Pensions perform better than DC plans, fees a factor

An American study shows that over a 12-year period defined benefit pension plans outperformed defined contribution retirement schemes, in part because of higher fees associated with the latter model.

The analysis from the Center for Retirement Research at Boston College uses data from the U.S Department of Labor (form 5500) to compare returns from 1990 to 2012, finding the DB plans did better than DC schemes, by an average of 0.7 a year, according to the report, Investment Returns: Defined Benefit Versus Defined Contribution Plans.

“The bottom line is that, during 1990-2012, defined benefit plans outperformed defined contribution plans … since this differential remains even after controlling for size and asset allocation, the likely explanation is higher fees in defined contribution accounts,” report the authors, including Jean-Pierre Aubry. 

With more retirement money being funnelled into DC-type plans like 401(k)s and subsequently rolled into individual retirement accounts (IRAS), worries are being expressed that retirees will be in even worse financial shape as IRAs are producing lower returns than DC plans.

“The available data suggest that IRAs produce even lower returns than defined contribution plans, which implies trouble ahead given the massive amount of money that is being rolled over into IRAs,” say the authors. Higher fees, the report continues, “can sharply reduce a saver’s nest egg over time.”

Exploring the role investment fees play in DC plans, the authors say that such fees account, on average, for 80-90 per cent of all expenses. Fees associated with DC plans are cited as examples of why DB models, with their lower fees, are more efficient at generating retirement income. Scale can help reduce DC fees and sponsors have a fiduciary duty to look after the best interests of members, but individual investors often face much higher fees.

“The reason for the higher fees is that defined contribution plans invest through mutual funds, while defined benefit plans do not. Mutual funds charge fees for selecting the stocks and undertaking the research that leads to buy and sell decisions. These fees are usually assessed as a percentage of invested assets and are paid by the account holder through lower investment returns,” relates the report.

“Of course, defined benefit plans also have some investment fees, but these are small compared to those associated with defined contribution plans.”

The report shows the growth of IRAs in retirement savings, with this model now holding more funds than either DC or DB. Most of the money in IRAs has been transferred from plans sponsored by an employer, and the type of return generated will “have a substantial impact on … retirement security.” Data shows that as of 2014, IRAs held $7.4 trillion while DCs had $5.4 trillion, and DB $3.1 trillion.

Why are IRAs getting such a low rate of return? The authors suggest it may come down to two main reasons: asset allocation and fees. 

“The data suggest that 11 per cent of assets in traditional IRAs are invested in money market funds compared to four per cent for defined contribution plans. Since money market accounts produce safe but low returns, this difference in allocation can be part of the explanation for the low return on IRAs. The rest of the explanation must be that owners of IRAs are being sold many … high-fee products.”

The authors present three main conclusions: first, data shows that DB plans did better than 401(k) plans over the reviewed period; second, the difference can be partly attributed to fees associated with DC plans; and third, returns for IRAs are even less than what is generated by DC plans.

“Saving is too hard to have fees eat up such a large portion of investment earnings,” conclude the authors.