10 Pet Peeves About the Retirement Industry

 Life is full of annoyances – all the better to appreciate the blessings that surround us. That said, there are things about the retirement industry that really bug me. 

I recently had the privilege of being part of the Leafhouse National Retirement Symposium. The theme was unfiltered – the unvarnished truth.  And it seemed an appropriate forum to share some of the things about the retirement industry that really bug me. 

Here’s the list:

Using the average or median retirement balance as a proxy for retirement readiness.

Generally speaking, retirement plans are comprised of a myriad of individual circumstances – participants of ages that run from late teens to beyond traditional retirement, savings behaviors based on income – and age – and company match… Not to mention that this might be only a half dozen years of a worker’s accumulation, with the rest on some other recordkeeping platform…

Why any rational person would think that combining those disparate elements and then either dividing them by the number of parts, or looking for some kind of middle grouping – well, it defies logic. And yet, this happens with distressing regularity. It’s worse than mush – it’s a mess – a nonsensical number that is easy to calculate, and completely meaningless. 

Asking people who have never tried to do a retirement needs calculation how much they’ll need for retirement – and then publishing that as an actual target.   

There is perhaps of some modest value in knowing how much people think they need for retirement – even if they have never actually sat down and tried to figure it out. Indeed, in recent weeks at least two major providers have done just that with headlines proclaiming that “magic” number. Setting aside for a moment the reality that it’s completely uninformed – the reality is that we know NOTHING about the incomes, lifestyle, health or residence of the individuals behind that “guess” (though USA Today actually took the time to ascertain the political affiliation of the respondents). 

And since we know nothing about their circumstances – and less about how they derived that number (much less how the uninformed choices of the survey population was construed into that final number) – well, why would anybody care? But while this COULD be a teachable moment – where the survey writers point out that the number might be wildly overblown, and the importance of doing an actual assessment…and then there’s…

Using survey results of people who have never done a retirement needs calculation to “prove” there’s a retirement crisis.

The aforementioned “reports” instead choose to present those “pulled out of their…” guesses as a valid conclusion, and one that not only confirms that (a) there is a retirement crisis (and just in case that point was missed, asking them AFTER they provide a retirement number), but that (b) there’s a crisis precisely because folks are never going to be able to achieve that made up number based on the average savings amount (see above).   

Saying there’s a retirement “crisis” without ever defining what that means.

“Crisis” is a word much bandied about these days, most particularly as a label applied to retirement — by foes and fans alike. Indeed, while not so long ago headlines posed that premise as a question (“Is there a retirement crisis?”), it is now generally posited as a current reality (often accompanied by an exclamation point) — even though an examination of objective data and a clinical application of the term “crisis” suggests otherwise.

For most in the retirement industry, it’s meant as a call to action – built on the notion that time is a valuable asset in helping retirement savings grow. But the dictionary definition is of an event or situation where disaster is imminent – something that calls for immediate, and potentially drastic action. And that is how the critics of the 401(k) see it, as they call for immediate drastic action to replace the 401(k) with some alternative (or to defund the 401(k) in order to build an alternative).  Those who claim there is a retirement crisis without context are, quite simply, fueling their fire.

Pretending that everybody used to have a defined benefit plan/pension – and that those who did received a full pension.

This is a hugely exaggerated myth – actually one built on another – and one invoked with growing frequency by those who claim that the 401(k) is an inferior model. One that was “never intended” to be a full retirement plan unlike its defined benefit pension cousin. What gets overlooked is just how few Americans in the private sector were actually covered by a defined benefit pension (29% at the peak), and even among those who were covered, how few actually worked for that employer long enough to qualify for a “full” pension (something on the order of 12% of those who were covered). 

Quite simply, only a very small minority of individuals (in the private sector) who were covered by a pension actually collected a full pension. If that was a plan design INTENDED to be a retirement plan, it didn’t do a very good job of it for most.

Next time: the rest of the list.

