DB vs DC Outcomes Determined by Generosity, Design

The Employee Benefit Research Institute (EBRI) has published a new in-depth analysis comparing the benefits generated by defined benefit (DB) plans compared with automatic enrollment defined contribution (DC) plans.

Previous EBRI research reported on a comparative analysis of future benefits from private-sector, voluntary enrollment 401(k) plans and stylized, final-average-pay defined benefit plans. According to EBRI, the new report expands on the previous research by computing the actual final-average DB accrual that would be required to provide an equal amount of retirement income at age 65 as would be produced by the annuitized value of the projected sum of the 401(k) and IRA rollover balances under automatic enrollment 401(k) plans.

Assuming historical rates of return as well as annuity purchase prices reflecting average bond rates over the period from 1986 to 2013, the analysis shows that, for males, defined benefit “break-even” rates are “rarely less than 1.5% of final pay.” In fact, EBRI says that in only two of the 16 combinations of wage quartiles and years of plan eligibility analyzed for males are defined benefit break-even rates less than 1.5% of final pay per years of service.

For women, five of the 16 combinations have “break-even” rates under 1.5%, EBRI reports. Furthermore, when these findings are subjected to the scrutiny of various “stress tests” both by reducing the rate of return assumptions by 200 basis points as well as utilizing current annuity purchase prices, results show that in many cases the automatic enrollment 401(k) plans lose their comparative advantage to the stylized, final-average DB plans, especially for lower-paid employees as demonstrated by the lower break-even accrual rates.

Additional DB vs. DC Insights

According to EBRI, given their “higher conditional probabilities” of participation in an automatic enrollment 401(k) plan when eligible, as well as lower opt-out rates after the initial year, one might expect that higher-income employees would need a higher DB accrual rate to produce an equivalent level of retirement income as the 401(k) plan. This is indeed what is generally observed, EBRI says.

“For all years-of-eligibility categories, the larger income quartiles have higher break-even accrual rates,” the report says. “For example, for those in the lowest income quartile, the median DB accrual rate that males with 31 to 40 years of plan eligibility would need in order to generate the same retirement income that they are projected to have with a 401(k) is 2.4% of final compensation. This increases to 2.5% for the next income quartile and 2.7% for the third income quartile. Those in the highest income quartile would need a 3.1% accrual rate for equivalency.”

Given their longer life expectancies at age 65 (and hence higher annuity purchase prices in the individual market), EBRI says females would be expected to need lower DB accrual rates for equivalency.

“And, in fact, comparing figures 1A and 1B shows that for all 16 combinations of years-of-eligibility categories and income quartiles, the median DB accrual rate for females is less than, or equal to, the corresponding rate for males,” the report says. “Figures 2A and 2B show the impact on the DB accrual rates needed for equivalency for males and females, respectively, of reducing the assumed rates of return for the first ten years from historical norms to conform to consultant expectations. Because the lower rates of return in the short term would reduce the expected account balances, the DB plan would require a lower accrual rate to provide an equivalent benefit.”

As an example, the report points to the lowest income quartile, where the median DB accrual that males with 31 to 40 years of plan eligibility in their careers would need in order to have the same retirement income that they are projected to have with a 401(k) plan is 2.2% of final compensation.

“This is an 8% reduction compared with the 2.4% value under the baseline return assumptions in Figure 1A,” the report says. “Figures 3A and 3B show a similar impact of reducing the assumed rates of return; however, this time it is assumed to be a permanent reduction of 200 basis points. For example, for the lowest income quartile, the median DB accrual that males (Figure 3A) with 31 to 40 years of plan eligibility in their careers would need in order to have the same retirement income that they are projected to have with a 401(k) plan is 1.6% of final compensation. This is a 33% reduction compared with the 2.4% value under the baseline return assumptions in Figure 1A.”

EBRI Weighs Impact of Auto-Portability

In June 2018, EBRI issued a report saying that if the Automatic Retirement Plan Act were passed, it would reduce the $4.13 trillion retirement savings shortfall for U.S. households headed by those between the ages of 35 and 63 by $645 billion, or 15.6%.

The newly published EBRI report also considers this topic, finding that, as expected, the impact of auto-portability would be greatest among the lowest income quartile, given their lower account balances and the negative correlation between account balances and cash-out activity.

“For example, for those in the lowest income quartile, the median DB accrual that males with 21 to 30 years of plan eligibility would need in order to have the same retirement income that they are projected to have with a 401(k) plan is 2.3% of final compensation,” the report says. “This represents a 28% increase from the 1.8% value under the baseline assumptions. The results are even more dramatic for males in the lowest income quartile with only 11 to 20 years of plan eligibility. In this case, the 3.1% median accrual rate needed for equivalency is 82% greater than the 1.7% value in Figure 1A.”

Assuming the auto portability scenario for 401(k) plans, EBRI says the results for those with only one to 10 years of eligibility are at least 6.2% for all income quartiles for males and at least 5.9% for females.

“This reflects the larger propensity for those who end up in this category to have shorter tenure positions and hence lower account balances at job change,” EBRI says.

The full EBRI report can be downloaded here.