There’s more money in corporate defined contribution (DC) plans than there is in corporate defined benefit (DB) plans today¹, and the gap is only going to get bigger from here. Trouble is: the DC money doesn’t seem to be able to earn the same level of investment returns as DB money does.
The chart below is based on the more-than-80,000² form 5500s that are gathered each year by the Department of Labor, as summarized in the latest release of their private pension plan bulletin (which runs through the end of 2011). The chart shows the aggregate rate of return earned over the twenty years 1992-2011. DB (in blue) beat DC (in black) in 14 out of 20 years, including 12 of the last 13. A dollar invested on January 1, 1992 and earning DB rates of return would twenty years later have been worth $4.36; earning DC rates of return, just $3.70. That’s quite a shortfall.
Source: Department of Labor, Russell Investments.
And it’s not because DB plans were following a riskier investment strategy: DC asset allocations were in aggregate more aggressive and returns were more volatile than DB, and some of the biggest DC underperformance came in the years in which markets fell. In an earlier study, researchers at Boston College found three main causes of the difference in returns: asset allocation, fees, and investment habits. Asset allocation tended to enhance DC returns on average (mainly because of the more aggressive allocation); fees were a material drag on DC; investment habits—notably “poor timing and other investment mistakes”³—were another big negative.
That and other similar studies were one of the reasons the DC system has re-aligned itself from a do-it-yourself system relying on participant education and retail mutual funds into a default-based system built on nudging and decision architecture.
It’s difficult to extract the data to confirm whether those changes are having the desired effect: Qualified Default Investment Alternatives (QDIAs)—the investment vehicles at the heart of the new system—still represent a small, albeit growing, percentage of total DC assets. The most popular QDIA option is a Target Date Fund (TDF); these tend to have a higher allocation to equities than either the DB or DC system as a whole, reflecting the age profile of the investors in those funds and the sizeable allocation to stable value funds among non-QDIA DC assets. The data that is available seems to point to aggregate TDF performance being more volatile than DC plans in general (doing better in strong markets, worse in weak), almost certainly a result of that higher equity allocation. So performance comparisons are not necessarily comparing like to like.
But we know enough about current practices to know the main weaknesses are being addressed: we know the level of attention paid to fees is much greater than it was in the past; we know QDIAs follow disciplined asset allocation strategies, not chasing recent performance.
It is not a new idea that “Policymakers will not accept going from an efficient system to an inefficient one,”⁴ but there are signs that the steps taken to date are moving us in the right direction.
¹According to the Federal Reserve’s latest Flow of Funds report, there is $2.6 trillion in private DB plans and $4.3 trillion in private DC.
²The data shown is for plans with more than 100 participants. There were a further 600,000 or so pension plans—mainly DC—with fewer than 100 participants, whose results were not included here.
³Munnell, Soto, Libby and Prinzivalli (2006). Investment returns: defined benefit vs. 401(k) plans. Center for Retirement Research at Boston College, Issue Brief #52.
⁴Michael Barry of Plan Advisory Services, quoted in Ezra, Collie, Smith (2009) The Retirement Plan Solution John Wiley and Sons, p12.