- Nevin E. Adams, JD

A Penchant for Pensions?

  I’m not sure how old I was when I first saw “Night of the Living Dead”—but I have long been intrigued by stories of a zombie apocalypse—where mindless beings inexplicably rise from the dead, with no memory of their past, just a relentless (and apparently insatiable) hunger for…well, “us.”

That is perhaps an unfortunate comparison to last week’s hearing by the Senate Health, Education, Labor and Pensions (HELP) Committee, one ostensibly held to focus on how we were going to stave off the retirement “crisis” by…bringing “back”[i] defined benefit plans.[ii]

There were two fundamental premises underlying the hearing; first that there is, in fact, a retirement crisis, and second, that the restoration of defined benefit plan designs would remedy that situation.  

There remains in many circles (including last week’s hearing) a pervasive sense that the defined contribution system is inferior to the defined benefit approach—a sense that seems driven not by what the latter actually produced in terms of benefits, but in terms of what it promised. Even now, it seems that you have to remind folks that the “less than half” covered by a workplace retirement plan was true even in the “good old days” before the 401(k), at least within the private sector. And when it comes to defined benefit plans, it was significantly less than half.

And while you can (eventually) wrest an acknowledgement from those familiar with the data, almost no one EVER talks about how few of even those covered by those DB plans put in the time required to vest in their full pension (particularly prior to the Tax Reform Act of 1986, which accelerated vesting schedules). Those who demonize the 401(k) are never asked to speak to the “coverage gap” that was actually wider when defined benefit structures were “in vogue,” nor called for an accounting of the shortfall between the actual benefits delivered versus the “promise.” And yet, those 401(k) critics in last week’s hearing—with a straight face—held forth on how much better things would be…if only defined benefit plans would come back.

Don’t get me wrong—defined benefit plans continue to serve a valued societal purpose (not the least of which the income they provide my 93-year-old mother, though given the state’s finances, she remains concerned how long they will last), though they tend to work “better” in the public sector and among unionized workforces, where one’s profession and job tenure tend to be less volatile. That said, it’s not like there was some kind of cataclysmic event that wiped them out overnight in the private sector. Rather, their demise was one of a hundred painful “cuts”—all well-intentioned, of course. 

There were (and are) premiums to provide insurance backing for plans that “fail,” disclosures to try and avoid (unexpected) failures, demands for a full accounting of the potential financial obligations those plans represented for the organizations that sponsor them, and finally a demand that those financials be moved from footnotes to the corporate balance sheet itself. At any number of points along that continuum, one could well understand and appreciate why employers would choose to step away from that burden—and they did. 

Moreover, with few exceptions they were able to do so without opposition from employees—who typically didn’t (and largely still don’t) appreciate the cost or benefit of a promise that won’t come to fruition until years, if not decades, beyond the date they expect to be employed by the firm making that promise. And that ignores a criticism highlighted by several in the hearing—that these programs aren’t always well-managed or funded to provide those promised benefits.         

Yes, a fully funded, fully vested benefit that you’ve paid nothing for is certainly a good thing. Little wonder that a recent survey (by one of those firms represented at the hearing) suggested a massive public clamoring for the alleged panacea of these programs. And considering the plethora of headlines proclaiming the dire straits of today’s retirees, who can be faulted for clinging to a benevolent notion of a simpler time when someone else worried about such things?

All that said, there was little in the way of actual data at the hearing to suggest that a return of DB (certainly at the expense of the 401(k)) would actually resolve the issues. Mostly the witnesses focused on the alleged shortcomings of the current system (albeit with some sharp differences in conclusions, and a brief debate about the different results one gets from actual data versus surveys reliant on what people think in terms of establishing whether or not there is an actual crisis), alongside some optimism that SECURE and SECURE 2.0 had laid the groundwork for potential improvement in coverage, sufficiency and decumulation options. If there was a consensus, it might have been that we need to address the projected shortfalls in Social Security benefits—and, truly, if that isn’t, then we really will be looking at a crisis.

