Insights on 401(k)-Style Retirement Plans Vs. Pensions

What type of retirement savings option does your company offer to your employees? Every industry has its preferred types, but bid you know that large differences exist between some of the most common offerings? At first, it may seem like there is parity between some of the most common ones, like a 401(k) or a pension plan. Most folks might assume the two are on par in the long run. But recent data suggests that if we fast forward to our employees’ post-retirement years, there might be a large financial gap among the outcomes.

The National Institute on Retirement Security (NIRS) released an analysis on the costly differences between 401(k) retirement accounts and pension plans at the start of 2022. NIRS is a Washington DC-based nonprofit that works to inform employees and employers about the value of retirement security.

In their analysis of 401(k) retirement accounts and pension plans, NIRS found that “Defined benefit (DB) pension plans offer substantial cost advantages over 401(k)-style defined contribution (DC) accounts. A typical pension has a 49% cost advantage as compared to a typical DC account, with the cost advantages stemming from longevity risk pooling, higher investment returns, and optimally balanced investment portfolios.”

Key Terms to Know:

• • Defined Benefit (DB) = Pension Plans
  • Defined Contribution (DC) = 401(k)-Style Accounts

Cost of DB and DC plan as percentage of payroll. Image from National Institute on Retirement Security.

Most of the cost disparities occur during a person’s post-retirement years, according to the researchers. Many individuals with 401(k)-style plans might incur higher fees when assets are withdrawn, and people have a tendency to shift their savings to lower-risk, lower-return classes. This would certainly slow retirees down in the race for gains.

“Pensions have economies of scale and risk pooling that just can’t be replicated by individual savings accounts,” said Dan Doonan, NIRS executive director. “This means pensions can provide retirement benefits at a much lower cost.”

“At the same time, 401(k)s have made significant progress in recent years when it comes to reducing costs and making investing easier for individuals,” Doonan said. “But the post-retirement period remains difficult to navigate for those in a 401(k) account. Retirees are transitioning from saving to spending down their retirement income at the right rate so they don’t outlive their savings.”

Additional findings from the research included several key details:

• The 49% cost advantage between pension plans over 401(k) types of accounts breaks down as:
  • 7% cost savings from longevity risk pooling,
  • 12% from a more diversified portfolio,
  • 30% cost reduction from superior net investment returns created by lower fees and professional asset management.
• Pension plans cost 27% less than an “ideal” DC plan, with below-average fees and no individual investor deficiencies.
• Retirees typically move from an environment that benefits from a long investment strategy to one where individuals manage their spend-down on a short-term basis without the benefits associated with longevity risk pooling.

Given the widespread national concern about retirement savings levels and the worries that are present throughout many U.S. working households, NIRS offered a few recommendations regarding the results of these findings. Officials said that policymakers would be wise to protect existing pensions, while also finding ways to foster innovation and greater financial security for 401(k) accounts. They also recommended that policymakers focus on ways to develop improved post-retirement options for 401(k) account holders.

By Nick Dmitrovich with data from the National Institute on Retirement Security.

Source: the National Institute on Retirement Security (NIRS), A Better Bang for the Buck 3.0: Post-Retirement Experience Drives the Pension Cost Advantage.