Investment Returns: Defined Benefit vs. Defined Contribution Plansonsdag, 16 desember 2015
Pension coverage in the private sector has shifted from defined benefit plans, where professionals make investment decisions, to 401(k) plans, where participants are responsible for their own investment strategy. The supposition is that individuals are not very good at investing their own money and face high fees. The question is whether this supposition is borne out by the facts. That is, are returns on defined contribution plans markedly lower than those on traditional defined benefit plans?
This brief first discusses alternative ways to measure the rate of return. The second section reports, under a variety of definitions, returns on defined benefit and defined contribution plans for 1990-2012 from the Department of Labor’s Form 5500. The third section explores the asset allocation of defined benefit and defined contribution plans and its potential impact on returns. The fourth section presents regression results of the relationship between returns and plan type (defined benefit or defined contribution), controlling for plan size and asset allocation. The fifth section discusses the extent to which fees may explain the lower return in defined contribution plans. The final section reports on Individual Retirement Accounts (IRAs) – the assets in these accounts now exceed holdings in either defined benefit or defined contribution plans, largely due to rollovers from employer-sponsored plans.
The bottom line is that, during 1990-2012, defined benefit plans outperformed defined contribution plans by 0.7 percent. Since this differential remains even after controlling for size and asset allocation, the likely explanation is higher fees in defined contribution accounts. The available data suggest that IRAs produce even lower returns than defined contribution plans, which implies trouble ahead given the massive amount of money that is being rolled over into IRAs.