The thing that makes cinematic zombies so terrifying is that there are so many of them—and that they keep getting up and pursuing you no matter how much damage you inflict.[iii] That, and they manage to “convert” more with a simple bite. Let’s face it—a truly serious look at the retirement “crisis” would acknowledge that under traditional vesting definitions and job turnover rates in the private sector, defined benefit designs are, at best, a dubious solution. 

A penchant has been described as an irresistible attraction, as someone having a “penchant” for taking risks. 

A more practical one would be to look at a system that is already in place and working for those with access—and talk about ways to make THAT reality a reality for all.

- Nevin E. Adams, JD

 

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[i] In fairness, there are still defined benefit plans about, even in the private sector—though they are considerably fewer than they were a generation ago, and many are frozen or in termination status. 

[ii] The hearing was titled and you can still listen to a recording of it here, "Taking a Serious Look at the Retirement Crisis in America: What Can We Do to Expand Defined Benefit Pension Plans for Workers."

[iii] Well, except for the occasional well-placed headshot.

Myth Understandings

A frequent criticism of the 401(k) design is that it was “never designed” to provide a full retirement benefit, unlike, as it’s often stated or implied, the defined benefit plan.

Moreover, while there is a very real tendency to focus on the CURRENT balance[i] in a defined contribution/401(k) plan and treat that as the ultimate outcome, for reasons I’ve never really been able to understand, people tend to think and talk about defined benefit (DB) plans in terms of the benefit they are capable of providing, rather than the actual benefits paid.

However, the data show that some of the common assumptions about defined benefit pensions are out of line with the realities, including:

Once upon a time, everybody had a pension.

“Coverage” is a hot topic among policymakers these days, or more accurately, the lack of it. One of the most frequently invoked criticisms of the current system is that so many American workers don’t have access to a retirement plan at work. But in 1979, only 28 percent of private-sector workers participated in a DB plan, with another 10 percent participating in both a DB and defined contribution (DC) plan. By any measure, that’s a long way from “everybody.”

The reality is that more private-sector workers are participating in a workplace retirement plan today than in 1979.

People used to work for the same employer their whole careers.

My kids think their generation is the first to anticipate having many employers during their careers, but the reality is that American workers, certainly in the private sector, have long been relatively mobile in the workforce. Median job tenure of the total workforce has hovered at about five years since the early 1950s (in fact, as EBRI’s latest research points out, the average median job tenure has now risen, to 5.4 years).[ii] The data on employee tenure—the amount of time an individual has been with his or her current employer—show that career jobs never existed for most workers and have continued not to exist for most workers.

And that has implications for pension benefits.

Everybody who had a pension got a full benefit.

Those who know how defined benefit plan accrual formulas work understand that the actual benefit is a function of some definition of average pay and years of service. Moreover, prior to the mid-1980s, 10-year cliff vesting schedules were common for DB plans. What that meant was that if you worked for an employer fewer than 10 years, you’d be entitled to a pension of … $0.00.

As noted above, the American workforce has, since the end of World War II, been relatively, and consistently, mobile. Between 1987 and 2012, among private-sector workers, fewer than 1 in 5 have spent 25 years or more with one employer. Under pension accrual formulas, those kinds of numbers meant that, even among the workers who were covered by a traditional pension, many would actually receive little or nothing from that plan design.

And that’s for those who were covered in the first place[iii].

People used to get more retirement income from pensions than they do today.

There are undoubtedly different challenges ahead for retirees than for prior generations – longer lives, higher health care costs, the pressures of affording long-term care – but when it comes to sources of retirement income for those over the age of 65, there has been remarkably little change over the past several decades.

Social Security is and has been a consistent source, representing somewhere between 40 and 45 percent of aggregate income (excluding non-periodic distributions from DC plans and IRAs) during most of that time, and into the current time, according to data from the Census Bureau. Pension annuity income, which constituted about 16 percent of aggregate income in 1976, rose to as high as 21 percent in the early ’90s – about where it stands today.

