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Defined-Contribution Pensions

Defined-Contribution Pensions Are Cost-Effective

Defined-Contribution Pensions Are Cost-Effective by Josh B. McGee, Manhattan Institute

Executive Summary

In recent decades, U.S. private-sector employers have increasingly offered retirement benefits through defined-contribution retirement (DC) plans. The share of workers who are offered a retirement plan through their employer and who participate only in a DC plan has increased—from 16 percent in 1979 to 69 percent in 2011. Yet the vast majority of American public-sector workers (75 percent) still earn retirement benefits under a defined-benefit retirement (DB) plan.

The relative merits of DC plans and DB plans have long been debated. Many public-sector employers have recently considered placing new employees in a DC plan; but only two states, Michigan and Alaska, as well as a handful of cities, currently use a DC plan as the primary retirement savings vehicle for new employees. When state and local governments have considered adopting a DC plan for new employees, they have encountered significant opposition from organized labor, managers of current public-retirement systems, and the cottage industry of consultants that supports public DB plans.

Critics of DC plans argue that DB plans are more cost-effective because the latter deliver higher investment returns and convert retirement savings into annuities. This paper investigates whether such assertions hold up to empirical scrutiny. Key findings include:

1. DB plans are not structurally more cost-effective than DC plans. Claims of the superior efficiency of DB plans—underpinned by false assumptions and a neglect of pension debt as a significant cost driver—are not supported by empirical evidence.

2. DC plans achieve similar investment returns. Between 1995 and 2012, average estimated ten-year performance differences between DB and DC plans—at the mean, median, 25th, and 75th percentiles—were less than half a percentage point and were generally not statistically significant. Bottom-performing DB plans outperformed bottom-performing DC plans; top-performing DC plans outperformed top-performing DB plans. Since 2000, performance differences have further narrowed.

3. DC plans can—and do—offer annuities. The limited availability of annuities among private-sector DC plans is largely the result of misguided federal regulation discouraging their provision. Nevertheless, a number of private-sector firms provide annuities under their DC plans. And most public-sector employers—which do not face regulation hostile to annuities—provide annuities at favorable prices under their DC plans.

4. Pension debt is a significant cost driver for DB plans. DC plan critics generally ignore the cost of carrying pension debt—one of DB plans’ largest cost drivers—in their DC-DB plan comparisons. For example, carrying a pension debt equal to 10 percent of liabilities would increase annual cost as a percentage of payroll by around 70 percent; carrying a debt equal to 20 percent of liabilities would increase annual cost by around 140 percent.

5. Defined-Contribution pensions plans are a good option for providing retirement security. Most current DC plans include a number of plan features—including well-designed, diversified, professionally managed investment products—that automatically place participants on a secure retirement path. DC plans can also solve many of the political-economy and benefit-design problems associated with DB plans.

Defined-Contribution Pensions Are Cost-Effective – Introduction

Retirement benefits are an important and valued component of compensation, and promoting retirement security is a worthy policy goal. Recognizing this, the vast majority of employers offer full-time workers some form of retirement benefits. Two broad categories of retirement savings vehicles have evolved over the years: defined-benefit (DB) and defined-contribution (DC) plans. In a typical DB plan, workers are promised a monthly retirement benefit based on salary, age, and years of service. In a typical DC plan, workers are promised a certain level of annual employer contributions to individual accounts.

The relative merits of DB and DC retirement plans have long been debated. This debate has occurred as the use of DC plans has increased significantly in the private sector, from 16 percent of primary-plan participation in 1979 to 69 percent in 2011. The vast majority—in 2014, 75 percent—of public-sector employees continue to earn retirement benefits under a DB system.

The private-sector shift to DC plans has been driven by a number of factors widely discussed in the academic literature. While some of the causes are unique to the private sector, public-sector plans have experienced their own challenges that have precipitated retirement plan changes in nearly every jurisdiction in the United States. State and local governments now shoulder a public pension debt of $1.3–$6 trillion for benefits that workers have already earned. Since 2001, taxpayer contributions to public-retirement plans have nearly tripled. In 49 of 50 states, benefits have changed substantially for at least some public workers as well.

Defined-Contribution Pensions

Defined-Contribution Pensions

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