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Munnell Report Rattles DC vs. DB Plan Debate on Investing, Fees

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A paper published in December by the Center for Retirement Research at Boston College questions the conventional wisdom that defined contribution participants are not good at investing their money and are paying higher fees than participants in a defined benefit plan resulting in lower returns.

“Are returns on defined contribution plans markedly lower than those on traditional defined benefit plans?” the authors asked.

It seems that yes, DB plans do show higher returns than DC plans, but not by much. Between 1990 and 2012, the report found, defined benefit plans did outperform defined contribution plans — by just 0.7%.

However, that difference persisted across plans of different sizes and allocations. “Since this differential remains even after controlling for size and asset allocation, the likely explanation is higher fees in defined contribution accounts,” according to the report.

The report uses data from the Department of Labor’s Form 550 between 1990 and 2012 to draw its conclusions. Authors Alicia Munnell, Peter Drucker and Jean-Pierre Aubry identified several factors that lead to higher returns in DB plans.

Plan size. In defined benefit plans, returns increased as the plan size did. DB plans with under $100 million in assets returned 6.5%, according to the analysis, jumping to 7.5% for the $100 million to $500 million plan size and increasing steadily to 8.3% for plans with over $5 billion.

For DC plans, there was a more pronounced increase between the smallest plan categories — 5.9% to 7.2% — but returns started to decrease after the $1 billion mark.

“In both cases, excluding plans with ‘less than $100 million” will produce higher returns,” according to the report. “Weighting by assets will also produce higher returns for both types of plans because it will de-emphasize the low returns earned by small plans.”

The smallest plans account for the greatest number of plans. Almost three-quarters of DB plans and the majority — 93.8% — of DC plans have less than $1 million in assets.

However, over 70% of the $2.4 trillion in DB plans are held in plans with over $1 billion in assets. The $3.1 trillion of DC assets are distributed more evenly across plan sizes, with the $1 billion to $5 billion category holding the greatest proportion of assets (26.5%).

Asset Allocation. The analysis also compared plans based on their concentration of higher risk investments like equities. Defined benefit plans have reduced their allocations to equities since 2000 “to match liabilities as companies have frozen their plans,” the report found. DC plans increased their allocation to equities through the mid 90s, and they’ve held steady at over 60% of the portfolio ever since.

“Although the asset allocation of the two types of plans differed significantly over the period 1990-2012, asset allocation would be expected to have only a modest effect on returns,” the authors wrote. “The reason is that the long-run (1926-2014) pattern, where risky equities significantly out-performed less risky long-term corporate bonds, has not held over the past two decades.”

Between 1990 and 2012, equities and corporate bonds had almost identical returns, the report found: 8.6% and 8.7%, respectively.

Fees. In light of the above, investment fees “are the most likely reason that defined contribution plans earn lower returns than defined benefit plans,” according to the report. Investment fees typically account for between 80% and 90% of a plan’s total expenses, CRR found.

Furthermore, the analysis found fees vary significantly not just across fund types but within types. Using data from ICI, the report found the least expensive funds, institutional money market funds, charged a median 0.44% of assets, compared with 1.24% for hybrid funds. Within fund types, the least expensive index equity funds had an expense ratio of 0.08%, while the most expensive charged 1.56%.

Not investing in mutual funds results in higher returns for defined benefit plans, according to the report.

“When weighted by assets, fees for equity funds, bond funds and hybrid funds, while declining over time, accounted for about 0.80% of assets under management between 2000 and 2014 and were probably substantially higher before that time. Of course, defined benefit plans also have some investment fees, but these are small compared to those associated with defined contribution plans.”

How do IRAs Compare?

The report found IRAs had lower returns than either defined benefit or defined contribution plans, although it analyzed a shorter time period.

IRA owners don’t have to fill out Form 550, so CRR based its analysis of IRA returns on data from the Investment Company Institute. It found that between 2000 and 2012, IRAs produced “substantially lower returns” than DB or DC plans: 2.2%, compared with 4.7% and 3.1%, respectively.

Unfortunately, the plans with the lowest returns also have the most assets, CRR found. Fed data show IRAs had $7.4 trillion as of the end of 2014, $2 trillion more than in DC plans and more than double the assets in DB plans.

The report blamed IRAs’ low returns on asset allocation and fees. “Indeed, the data suggest that 11% of assets in traditional IRAs are invested in money market funds compared to 4% 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 authors wrote.

The report posited that low returns must also be because owners of IRAs are being sold high-fee products such as hybrid funds, which ICI found has a median expense ratio of 1.24% of assets, followed by global funds at 1.39% and equity value funds at 1.18%

“Forgoing returns over long time periods means that assets at retirement will be sharply reduced. Saving is too hard to have fees eat up such a large portion of investment earnings,” the authors wrote.

— Read “Pension Advisors, Be Careful With ESG Investing” on ThinkAdvisor.


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