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In Defense of Defined-Benefit Pensions

In Defense of Defined-Benefit Pensions

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The way forward for most public-sector defined-benefit plans is through reform, not replacement, write David Madland and Nick Bunker.
The way forward for most public-sector defined-benefit plans is through reform, not replacement, write David Madland and Nick Bunker.

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Published by: Center for American Progress on Feb 01, 2012
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In Deense o Defned-Beneft Pensions
Modest Reorms to State Plans Are Best Option or Taxpayers
By David Madland and Nick Bunker February 2012
Introduction
Because many saes’ public-employee pension plans are currenly underunded—meaning ha curren asses are less han promised reiremen benes—proposals odrasically reshape public-secor pensions or eliminae hem in avor o 401(k)-sylereiremen plans are expeced o once again be inroduced his coming year in sae-houses across he counry. Whileproponensargue ha hese alernaivedened-con- ribuionplans are good or axpayers,
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in mos cases axpayers are beter o makingrelaively minor reorms o he currendened-benepension sysem raher hanscrapping i enirely. Why? Because he dened-bene pensions held by public employees are much morecos eecive han 401(k)-syle reiremen plans,cosing roughly hal 
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as much o pro- vide he same level o reiremen bene o workers such as police ocers and regh-ers, librarians and eachers, and oher public-secor workers. In shor, he smar money in any sae pension-reorm plan would go oward smaller-scale changes.o help guide sae legislaors as hey consider reorm proposals or public-secor pen-sions, his issue brie will discuss he advanages and disadvanages o axpayers o hemajor ypes o reiremen plans, review he curren level o pension shoralls, and con-clude by providing some guidance or uure acion. In brie, our main conclusions are:Relaively modes changes o public-pension plans—such as o increase conribuionsrom employers and workers—should signicanly correc he underunding problemha many plans currenly ace.
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—such as requiring saes omake annual conribuions
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hareec heir share o plan coss—can shore up mos dened-bene plans or he longhaul, and minimize he need or making addiional conribuions in he uure.
1Center or American Progress Action Fund | In Deense o Deined-Beneit Pensions
 
2Center or American Progress Action Fund | In Deense o Deined-Beneit Pensions
Eliminaing dened-bene pension plans andswiching
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o 401(k)-syle dened-con-ribuion plans willno save money 
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because dollar-or-dollar dened-bene pensionplans are much more ecien.Hybrid proposals ha atemp o combine elemens o dened-bene pensions anddened-conribuion plans areunlikely o provideshor-ermcos savings, hough hey  do hold some promise or managing hedownsides o boh ypes o plans.
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 The advantages o deined-beneit pensions or taxpayers
Reiremen plans come in wo basic varieies: dened bene and dened conribu-ion. No ype o reiremen plan is perec. All involve radeos beween cos, risk, andreiremen adequacy, and all involve dieren choices abou who bears hese coss andrisks—employers or employees. In shor, boh dened-bene and dened-conribu-ion plans have advanages and disadvanages.In dened-bene plans (ofen called radiional pensions) he amoun o bene a worker receives upon reiremen is dened by he rules o he plan based on a ormulaha accouns or salary and years o service, among oher acors. In mos dened-bene- plans or public employees, boh he employer and employee makes conribuions ohe plan, bu only he employer assumes he invesmen and oher risks associaed wihmanaging he plan o mee he arge reiremen bene.In conras, in dened-conribuion plans such as 401(k)s, he conribuion by heemployer is dened by he rules o he plan, ypically a percenage o salary or a mach o  worker conribuions up o a cerain limi. Te end reiremen bene or he worker isno dened, bu is insead deermined by whaever is in he accoun—depending uponconribuions, invesmen perormance, plan coss, and wihdrawal iming, among oheracors. Wih a dened-conribuion plan, employees bear he risk, while wih dened- bene pensions, more risk is borne by he employer.On mos measures, dened-bene pension plans sack up quie well. axpayer cos is hemeric a he cener o he debae, so we’ll ocus on ha, bu i is worh noing ha dened- bene plans also have signican benes or workers and heir employers. Sudies show ha workers wih dened-bene plans have signicanly higher sandardso living inreiremen, beneing rom boh he money and he securiy o he monhly checks ha hedened-bene plan provides, and are much less likely o be inpovery during reiremen.
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Tese human-capial benes may be especially imporan in he public secor wiha large percenage o careers such aseachers ,
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reghers, and cops involving largeraining expenses ha employers are only able o recoup by minimizing urnover.
 
3Center or American Progress Action Fund | In Deense o Deined-Beneit Pensions
For any given level o reiremen benes, dened-bene plans are less expensive han401(k)-syle dened-conribuion plans. Ta means ha in order or workers o reire wih, or example, 75 percen o heir pre-reiremen income (he level recommended by many reiremen planners), i is cheaper o do so wih a dened-bene pension plan.Te same holds wih any oher level o reiremen income. Ta’s because dened-bene- plans have higher reurns, more balanced porolios, and greaer abiliy o pool risk. All old, dened-bene plans cos abou hal as much as dened-conribuion planso provide he same level o bene due o hese eecs, according o research by heNaional Insiue on Reiremen Securiy .
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Dened-bene plans achieve hese cossavings because o he way hey are srucured as a large, diversied, proessionally man-aged invesmen und, wih he abiliy o maximize reurns over a long ime horizon.In conras, dened-conribuion plans are small, worker-man-aged invesmen unds wih a ime horizon ha varies dramai-cally based on he worker’s age. Te sudy nds ha providing workers wih a secure level o reiremen income would cos 12.5percen o payroll wih a dened-bene plan bu 22.9 percen o payroll wih a dened-conribuion plan. Wha’s more, he sudy  breaks down he dened-bene plan savings o nd ha hey deliver superior invesmen reurns savings o 26 percen (due oproessional managemen), longeviy risk pooling savings o 15percen (due o he abiliy o plan or average lie expecancy),and porolio balancing savings o 5 percen (due o he more balanced porolios o managed unds)—or a combined savingso 46 percen. (see Figure 1)Dened-bene plans average higher invesmen reurns in par because invesmen decisions made by proessional invesors aremore likely o be wiser invesmens han hose made by ordinary  workers. Individuals have o become more conservaive wheninvesing as hey age because hey have less ime o recover any possible losses (resuling in lower reurns) bu individuals ofendo jus he opposie (depleing heir savings). Tese pensionplans also have he abiliy o pool invesmen risks over a longer ime period and agreaer number o people compared o a dened-conribuion plan. When accouns o  boh older and younger workers are pooled ogeher, he und manager can shoo or ahigher reurn as he plan has a much longer invesmen ime horizon.One sudy o he dierence in reurns by he global benchmarking rm CEMBenchmarking Inc. nds ha beween 1998 and 2005 dened-bene plans hadannual reurns 1.8 percenage poins higher han dened-conribuion plans.
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Overime his seemingly small dierence can be signican due o compounding growh.
Why Traditional Pensions Cost Less
The cost of a defined-benefit pension plan and adefined-contribution pension plan as a percent of payroll
0510152025
Defined-contribution planDefined-benefit planDefined-benefit costLower investment returnsLess balanced portfolioNo longevity risk pooling
Source: Beth Almeida and William B. Fornia, “A BetterBang or the Buck: The Economic Eciencies o DefnedBeneft Pension Plans,” (Washington, DC: NationalInstitute or Retirement Security, 2008.

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