Defined Contribution Plan Cost is More Than Pension

Improve Retirement ReadinessDefined contribution plan cost is a true expense for employers. But where does the Defined Contribution plan cost stack up against the old pension plans?  It turns out that defined benefit plans may be less expensive for employers than the defined contribution plan cost – such as 401(k)s. That includes viewing overall costs to both employers and employees.  This is according to a recent survey from the National Institute on Retirement Security.

The survey, cited in InvestmentNews, found that while initially, switching to a DC plan may save an employer money, the cost of the benefit rises over time. According to the report’s authors, William Fornia and Dan Doonan, quoted in InvestmentNews, “‘Switching from a DB to a DC system saves money only if it involves substantial cuts to employee benefits…  a typical DB plan, with advantages based on longevity risk pooling, asset allocation, low fees and professional management, has a 49% cost advantage compared to a typical individually directed DC plan.’”

According to the report, that difference is due to a:

  • 7% cost savings from longevity risk pooling in DB plans
  • 12% savings from more diversified portfolios
  • 30% savings from higher net investment returns

The cost savings gap is smaller for an “ideal” DC plan, at 27%. The NIRS report defines this type of plan as one where participants are put into appropriate, all-in-one investment options with low fees. However, that figure doesn’t account for participants who take loans or cash out early, the study’s authors noted.

The past several decades have seen employers switch increasingly to DC plans from DB plans.  Many times this is in an effort to reduce the liability when it came to providing pension payments to retired employees. This challenge was exacerbated by longer life expectancies. As of 2020, assets in U.S. pension plans totaled roughly $10.5 trillion, accounting for about 30% of the total $34.9 trillion in overall retirement assets in the country, according to data from the Investment Company Institute cited in InvestmentNews. By comparison, pension assets were about $6 trillion in 2005, representing nearly 42% of all U.S. retirement savings, or $14.4 trillion.

Retirement years account for about 80% of the difference in cost of DB vs. DC plans. Defined contribution plan cost has an impact on both plan sponsor and plan participants.  Defined benefit plans benefit from risk pooling and higher returns. Contrast that to DC plan participants, who typically must figure out how to purchase an annuity or strategically spend down their savings on their own, according to the report. Defined contribution plan cost often includes the risk of either spending down assets too quickly, or holding onto them and having a lower standard of living as a result.

Lifetime income options may help to mitigate some of these risks, however, most retirement plan sponsors still don’t offer them. The SECURE Act 2.0, still under consideration on Capitol Hill, may make it even easier for employers to offer lifetime income options in retirement plans. According to the report’s authors, helping DC plan participants generate a guaranteed stream of retirement income could vastly improve their experience in these plans.

According to InvestmentNews, “The researchers based the comparison on savings for a hypothetical group of 1,000 newly hired employees, all 30-year-old female teachers. Those workers took a two-year break from their careers to raise children, resumed work at age 35 and retired at 62 with a final salary of $60,000. The target retirement benefit for those teachers was just over $32,000 a year, with an annual cost-of-living adjustment. Combined with Social Security, that would yield retirement income of about 83% of their pre-retirement levels, according to the report.

To reach that level, a DB plan would need to accumulate $520,000 per worker, while a DC account would need to reach $600,000 in order to minimize the risk of running out of money, the authors noted.”

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