There has been a heated debate over the respective merits of defined-benefit versus defined contribution retirement plans for many years now. A pension is perhaps the most well-known type of defined-benefit (DB) retirement plan, and a 401k is likely the most popular type of defined-contribution (DC) retirement plan.
Over the last few decades, with the exception of the public sector, the trend has been away from DB plans and toward DC plans. Critics of DC plans have argued that DC plans don’t offer retirees equal benefits or security as DB plans. In his report Defined-Contribution Pensions Are Cost-Effective, Josh B. McGee of the Manhattan Institute argues that DC plans have gotten a bad rap, and that defined-contribution retirement plans produce equal returns and can offer retirement security.
McGee identifies five key areas in which defined-contribution retirement plans have been maligned
In his report, McGee refutes five arguments against defined-contribution retirement plans which he says don’t hold water.
1. DC plans are just as cost-effective as DB plans. McGee notes: “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 and DB plans achieve similar investment returns. For the 17 years preceding 2012, the average estimated ten-year performance differences between DB and DC plans were less than half a percentage point and were not statistically significant in most cases. While bottom-performing DB plans outperformed bottom-performing DC plans, top-performing DC plans also outperformed top-performing DB plans. McGee notes that performance differences have decreased even further since 2000.
3. DC plans do offer annuities. McGee also points out that “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 major cost for DB plans. Critics of DC plans typically ignore the cost of carrying pension debt (one of the biggest cost drivers of DB plans) when making comparisons. McGee offers the example of carrying a pension debt of 10% of liabilities would boost annual costs as a percentage of payroll by around 70%; carrying a pension debt equal to 20% of liabilities sends annual costs surging to close to 140%.
5. DC plans can provide solid retirement security. Finally, McGee argues that most DC plans today include plan features such as “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.”
See full study below.