Report Suggests DC Plans At Least As Efficient As DBs

Analyses of the cost effectiveness of DB plans ignore pension debt, according to one researcher.

A Civic Report published by the Manhattan Institute aims to refute earlier studies that find defined benefit (DB) plans are more cost-effective for state and local governments than defined contribution (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,” writes Josh B. McGee, senior fellow at the Manhattan Institute, in “Defined-Contribution Pensions Are Cost-Effective.”              

McGee notes that governments that have considered switching to DC plans have encountered significant resistance from organized labor, managers of current public-retirement systems, and the industry of consultants that supports public DB plans. He points out that one of the most vocal critics of DC plans for government workers is the National Institute for Retirement Security (NIRS), which has published reports asserting that DB plans provide benefits at nearly half the cost of those provided by DC plans.

McGee contends that analyses such as NIRS’s ignore pension debt as a significant cost driver for DB plans. In addition, he argues that both theory and practice suggest that well-designed DC plans can deliver benefits at least as efficiently as DB plans. “Though not a panacea for all retirement-policy problems and not the only viable option, well-designed DC plans address some of the most significant flaws of the predominant DB model. DC plans are less back-loaded than DB plans—allowing workers to earn a reasonable retirement benefit regardless of age and tenure—and they eliminate the prospect of pension debt,” he writes.

NEXT: Debunking arguments

The paper notes that a defining feature of U.S. DB pension plans is that plan sponsors generally carry some unfunded liability or pension debt.

“Ignoring the cost of under-funding is an oversight that omits one of DB plans’ largest cost drivers,” McGee writes. According to the report, governments now owe public pension plans somewhere between $1.3 trillion and $6 trillion for benefits that public workers have already earned. Debt-service payments to pay off the accumulated pension debt are now larger than the annual cost of benefits earned by workers in most jurisdictions (2013 debt-service payments made up approximately 70% of annual required contributions). Since 2001, annual government contributions have nearly tripled, from 6.7% to 18.6% of payroll—even though, over the same period, benefits were reduced in many jurisdictions.

Carrying a pension debt equal to 10% of liabilities would increase annual cost as a percentage of payroll by around 70%; carrying a debt equal to 20% of liabilities would increase annual cost by around 140%, McGee found in an analysis.

Answering critics that argue DB plans are more cost-effective because they deliver higher investment returns and convert retirement savings into annuities, McGee says 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, and since 2000, performance differences have further narrowed.

According to McGee, 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,” he says.

The full report can be downloaded from here.