DB pensions are cheaper than DC pensions
Yes, you read that right.
If you are trying to achieve a given level of retirement benefits it is cheaper to do it through a Defined Benefit pension than through a Defined Contribution pension.
The evidence is here in this important report from the National Institute on Retirement Security – a US pensions think-tank. This has been in my reading pile for months, but it’s taken a day off to get round to reading it.
(I realise that deserves a high score on the sad-ometer).
The report identifies three factors that in the USA make providing a DB pension cheaper than a DC pension (for the same level of benefits). Altogether these add up to a whopping 46 per cent.
- DB pensions pool longevity risk and saves 15 per cent. This is the most complex argument and you should read the report for this. If there is one area where the slightly different structure of US pensions may produce a different result it is this element.
- In a DC pension individuals need to accept lower returns in order to reduce investment risk as they approach retirement. In other words you have to ensure that your pension isn’t wiped out by a stock-market crash the day before you turn it into an annuity. But this means putting in boring investment with low rates of return. In a DB scheme these risks can be pooled. This saves 5 per cent.
- A collective DB scheme can achieve higher investment returns because the scheme can be run more cheaply than an individualised DC scheme. This is very important. If charges are 1% higher in a DC scheme, then over 40 years that reduces the value of a pension pot by 24 per cent. This factor is the most important and saves 26 per cent.
This last point about charges is also well made in the Tomorrow’s Investor Report written for the RSA by David Pitt-Watson.
Of course for employers DC pensions are usually cheaper than DB pensions because they are usually use the switch to reduce their contributions. But what this work shows that if employers reduce their contributions by half when changing from DB to DC, employees will not just receive a riskier and more volatile pension but it’s likely to be significnatly smaller than the cut in contributions would suggest.
There is another conclusion that can be drawn from this work. Persuading employers to move back to DB from DC may be extremely difficult, but are there ways of restructuring DC schemes to give them some of the same advantages – particularly through lower charges and possibly some degree of risk-sharing between scheme members?