There’s no question that some Americans in the private sector have derived, and will continue to derive, significant retirement income from DB plans, and DB plans did and can deliver for the portion of the population that does stay with one employer/plan for a full career[iv].

The data show, however, that many Americans were not covered by those plans, even in the “good old days,” and that even many of those who were covered, for a time anyway, were not likely to receive the full benefit that the design was capable of delivering because they didn’t have, or take advantage of, the opportunity.

Sound familiar?

Nevin E. Adams, JD

[i] Worse, that 401(k) balance is frequently an AVERAGE 401(k) balance, which includes the relatively small balances of those who have just started saving with those who have had a full career to save. That’s why reports from the EBRI/ICI 401(k) database have long differentiated average and median balances by age and tenure. See “401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2012.”

[ii] See “Employee Tenure Trends, 1983–2012.”

[iii] Expectations for pension benefits appear to exceed the reality, even among workers. The 2014 Retirement Confidence Survey found that while 56 percent of workers expect to receive benefits from a defined benefit plan in retirement, only 31 percent report that they and/or their spouse currently have such a benefit with a current or previous employer. See here. 

[iv] For an analysis of possible outcomes from DB and 401(k) plans, see “Reality Checks: A Comparative Analysis of Future Benefits from Private-Sector, Voluntary-Enrollment 401(k) Plans vs. Stylized, Final-Average-Pay Defined Benefit and Cash Balance Plans.”

Use It or “Lose” It

At the time that EBRI was founded 35 years ago, I was about six months into a job doing pension accountings for a large Midwestern bank. At the time, I didn’t realize I’d still be working with those kinds of issues in 2013—in fairness, like most recent college graduates, I wasn’t really thinking about anything that was 35 years in the future. I had a job, a car that ran, and a reasonably nice stereo in an apartment in the Chicago suburbs that didn’t have much else.

My employer had a nice defined benefit (DB) pension, and an extraordinarily generous thrift-savings plan, but those weren’t big considerations at the time. I had to wait a year to participate in the latter (pretty much standard at the time), and as for the former—well, you know how exciting pension accruals are to 22-year-olds (even those who get paid to do pension accountings). Turns out, I worked there for nearly a decade, and walked away with a pretty nice nest egg in that thrift savings plan (that by then had become a 401(k)), and a pension accrual of…$0.00.

At the time, I didn’t think much about that.  Like many private-sector workers, I hadn’t contributed anything to that pension, and thus getting “nothing” in return didn’t feel like a loss.

By the time I left my second employer (this time after 13 years), the mandated vesting schedules had been shortened by legislation—but even then, the benefit I hope to collect one day won’t amount to much on an annual basis, and won’t be anything like the benefit that plan might have provided if only I had remained employed there – for the past 20 years. Instead, like my service with that prior employer, that DB benefit is frozen in time. That result stands in sharp contrast with the 401(k) balances I have accumulated and that continue to grow, despite having changed employers twice since then.

Of course, national tenure data suggest that my job experience was something of an anomaly.  When you consider that median job tenure in the United States  has hovered in the five-to-seven-year range going back to the early 1950s[i], there have doubtless been many private-sector workers who were, for a time, like me, participants in a traditional defined benefit pension plan, only to see little or nothing come of that participation[ii].

I often hear people say that 401(k)s were “never designed to replace pensions,” a reference to the notion that the benefit defined by most traditional pension plans stood to replace a significant amount of pre-retirement income at retirement.  Now, there’s no question that the voluntary nature of the 401(k) programs, as well as their traditional reliance on the investment direction and maintenance by participants, can undermine the relative contribution of the employer-sponsored plan “leg” to a goal of retirement income adequacy.

However, what often gets overlooked in the comparison with 401(k)s is that when you consider the realities of how most Americans work, traditional defined benefit realities frequently fell short of that standard as well. Indeed, in many cases, based on the kinds of job changes that occur all the time, and have for a generation and more, they could provide far less[iii].

