One of the major hurdles in preparing for retirement is access to an employer-sponsored pension scheme. Unfortunately, retirement coverage in the United States is not universal, and only about half of workers participate in either a defined benefit plan or a 401(k) account, according to the Boston College Center for Retirement Research. That percentage has been steady for decades and is a chronic obstacle to financial security for far too many American workers.
However, financial security in retirement is also not guaranteed for employees with access to a pension scheme at work. Workers best positioned to be self-sufficient in retirement have what’s known as the “three-legged retirement stool” — a defined benefit (DB) pension, individual savings in a 401(k)-style defined contribution (DC) plan, and welfare security.
DB pensions are particularly important because they are pension-oriented lifetime retirement income with minimal employee effort. The plan’s assets are pooled and the investments are managed by professionals who have a duty to act in the best interests of the plan’s participants. Retired employees receive a predictable monthly salary for life when they retire.
But what about employees without a pension? Certainly, retirement is more complex and expensive if you rely on a 401(k) savings account instead of an annuity. Instead of retirement income guarantees, DC plans are designed for accumulation retirement provision. Individuals have full responsibility for saving, making investment decisions and deciding how to spend their savings at exactly the right interest rate. Research shows that all of these tasks are complex for individuals, especially when spending savings. Retirees can withdraw funds too quickly and risk running out of money. Or retirees can be tight on funds, leading to lower living standards in retirement.
Another issue associated with DC plans is how investments change over time. Retirement experts typically advise younger people on 401(k) plans to invest more of their savings in stocks, which typically carry higher returns but also carry greater risk. As one nears retirement, experts often suggest shifting savings from stocks to safer, lower-yielding investments like bonds. This shift protects against a sharp decline in pension savings near and at the time of retirement. But this loss of investment income makes retirement more expensive.
Importantly, a typical annuity is significantly more cost-effective than a typical DC account and provides the same annuity benefits as a 401(k) account at about half the cost.
In other words, to achieve a target pension that replaces 54 percent of a person’s final salary, a pension plan requires contributions equal to 16.5 percent of salary. In contrast, a customized DC account requires almost double the contributions of retirement savings at 32.3 percent of payroll.
a new analysis, Better value for money 3.0, notes that there are three main reasons for the significant cost advantage of pension plans over DC accounts, as shown in Figure 1A.
First, annuities pool the longevity risks of a large number of people. Pooling longevity risk allows DB pension plans to fund benefits based on average life expectancy, paying each worker a monthly income regardless of how long they live. In contrast, DC plan participants must save excess contributions if they live longer than average life expectancy. This is important because saving and spending savings in an individual account looks very different when a person turns 70 or 100.
Second, annuities have higher investment returns compared to individually tailored DC plans. Defined benefit annuities have higher net investment returns due to professional management, as well as lower fees due to economies of scale.
Third, bonds have optimally balanced investment portfolios. Fixed income is ‘timeless’ and as such can sustain an optimally balanced portfolio of investments over time, rather than the typical individual strategy of shifting to a lower risk/reward asset allocation over time. This means that annuities generate higher investment returns over a lifetime compared to DC accounts.
To be fair, DC 401(k)-style plans have improved significantly since the topic was first explored in 2008, particularly when it comes to fees, investment options, and investor behavior. For example, investment fees under employer-provided plans have been reduced by about half since 2000. And there’s an increasing use of fixed date funds to fix individual investors’ investment and asset allocation missteps. Additionally, annuities continue to attract interest from policymakers as a way to turn DC account balances into a lifetime income stream.
But even with these improvements, 401(k) accounts just can’t replicate the efficiencies embedded in the very structure of retirement plans. Indeed, the Better Bang for the Buck study noticed, that Four-fifths of the total retirement cost benefit occurs after retirement, typically after a person leaves their employer-sponsored plan.
With longer life expectancies and low retirement savings, employers and policymakers would do well to find ways to provide US workers with a reliable lifetime retirement income in the most cost-effective manner. For those in self-saving plans like 401(k)’, more needs to be done to improve the post-retirement experience in a commercially efficient manner. This is particularly true if the current low interest rate environment persists.
Getting back to the basics of retirement — providing workers with a pension, coupled with a 401(k) and Social Security — will go a long way in making retirement a lot easier and a lot less expensive