Defined Contribution vs. Defined Benefit

In yesterday’s post, inspired by Chris from California’s comment to March 1’s post, I burdened you with my observations of how 401(k) plans have been the (perhaps) unintended vehicle for companies to shift the burden of paying for retirement onto the shoulders of the employees. Today I’d like to talk about the burden of investment risk.

All financial markets are risky. Even the smartest investors can forget that sometimes, especially after a long run of favorable returns. But anyone who forgot about risk was certainly reminded—ever so gently—by the crushing losses of the last year. For the wise investor, risk is (or ought to be) accompanied by reward: higher returns averaged over time for taking on the risks of the markets’ ups and downs.

In defined contribution plans—epitomized by 401(k) plans—the risks and rewards are borne (and enjoyed) by the employee as his account goes down and up. In defined benefit plans—you know, the ones that promise traditional monthly pensions (maybe your dad had one, or perhaps you read about them in the history books)—the employer bears the risks and rewards of investment performance. As the big collective pot drops in value, the company is required to contribute more; and as the pot enjoys favorable investment experience, the company is required to contribute less to meet its pension promises.

So who is in the better position to deal with the volatility (nay, turbulence) of the financial markets? The employer and its defined benefit plan, or the employee and her defined contribution plan account? To ask the question is to answer it. It sure as shootin’ ain’t the employee! That’s the whole raison d’etre for this blog! As an individual, how much should I salt away? How should I invest it? How much should I spend? If these questions weren’t so intractable, this blog would have no reason to exist. (Wouldn’t that be tragic.)

These are all very difficult questions for individuals, not because we’re stupid, but because we’re individuals. We're limited to live but one financial life, unable to benefit from averages.

But what about the employer and the defined benefit plan? That kind of collective pot of assets can act like a reservoir, with the employer filling it up when bad times cause it to run low; and slowing down its funding in good times. A community reservoir is much better at collecting water for everybody, than a bunch of individual cisterns. When was the last time you saw a cistern? I think it was the Middle Ages.

In a crystalline, brilliantly concise paper on the subject (“A Better Bang for the Buck”), Beth Almeida (of the National Institute on Retirement Security) and William B. Fornia describe how dollars spent by a company in funding a defined benefit plan go further than the same dollars spent funding a defined contribution plan, e.g., as matching contributions in a 401(k) plan.

There are three reasons for this:
Longevity Pooling. You have to save more because you don’t know how long you and your spouse will live. You have to plan for the worst. (Or is it the best?) But a company’s actuary can tell you how long the average employee, among thousands, will live. The company can fund for the average lifetime rather than an extra-long possible lifetime. You don’t have that luxury.
Asset Allocation. Your asset allocation should get more conservative as you grow older, because you can ill afford the volatility of too much stock in your 401(k). But a company pension plan, being a large reservoir for employees of all ages, can better afford to weather the downs of bear markets in order to benefit from the ups of bull markets. It can afford a less conservative asset allocation based on the average age of all pension plan participants. And it can afford to venture a few dollars in riskier (but more rewarding) illiquid alternative investments, which are foreclosed to your measly 401(k) account.
Efficient Investor. With economies of scale, an employer plan can pay for good investment advice at a lower cost than you can. They can get it wholesale. You can’t.

Almeida and Fornia actually take a stab at quantifying these three factors, and conclude that on average it costs 46% less for a company to deliver a dollar of an employee’s retirement income through a defined benefit plan compared to a defined contribution plan. Keep that in mind if you’re a human resources manager about to design your company’s retirement program.

It's an informative paper, but back to reality. The traditional pension plan is probably not poised for a comeback. Maybe your employer doesn’t want to pay the cost of your retirement, and maybe it doesn’t want to take on the investment risks of your retirement. So what can you do? That’s for tomorrow’s post.