In both cases, it’s not the design that’s at fault—it’s how they are used, both by those who sponsor these programs, as well as those who are covered by them.

Nevin E. Adams, JD 

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[i] See “Employee Tenure Trends, 1983–2012” available here.  

[ii] And a great number of private-sector workers never participated in a defined benefit plan.  See “Pension Plan Participation” available here.  

[iii] A recent EBRI Issue Brief provides a direct comparison of the likely benefits under specific types of defined contribution (DC) and DB retirement plans. See “Reality Checks: A Comparative Analysis of Future Benefits from Private-Sector, Voluntary-Enrollment 401(k) Plans vs. Stylized, Final-Average-Pay Defined Benefit and Cash Balance Plans”.

Foregone “Conclusions”

Behavioral finance drives much of the discussion around retirement plan design innovations these days, for the very simple reason that it seems to help explain what might otherwise be viewed as irrational behaviors. For example, human beings are prone to something that behaviorists call “confirmation bias,” a tendency to favor information that confirms what we already believe. While doing so generally contributes to quicker assessments of information, there are some obvious shortcomings to that approach in terms of critically evaluating new information, particularly information that contradicts what we have already chosen (rightly or wrongly) to accept as reality.

Last month EBRI published an analysis of a direct comparison of the likely benefits under specific types of 401(k) plans and defined benefit (DB) pension plans.(1) As anyone who has worked with employment-based retirement plans knows, individual participant outcomes can vary widely based on a complex combination of decisions by both those that sponsor the plans and the individual workers who are eligible to participate in them, as well as a host of external factors (notably the investment markets) that lie outside their control.

The EBRI report took pains to not only select but to explain the key assumptions in our analysis. As it turns out, the analysis highlighted a number of circumstances in which traditional pensions (where offered) could produce a higher benefit at retirement—and some in which 401(k)s were superior in that regard.

However, some of the reporting and commentary that followed its publication suggest that some either did not read with care the entire analysis, or chose to ignore the totality of the report. Here, in a Q&A format, we deal with most of the mischaracterizations(2) we’ve seen thus far:

• Did the report conclude that 401(k) benefits were better for almost every age and income cohort?

♦ No. While an analysis of just the median results for just the baseline assumptions might suggest this conclusion, the EBRI Issue Brief followed with seven different sensitivity analyses with different assumptions that produce different results. Moreover, the entire analysis was restricted to employees currently ages 25–29, because those individuals would have the opportunity for a full working career with those 401(k)s, as well as the modeled defined benefit results.

• Did the study make assumptions that are biased toward 401(k)s?

♦ Quite the contrary. The baseline used historical averages and ran many sensitivity analyses that were biased AWAY from 401(k)s to test how robust the results were.

• Why did you exclude automatic enrollment designs in 401(k) plans from the analysis?

♦ While a great many employers have adopted automatic enrollment with automatic escalation provisions in recent years, sufficient time has not yet passed since the establishment of most of these escalation features to know how long, and to what levels, participants will allow the escalation provisions to continue before they opt out.

• How does excluding those automatic enrollment plan designs from the analysis impact the results?

♦ Some have argued that automatic enrollment is actually bad for retirement savings because, in some cases, the AVERAGE rate of deferral—when computed only for those who make a contribution—initially decreases.(3) However—and as previous EBRI research has documented—the decline in average deferrals masks the reality that while some individuals initially save at lower rates (certainly in the absence of provisions to increase those initial rates automatically), many lower-income workers become savers under an automatic plan design who would not contribute anything had they been eligible for a voluntary-enrollment 401(k) plan instead.

 

The June 2013 Issue Brief(4) specifically treats these individuals as making zero contributions and does NOT simply exclude them. This is the major reason why low-income employees do not do as well as high-income employees under THIS TYPE of 401(k) plan. EBRI has done previous analysis(5) showing the difference between automatic-enrollment and voluntary-enrollment types of 401(k) plans and specifically documents how much better automatic enrollment was for the retirement savings of lower-income cohorts.

