Retirement Is Complex And Expensive, But Pensions Have Built-In Advantages

One of the high hurdles when it comes to preparing for retirement is access to an employer-sponsored retirement plan. Unfortunately, retirement coverage is not universal in the U.S., and only about half of workers participate in either a defined benefit plan or a 401(k) account according to the Boston College Center for Retirement Research. This percentage has remained constant for decades, and it’s a chronic impediment to financial security for far too many American workers.

But even for employees with access to a retirement plan at work, financial security in retirement isn’t guaranteed. Workers best positioned to be self-sufficient in retirement have the so-called “three-legged retirement stool”– a defined benefit (DB) pension, individual savings in a 401(k)-style defined contribution (DC) plan, and Social Security.

DB pensions are particularly important because they are designed to provide lifetime retirement income with minimal effort from employees. Pension plan assets are pooled, and investments are managed by professionals who are required to act in the best interest of the retirement plan participants. At retirement, employees with a pension receive a predictable monthly paycheck for life.

But what about employees lacking a pension? For certain, retirement is more complex and expensive when relying on a 401(k) savings account instead of a pension. Rather than retirement income guarantees, DC plans are designed to accumulate retirement savings. Individuals bear the full responsibility for saving, making investment decisions, and determining how to spend down their savings at just the right rate. Research indicates that all of these tasks are complex for individuals, especially spending down savings. Retirees can draw down funds too quickly and risk running out of money. Or, retirees can hold on to funds too tightly resulting in a lower standard of living in retirement.

Another issue associated with DC plans is modifying investments over time. Retirement experts typically advise younger individuals in 401(k) plans to have a larger portion of their savings invested in stocks, which usually have higher returns but also greater risks. As one gets closer to retirement, experts often suggest moving savings away from stocks into safer, lower return assets like bonds. This shift helps guard against a large drop in retirement savings near and at retirement. But this loss of investment returns makes retirement all the more expensive.

Importantly, a typical pension is substantially more cost-efficient than a typical DC account, providing the same retirement benefit as a 401(k)-style account at about half the cost.

Or said another way, to achieve a target retirement benefit that replaces 54 percent of an individual’s final salary, a pension plan requires contributions equal to 16.5 percent of payroll. In contrast, an individually directed DC account requires contributions almost twice as high as the pension plan, at 32.3 percent of payroll.

A new analysis, A Better Bang for the Buck 3.0, finds there are three primary reasons behind pension plans’ substantial cost advantage over DC accounts, as illustrated in Figure 1A.

First, pensions pool longevity risks across a large number of individuals. The pooling of longevity risk enables DB pension plans to fund benefits based on average life expectancy and pay each worker monthly income no matter how long they live. In contrast, DC plan participants must have excess contributions saved in the event they live longer than the average life expectancy. This is important because saving and spending down savings in and individual account looks very different if a person lives to age 70 versus 100.

Second, pensions have higher investment returns as compared to individually directed DC plans. Defined benefit pensions have higher net investment returns due to professional management, along with lower fees stemming from economies of scale.

Third, pensions have optimally balanced investment portfolios. Pensions are “ageless” and therefore can perpetually maintain an optimally balanced investment portfolio rather than the typical individual strategy of down-shifting over time to a lower risk/return asset allocation. This means that over a lifetime, pensions earn higher investment returns as compared to DC accounts.

To be fair, 401(k)-style DC plans have improved significantly since this issue was first examined in 2008, especially when it comes to fees, investment options, and investor behavior. For example, investment fees within employer-provided plans have been cut by about half since 2000. And there is a growing use of target date funds to help address individual investor missteps on investments and asset allocation. Additionally, annuities continue to garner interest among policymakers as a means to convert DC account balances into a lifetime income stream.

But even with these improvements, 401(k) accounts just can’t replicate the efficiencies that are embedded in the very structure of pension plans. In fact, the Better Bang for the Buck study found that four-fifths of the total pension cost advantage occurs after retirement, typically after an individual leaves their employer sponsored plan. 

With longer life expectancy and low levels of retirement savings, employers and policymakers are wise to find ways to provide U.S. workers with dependable lifetime retirement income in the most cost-efficient way possible. For those who are in self-saving plans, like 401(k)’, more must be done to improve the post-retirement experience in an economically efficient manner. This is especially true if the current low-interest rate environment to persist.

Getting back to retirement basics – providing workers with a pension, coupled with a 401(k) and Social Security – will go a long way toward making retirement a whole lot easier and much less expensive