During the month of October, we at the National Public Pension Coalition are celebrating retirement security. Next week is National Retirement Security Week. We’ll have more to say about retirement security in a series of blog posts next week. This week, we want to focus on the economics of pensions, the most secure form of retirement savings. Today we’re examining why defined benefit pensions cost less than 401(k)-style defined contribution plans.
Defined benefit pensions cost less than 401(k)s because they are more efficient. Pensions are group plans where thousands of workers and their employers all pay into one fund. That fund is managed and invested by professionals, who invest for long-term growth. As a result, most public pension funds earn between two-thirds and three-quarters of their revenue from investment returns. Also, because risk is pooled and shared collectively among all members of the plan, no individual worker is at risk of losing her retirement savings if the market crashes shortly before a planned retirement.
Pension plans are also able to invest on an infinite time horizon. Pension plans have no end date. As long as active employees are paying in while retired employees are collecting their benefits, the pension plan can continue to function. This allows the plan managers to balance low-risk and high-risk investments and achieve steady returns over the long-term.
Defined contribution plans, such as 401(k)s, do not have these benefits. 401(k)-style plans are individual accounts managed by individual workers. They do not pool risk or allow fund managers to invest on an infinite time horizon. 401(k)-style plans are completely tied to the individual who owns them. If the market takes a dive shortly before that individual plans to retire, she could be forced to delay retirement or accept a lower standard of living in retirement. Also, that individual must choose her own investments and hope that they earn enough to provide for a secure retirement. On average, defined contribution plans earn lower investment returns than defined benefit pensions.
It’s not just individuals who benefit from the cost savings of pensions over 401(k)s, it is state governments and taxpayers as well. In 1991, West Virginia closed its defined benefit pension plan for teachers and began enrolling all new teachers in a 401(k)-style defined contribution plan. A decade later, with costs rising for the state and retirement security plummeting for teachers, the state of West Virginia conducted a study that concluded that the state could provide an equivalent retirement benefit at half the cost with a defined benefit pension instead of the 401(k)-style plan. The state legislature voted to reopen the closed teacher pension plan and new teachers began joining the reopened plan in 2005. Three years later, the state gave teachers in the 401(k)-style plan the option to switch to the reopened pension plan. More than 78 percent did. Because such a high percentage of teachers made the switch, the state is projected to save $1.2 billion dollars over 30 years.
Due to their more efficient plan design, pensions cost less than 401(k)-style defined contribution plans. This is one reason cities and states have offered pensions to their public employees for more than a hundred years. Later this week, we’ll explore how defined benefit pensions support local economies and provide a steady source of tax revenue for state and local governments.