The Department of Labor (DOL) has just issued its latest plan summary data (bringing us up to the end of 2014), which I’m taking as an excuse to step back and look at progress within the broader retirement system. In particular, what is the driving force behind the reinvention of defined contribution (DC)?
Can the DC system be as effective as DB?
The phrase “the reinvention of defined contribution” happens to be the subtitle of a book I wrote with Don Ezra and Matt Smith in 20091, although the concept is more widespread than the book ever was: it’s the idea that key features of the DC system—and 401(k) plans in particular—remained rooted in DC’s origins as a supplemental savings vehicle. To properly and cost-effectively fulfill its new role as the primary retirement savings vehicle for tens of millions of Americans, serious redesign was needed.
DC has long struggled to generate the same investment returns as the defined benefit (DB) system. The latest DOL report gives us a new data point in tracking progress on that front. This shows DB as having edged out DC in 2014, returning 9.2% to DC’s 7.0%. Because asset allocation differs, one year doesn’t tell us much, but (as illustrated below) DB has now provided superior returns in 16 of the past 23 years, and 14 of the past 16.
Chart 1: DB and DC returns 1992-2013 (for plans with over 100 participants)
Source: Department of Labor, Russell Investments.
A dollar invested on January 1, 1995 and earning DB rates of return would twenty years later have been worth $4.81; earning DC rates of return, just $4.13. That’s quite a shortfall. To make matters worse, DC’s inferior returns were delivered with greater volatility: the standard deviation of returns for DC was 11.1% a year, against DB’s 9.5%2. Previous posts have explored the reasons for the differences, such as asset allocation, fees, and investment habits (e.g. bad timing by DC plan participants.)
Much has changed in the past few years. The Pension Protection Act (PPA) of 2006 probably marks the point at which the effectiveness of the 401(k) system was recognized as a matter of public policy, and since then DC has been squarely in the spotlight. It’s led to wider use of auto-enrollment and a central role for Qualified Default Investment Alternatives (QDIAs), bringing specialist design to asset allocation. Developments such as these give reason to hope that—for large plans at least—DC really can aspire to DB-like levels of cost-effectiveness.
But there has not been progress on every front: we remain a long way from DC being truly built around the provision of lifetime income and not just the accumulation of assets. The DOL has not even finalized a rule to require the reporting of accrued benefits as an estimated lifetime income stream.
Not for the sake of plan sponsors
As I look back over what Don, Matt and I were saying about the reinvention of DC all those years ago, the section jumps out at me is one about why this reinvention is happening. We closed one chapter with a section headed “Hold on a Second…” This section points out that many plan sponsors have little incentive to welcome a new generation of DC plan that puts them back into the business of providing retirement income (getting out of which was, for many, one reason for closing the DB plan.)
But we argued that the feelings of plan sponsors were, in a sense, irrelevant: “There are wider societal forces that are driving the 401(k) system to reinvent itself. The changes in the PPA signal that the effectiveness of the system is now a matter of public policy.”3 In other words, even though plan sponsors will have a big say in how quickly the system is transformed (and those who naturally lean to a more paternalistic attitude will take the lead), the driving force behind change is how rule-makers see the challenge, not the needs or opinions of plan sponsors.
That’s an important point to remember as the system continues to change. And while DC may be less cost-effective than DB, it’s more cost-effective than IRAs (which are the focus of recent efforts by a number of states to expand retirement coverage.) As those programs move forward, as open MEPs gain support, and as the reinvention not just of DC but of the whole retirement system continues, plan sponsors are an important stakeholder in the conversation–but there are many others, too.