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Who's Winning the Pension Wars?

April 19, 2013

By Richard Dreyfuss

While most private corporations moved to defined contribution (DC) pension plans decades ago, defined benefit (DB) plans remain common throughout the public sector. In pension reform debates, DB plans are often defended as cheaper to administer, thus offering taxpayers "more bang for the buck." The National Institute on Security has estimated that DB plans can provide the same level of income at nearly half the cost of a DC plan.

This claim is misleading. DC plans are not inherently more expensive to administer than DB plans. Arguments that they are, by the NIRS and others, are typically based on two flawed assumptions.

First, DB advocates assume that DC plans are less professionally managed than DB plans. This is the old wisdom. When 401(k) plans were first introduced there was often an absence of diversified fund options and little investment guidance provided to participants. In those days, the default investment option was frequently a stable-value fund providing a fixed rate of return. For a variety of reasons, many early 401(k) fund managers did not properly diversify and consequently invested up to 100 percent of their assets in this low-risk/low-return option. Such returns were often the basis of comparison against properly diversified DB portfolios. But markets change in response to consumer needs. As evidence of this, target-date funds based upon the participant’s assumed year of have emerged and in many cases represent the default 401(k) investment option. These funds are diversified and the asset composition of the fund automatically changes as the participant approaches . For others the preferred option is to participate in several "professionally managed" funds using the guidance of financial planning resources readily accessible to members.

In contrast, many DB plans need to achieve long-term investment annual return assumptions in the 7.5 percent range. This often leads them to take on excessive investment risks with high expenses, whereas many top-rated DC firms including Vanguard and Fidelity have capably managed 401(k) assets in a low-cost, competitive environment for years. Second, DB plans are said to be more efficient since DC participants must "over-save" to ensure they do not outlive their assets. DB plans, by contrast, are designed to provide average payouts for everyone, and thus face no over-saving problem.

But this presumes that DB participants who die early are perfectly content to subsidize longer-living members. Wouldn’t most people prefer any unpaid funds to be directed to their surviving family members or a preferred charity rather than a stranger within the plan pool? DB plans are also said to be more efficient than DC plans because they can invest for indefinite time horizons, which increases returns and lowers costs. But this only works because of a forced intergenerational subsidy from younger employees to older employees. It requires an ongoing inflow of new employees to sustain this arrangement.

Taxpayers rarely realize any of the "savings" that DB plans supposedly provide. The possibility of lower costs is exploited by those looking for a rationale to increase pension benefits. Moreover in 2010, 38 states failed to make their required DB contributions. In the private economy, employer contributions must be made on an ongoing basis into individual accounts.

The reality is DC plans have costs that are current, predictable and can easily be designed to be affordable. More states need to seriously consider joining Michigan and Alaska in enacting a reform that will move new hires into defined contribution plans.

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