• Aren’t workers today changing jobs more frequently than they did during the heyday of defined benefit pensions?

♦ Actually, no. While it was not an explicit part of this report, a recent EBRI Notes article points out that the data on employee tenure (the amount of time an individual has been with his or her current employer) show that so-called “career jobs” NEVER existed for most workers. Indeed, over the past nearly 30 years, the median tenure of all wage and salary workers age 20 or older has held steady, at approximately five years. While the new analysis focused on the outcomes for younger workers, including the implications of their tenure trends on DB accumulations, the historical turnover trends suggest that this would have been problematic for full DB accumulations among previous generations of workers as well.

•  Were the rates-of-return scenarios “realistic” for 401(k) participants?

♦ The EBRI analysis presented baseline results under historical return assumptions that were adjusted for expenses by reducing the gross return by 78 basis points. Additionally, sensitivity analysis was also conducted in this study by reducing the returns by 200 basis points to determine the robustness of the findings.

• What about the fact that private-sector pensions are largely funded exclusively by employers, while much of that burden falls on individual workers in 401(k) plans?

♦ The report acknowledges this difference, but as the title of the Issue Brief specifically states, this is a comparative analysis of future benefits from private-sector voluntary enrollment plans vs. two stylized types of defined benefit plans—not the financial impact on the individual participants during the accumulation period, or how he/she might deploy assets not committed to retirement savings. However, as both the academic papers cited in the Issue Brief state, a comparison of ALL aspects of this difference would likely need to incorporate the assumption that more costly employer contributions to a plan (whether defined benefit or 401(k)) will be at least partially offset by lower wages over the long run, everything else equal.

• Is it reasonable to compare defined benefit and 401(k) plan benefits?

♦ Retirement income adequacy studies have been undertaken in several reports by other organizations with the implicit assumption that 401(k) plans are unable to generate the same amount of retirement income (regardless of the source of financing). One of the primary objectives of the June EBRI Issue Brief was to actually test whether these implicit assumptions were correct.

So, which is “better”—a defined benefit plan or a 401(k)?

Well, as was noted in the Issue Brief, there is no single answer because a multitude of factors affect the ultimate outcome: interest rates and investment returns; the level and length of time a worker participates in a retirement plan; an individual’s age, job tenure, and remaining length of time in the work force; and the purchase price of an annuity, among other things.

The best answer depends on an incorporation of all the relevant factors, the tools to provide a thorough analysis, and an open mind with which to consider the results.

Nevin E. Adams, JD

(1) Jack VanDerhei, “Reality Checks: A Comparative Analysis of Future Benefits from Private-Sector, Voluntary-Enrollment 401(k) Plans vs. Stylized, Final-Average-Pay Defined Benefit and Cash Balance Plans,” online here.

(2) For example, see “Claim that 401(k)s Beat Defined Benefit Plans Stirs Controversy,” online here.

(3) This is the same type of mistake made in a 2011 Wall Street Journal article. See the EBRI blog “What Do You Call a Glass That is 60−85% Full?” as well as  “More or Less?”

(4) “Reality Checks: A Comparative Analysis of Future Benefits from Private-Sector, Voluntary-Enrollment 401(k) Plans vs. Stylized, Final-Average-Pay Defined Benefit and Cash Balance Plans,” online here.

(5) See Jack VanDerhei and Craig Copeland, “The Impact of PPA on Retirement Savings for 401(k) Participants.” Washington, DC: EBRI Issue Brief, no. 318, June 2008, online here.

"Better" Business

It has become something of a truism in our industry that defined benefit plans are “better” than defined contribution plans. We’re told that returns are higher(1) and fees lower in the former, that employees are better served by having the investment decisions made by professionals, and that many individuals don’t save enough on their own to provide the level of retirement income that they could expect from a defined benefit pension plan. Even the recent (arguably positive) changes in defined contribution design—automatic enrollment, qualified default investment alternatives, and the expanding availability of retirement income options(2)—are often said to represent the “DB-ification” of DC plans.

