(Bloomberg View) — Old style defined-benefit pensions get better investment returns than defined-contribution retirement plans such as 401(k)s. That’s been established in survey after survey. I cited it as fact in a column about state and local government pensions last week.
But what if this particular fact is out of date? That’s the argument that Josh B. McGee makes in a really interesting paper. McGee is a senior fellow at the conservative Manhattan Institute and a vice president at the Laura and John Arnold Foundation, which has been advising state and local governments on pension reform — and in many cases pushing them toward 401(k)-style plans. In his paper, he presents evidence that defined- contribution plan assets are being invested a lot more efficiently and responsibly than they used to be, and have wiped out pensions’ performance edge.
The differences between McGee’s results and those arrived at in the past by the likes of consulting firm Towers Watson and the Boston College Center for Retirement Research have a lot to do with how the data is sliced. Previous studies have weighted returns by assets, while McGee gives eachretirement plan equal weight. His reasoning: big plans generally outperform small plans, and pension plans tend to have more assets than 401(k) plans, so this approach gives a better sense of the role that plan design — as opposed to plan size — plays in returns.
I’m about to use the abbreviations DB and DC a lot, and I feel guilty about it, but they seem like the best choice here. Remember, DB = traditional pensions, DC = 401(k)s. What Magee finds is that DB plan investments made in the early 1990s outperformed their DC counterparts by a significant amount during the next decade. DC plans also had a much wider dispersion of returns — that is, the best-performing DC plans did much better than the best-performing DB plans, and the worst-performing DC plans did much worse. Then things began to change. Overall DC and DB performance converged, and the extremes of DC performance got less extreme. Here’s a graphic representation (the chart only goes up to 2003 because these are 10-year returns we’re talking about):
This makes historical sense. The 1990s was the Wild West era of 401(k)s, when companies often gave employees free rein to invest their own contributions, and paid out matching contributions in company stock. Since then, most have cleaned up their acts. Writes Magee:
In recent years, DC plan policy has shifted further away from the pure individual-investor model. Increasingly, DC plans include auto-enrollment, well-designed default-investment options, and automatic allocation-investment vehicles, such as target-date funds.
Big DC plan sponsors have also focused a lot on reducing investment managers’ fees. Pension funds, meanwhile, have been under increasing pressure to chase returns, leading to investments in high-fee hedge funds and private equity that haven’t always panned out. So I guess it shouldn’t be that big a surprise to see that the dispersion of returns in DC plans has narrowed, and that the performance gap between DB and DC has disappeared. If we counted the cost of carrying debt for unfunded pension liabilities as an expense for DB plans, Magee argues, their performance would actually lag significantly behind that of DC plans.
Does this mean that 401(k)s and other defined contribution plans are better than pensions? Well, maybe they could be, if they emulated even more of the strong points of pensions while avoiding the weaknesses. Those other strong points are, as I wrote last week:
Forcing people to save via a pension, while it limits freedom of choice, is a better way of ensuring adequate retirement income than simply offering a tax-advantaged or even employer-subsidized opportunity to save. And by spreading longevity risk over thousands of people, pension funds don’t have to set aside as much money per person to guarantee an adequate retirement income as individuals saving for themselves do.