numbers of individuals, DB plans avoid the “over saving” dilemma – that is, saving more than people need on average to avoid running out of cash – that is inherent in DC plans. Consequently, DB plans are able to do more with less.

Second, because DB plans, unlike the individuals in them, do not age, they are able to take advantage of the enhanced investments returns that come from a balanced portfolio throughout an individual’s lifetime.

Third, DB plans, which are professionally managed, achieve greater investment returns as compared with DC plans that are made up of individual accounts. A retirement system that achieves higher investment returns can deliver any given level of benefit at a lower cost.

Because of these three factors, we find that a DB pension plan can offer the same retirement benefit at close to half the cost of a DC retirement savings plan. Specifically, our analysis indicates that the cost to deliver the same level of retirement income to a group of employees is 46% lower in a DB plan than it is in a DC plan. This is an important factor for policy makers to consider, especially with respect to public sector workforces, where tax dollars are an important source of funds for retirement benefits. DB plans are a more efficient use of taxpayer funds when offering retirement benefits to state and local government employees.

More specifically, this study finds that…

  • Longevity risk pooling in a DB plan saves 15%,
  • Maintenance of a balanced portfolio diversification in a DB plan saves 5%, and
  • A DB plan’s superior investment returns save 26%

…as compared with a typical DC plan.

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For further reading from a more recent study, please see “The Pension Factor 2012: Assessing the Role of Defined Benefit Plans in Reducing Elder Economic Hardships.”