However, a recent analysis by EBRI reveals that DB is not always “better,” at least not defined as providing financial resources in retirement. In fact, if historical rates of return are assumed, as well as annuity purchase prices reflecting average bond rates over the last 27 years, the median comparisons show a strong outcome advantage for voluntary-enrollment (VE) 401(k) plans over both stylized, final-average DB plan and cash balance plan designs.(3)

Admittedly, those findings are based on a number of assumptions, not the least of which include the specific benefit formulae of the DB plans, and the performance of the markets. Indeed, the analysis in the June EBRI Issue Brief takes pains not only to outline and explain those assumptions,(4) but, using EBRI’s unique Retirement Security Projection Model® (RSPM) to produce a wide range of simulations, provides a direct comparison of the likely benefits in a number of possible scenarios, some of which produce different comparative outcomes. While the results do reflect the projected cumulative effects of job changes and things like loans, as well as the real-life 401(k) plan design parameters in several hundred different plans, they do not yet incorporate the potentially positive impact that automatic enrollment might have, particularly for lower-income individuals.


Significantly, the EBRI report does take into account another real-world factor that is frequently overlooked in the DB-to-DC comparisons: the actual job tenure experience of those in the private sector. In fact, as a recent EBRI Notes article(5) points out, the data on employee tenure (the amount of time an individual has been with his or her current employer) show that so-called “career jobs” NEVER existed for most workers. Indeed, over the past nearly 30 years, the median tenure of all wage and salary workers age 20 or older has held steady, at approximately five years. Even with today’s accelerated vesting schedules, that kind of turnover represents a kind of tenure “leakage” that can have a significant impact on pension benefits—even when they work for an employer that offers that benefit, they simply don’t work for one employer long enough to qualify for a meaningful benefit.

So, which type of retirement plan is “better”? As the EBRI analysis illustrates, there is no single right answer—but the data suggests that ignoring how often people actually change employers can be as misleading as ignoring how much they actually save.

Nevin E. Adams, JD

(1) In the days following publication of the EBRI Issue Brief, (“Reality Checks: A Comparative Analysis of Future Benefits from Private-Sector, Voluntary-Enrollment 401(k) Plans vs. Stylized, Final-Average-Pay Defined Benefit and Cash Balance Plans,” online here),  a number of individuals commented specifically on the chronicled difference in return in DB and DC plans; outside of some exceptions in the public sector, DB investment performance generally has no effect on the benefits paid.

(2) A recent EBRI analysis indicates that, even in DB plans, the rate of annuitization varies directly with the degree to which plan rules restrict the ability to choose a partial or lump-sum distribution. See “Annuity and Lump-Sum Decisions in Defined Benefit Plans: The Role of Plan Rules,” online here.

(3) While the DC plans modeled in this analysis draw from the actual design experience of several hundred VE 401(k) plans, in the interest of clarity it was decided to limit the comparisons for DB plans to only two stylized representative plan designs: a high-three-year, final-average DB plan and a cash balance plan. Median generosity parameters are used for baseline purposes but comparisons are also re-run with more generous provisions (the 75th percentile) as part of the sensitivity analysis.

(4) The report notes that a multitude of factors affect the ultimate outcome: interest rates and investment returns; the level and length of participation; an individual’s age, job tenure, and remaining length of time in the work force; and the purchase price of an annuity, among other things.

(5) The EBRI report highlights several implications of these tenure trends: the effect on DB accruals (even for workers still covered by those programs), the impact of the lump-sum distributions that often accompany job change, and the implications for social programs and workplace stability. “See Employee Tenure Trends, 1983–2012,” online here.

