How Defined Benefit Retirement Plans Outperform Defined Contribution Plans

A recent report from the Employee Benefit Research Institute (EBRI) sheds light on how badly lower income workers fare under the new defined contribution (DC) system compared with the defined benefit (DB) plans of old.
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A recent report from the Employee Benefit Research Institute (EBRI) sheds light on how badly lower income workers fare under the new defined contribution (DC) system compared with the defined benefit (DB) plans of old. For workers with 31 to 40 years of plan eligibility, their returns under the DC system are 10-13% worse than they would have been under a DB system (using current annuity prices and forecasts of stock and bond returns adjusted downward by 2 percentage points to 6.6% and 0.6%, respectively).

Sadly, this picture will likely be even worse for lower income workers because the report uses unrealistically rosy assumptions. For example, the report assumes that earnings will grow at 3.9% per year for workers ages 25 to 55, and then drop to 2.8% per year (These nominal rates imply a 1.1% real rate of growth until age 55, and then a 0% growth rate). These are implausible assumptions. Research from the Economic Policy Institute (EPI) finds that earnings are barely inching up, with average hourly compensation growing 0.95% per year from 2000 to 2011. Moreover, average hourly earnings at private employers have fallen on an inflation-adjusted basis all but once since February 2011.

The report also assumes that rates of coverage and participation in a retirement plan are higher than would be predicted by age and wage profiles. Our recent research finds that workers who suffer a spell of unemployment experience scarring, including a decreased likelihood of working in a job that offers retirement plan coverage. If workers lose access to a retirement plan at work or reduce their contributions following a job change, they accumulate even less funds in their DC accounts. This makes defined benefit plans that much more desirable.

The report finds that higher income workers obtain higher returns in a DC retirement plan than in a DB plan. This is because higher income workers can afford to take more risk, and they tend not to withdraw money in bad times. Middle income and poor workers cannot afford to play roulette with their retirement savings. As a result, they are less likely to invest in equities. Moreover, middle income and poor workers are more likely to withdraw money from their accounts when their income takes a hit.

That is why we endorse the guaranteed retirement accounts (GRAs) that are being promoted by state legislators around the country. This policy is a way to improve the retirement finances of today's workers. Unfortunately, it may be too late for those who are ready to retire now.

by Teresa Ghilarducci and Joelle Saad-Lessler

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