The San Francisco Symphony newslet on pensions in the December 2011 issue of Senza Sordino generated considerable interest. One reader pointed out that the loss due to lower rates of return on investments in defined contribution plans compared to defined benefit plans was actually understated. If the defined contribution plan experiences a return that is 1% lower each year, after 14 years the difference would be more than the 14% mentioned in the newslet because of the effects of compounding. But that just scratches the surface. Another factor that pulls down defined contribution plans is the longevity dilemma. As individuals grow older, it is prudent for them to reduce their risk by investing less heavily in the broad market. And, unless they plan to control the time of their death, they need to plan not to fully utilize their assets during their lifetime in order to avoid outliving their assets. Yet another factor is the higher fees paid by individuals in 401(k) or 403(b) plans. All of this suggests that defined contribution plans can be expected to underperform defined benefit plans by between 40% and 50%.
New York State Comptroller Thomas P. DiNapoli, who is the sole trustee of the $146.9 billion New York State Pension Fund, seems to have been on a one-man campaign to debunk some of the myths surrounding defined benefit pension plans and how they compare with 401(k)-style defined contribution plans. DiNapoli has posted a video in support of defined pension plans on his official New York Comptroller’s website in which he speaks to the issue. “Dollar for dollar, defined benefit plans are more cost effective and certainly do a better job of providing retirement security. 401(k)-style plans come with a greater cost. There’s more risk involved [in 401(k)-style plans].”
DiNapoli made some interesting points in a lecture he gave at the Schwartz Center for Economic Policy Analysis on December 12, 2011. “According to the National Institute on Retirement Security, defined benefit plans cost 46% less than individual 401(k)-style savings accounts for several reasons. First, individuals investing their own 401(k) pay significantly higher fees and earn significantly lower rates of return. Also, individuals must base their asset allocation on their age and whether they are nearing or in retirement, while a defined benefit plan bases its allocation on market conditions. And, finally, individuals must save at a rate that ensures that their funds will last well into the nineties. In contrast, large institutional plans like ours have assets based on the average mortality of our members.”
In an interview with Robin Young on NPR’s Here & Now, DiNapoli expounded further. “I do think the essential point is that a defined benefit plan is a much smarter, more cost effective way to provide retirement security for retired workers. … When you take a pool of capital, you professionally manage it and invest it, it’s a much more efficient way to provide the benefit than if you say to folks: ‘Put in your money. We’ll match it with some money.’ People tend not to have the investment expertise. So when you start adding in the fees … and then, some people will then go to financial planners to get advice on where to put their money if they’re in a 401(k)-style defined contribution plan. It’s going to cost more money. … Also, if you’re an individual, you’re going to base your decisions on how to invest your money based on where you’re at, age-wise, how close are you to retirement, and you may not be able to maximize the opportunities that are in the marketplace. When you’re part of a defined benefit plan, and money’s being managed for a whole pool of people that constantly has people at all ends of the age spectrum and retirement spectrum, you can take advantage of market opportunities. And the other piece, of course, is that we all think we’re going to live forever. … So, as an individual, you will target your investment strategy on an assumption you’re going to live to your nineties. The reality is that not everybody is going to live that long, and money through a defined benefit plan that’s being managed can base it on the reality of the mortality of the membership. All of that results in higher investment return, more efficient way[s] to deploy the capital, [and] less administrator cost as well. So it’s more efficient and, at the end of it, you get a more secure benefit as well.”
It’s good to know that the San Francisco Symphony is not alone in its conclusions about the need to preserve its defined benefit pension plan. Expect to see further coverage of pension plan issues in future issues of Senza Sordino. Our thanks to the readers who helped quantify the losses.