Goal Lines

That report, published by Towers Watson (see “Towers Watson Finds DB Plans Outperformed DC Plans” at ), compared the differences in investment results between 401(k) plans and defined benefit (DB) plans—and, in a contest that you’d surely have trouble getting decent odds on in Vegas, defined benefit plans fared better.

That shouldn’t—and probably didn’t—surprise anyone, IMHO. Defined benefit plans have a lot of things going for them that 401(k)s don’t. First, most DB plans have someone in an official capacity paying attention to them. They are obligations of the employer, after all, and they have a direct—and increasingly visible—impact on the bottom line. Second, in view of the first consideration, those responsible for that bottom line impact of the DB plan generally have the good sense to engage the services of experts to help them make the right decisions. Finally, and perhaps most importantly when it comes to making investment decisions, DB plans have the benefit of time—and in many cases, a nearly indefinite time horizon—upon which to base and fund their commitments. They have, in football parlance, a solid ground game, well-honed defensive line, a quarterback who is getting solid play-making support from the sidelines, and control of the clock.

401(k) plans, on the other hand, rely on the investment prowess of an untrained, and in most cases, wholly uneducated participant-investor. A “quarterback,” if you will, who effectively strolls out on the field, drops back and—well, sometimes they just fall on the ball, sometimes they try to run with it (for a short distance, anyway) and, yes, sometimes they just—in pure “Hail Mary” fashion—hurl the ball downfield and hope for the best.

Little wonder that, in the time periods that were the focus of the Towers Watson update, DB plans did better. In fact, after fees were taken into account, Towers Watson estimated that DB plans outperformed 401(k) plans by roughly one percentage point in 2008, though both types of plans lost value.

That said, when you look at the full Towers Watson analysis, the result is more nuanced. Over the decade and change it has been conducting this analysis, Towers Watson noted that DB plans do better (on a relative basis to 401(k)s) when the markets are bearish—and yet, 401(k) results, with all their faults and shortcomings, tend to fare better (at least at a plan average) when the bulls are in charge.

In fact, the Towers Watson report draws the following conclusion:

“After stronger performances by DB plans during the 2000-2002 bear market, 401(k) plans outperformed DB plans from 2003 through 2005, as measured by plan-level medians. DB plans and DC plans realized equal returns in 2006, with 401(k) plans taking the lead again in 2007. But, over the 13-year period, which captures both bull and bear cycles, DB plans outperformed 401(k)s by an average of 23 basis points.”

Read that last sentence again. That’s right—despite all their advantages, over one of the most tumultuous market cycles in memory (1995 to 2007), DB plans did better than their 401(k) brethren—by just 23 basis points.

Now, there are issues whenever you try to come up with something like an “average”(1) result in any evaluation, much less an “average” 401(k) plan investment result. For example, that “average” 401(k) plan might have a group of participants that gravitate toward more-conservative investments counter-weighted with a group of “shoot-the-moon” gamblers, yielding an “average” return that winds up being pretty diversified at the group level(2). Moreover, some of the plans in the Towers Watson evaluation had both a DB and a DC program and, at least in theory, participants covered by both programs might—and certainly should—invest differently than those with only a DC plan to rely on.

The bottom line: The presentation of a DB “average,” regardless of the care taken in presenting the data, may be something of a stretch; but, IMHO, while there may be an arithmetic “average” for 401(k) plan returns, it sheds little light on what is really going on at the level where such decisions matter—the not-so-average individual participant.

And, as many Super Bowl losers can attest, it isn’t about how many yards you gain on the ground, how many interceptions you’ve thrown, or how many sacks—it’s the score on the board at the end of the game that counts.

—Nevin E. Adams, JD

The Towers Watson study is online at http://www.towerswatson.com/research/845

(1) For another perspective on averages, see “IMHO: The Mean-ing of Average”

(2) The Towers Watson analysis noted that, over time, 401(k) plans do, in fact, have a wider distribution of returns than DB plans, and that, with the exceptions of 2002 and 2003, 401(k) plans had a wider distribution of investment returns in all years in the analysis.