Shift from DB to DC Resulted in Decline in Income Replacement

Researchers from the Center for Retirement Research at Boston College note the shift from a defined benefit (DB) employer-sponsored retirement plan landscape to a defined contribution (DC) plan landscape and question whether this shift has made households better or worse off.

Using data from the 1992, 1998, 2004, and 2010 waves of the Health and Retirement Study (HRS), a nationally representative survey of older Americans, and a sample including both single individuals ages 51 to 56 and couples in which at least one spouse was 51 to 56, the researchers found DB wealth in all years is higher than DC wealth. DB wealth is roughly constant over time, while DC wealth nearly doubled between 1992 and 2010. “Combine these patterns with the shift in coverage from DB to DC between 1992 and 2010, and the result is relatively level retirement wealth over time,” the researchers wrote in an Issue Brief.

However, they note that stable aggregate retirement wealth does not necessarily imply that households today are as well prepared for retirement as those in 1992. “Preparedness depends on how retirement wealth is distributed, how much income that wealth produces, and how that income relates to pre-retirement wages,” the paper says. The research found that DC plan wealth is skewed more toward those with more education and higher earnings, with the top quartile holding 52% of total DC wealth in 2010 compared to 35% of DB wealth. 

The researchers explain that the yield on DB wealth in recent years has been higher than that on DC wealth, because DC plan participants face two disadvantages when turning wealth into income: while DB participants face actuarially fair annuities, DC participants have to buy annuities on the open market where marketing and other costs reduce annuity factors by about 15% to 20%; and the interest rate used to calculate commercial annuity rates has declined sharply since 1992, while the interest rate assumption for DB annuities is a steady 5.8%. 

The research found retirement income at projected retirement ages as a percentage of wealth for those ages 51 to 56 in households with a plan was 12.5% in 1992 and 11.7% in 2010.

Given the growth of DC wealth and the disadvantages of annuitizing that wealth, one might have expected an even greater decline in the ratio of retirement income to current retirement wealth, the researchers note. They explain that the main reason the ratio did not decline more is that overall retirement ages have been increasing, and the difference in the retirement age between those in DC and DB plans has been getting larger. “Later retirement ages, all else equal, produce more annuity income per dollar of retirement savings because payout periods are shorter for people who work longer. Indeed, if the analysis had instead assumed that everyone retired at 62 over the entire period, the ratio of income to wealth would have declined much more sharply,” the paper says.

The researchers concluded that employer-sponsored plans are providing less income today than in the past. They suggest this outcome could be improved by making 401(k) plans work better through auto-enrollment, auto-escalation of default contribution rates, and reduced leakages; and expanding coverage to workers whose employers do not offer a plan.

The full issue brief may be downloaded from here.