Friday, May 24, 2013

The Defined Benefit Edge

The Defined Benefit Edge

Corporate and public defined benefit plans continue to be restricted or eliminated.  Companies don’t want to bear the risk of funding the retirement of their rank and file employees.  They are, of course, more than happy to supply their senior executives with supplemental retirement plans.  Meanwhile, states and municipalities are also trying to reduce their pension obligations.  As you’d expect, much of Wall Street is squarely behind this push as defined contribution plans, such as 401(K)s, are better for the Street’s bottom line.
 
Elevator Pitch (2001)
Towers Watson, the human resources consulting firm, reports that the returns of defined benefit plans exceeded those of defined contribution plans by largest gap in nearly 20 years.[1]  In the past ten years, traditional pension plans beat 401(K) type plans by an average of 0.86% per year.  A spread of only 0.86% doesn’t sound like a lot, but over 10 years it amounts to a nearly 9% difference, which translate into a lot of money (a hundred billion dollars or so) when applied to big financial liabilities such as pension plans.  In the last five years, the gap between the returns for defined benefit and defined contribution plans has narrowed to 0.39%.



What’s going on here? I think there are several factors at work.  Defined benefit plans are, on average, invested more consistently.  The professionals managing these plans, especially among larger plans, tend to stick with their investment policies, which keeps the portfolio exposed to the markets.  It’s market exposure (beta), not manager selection (alpha) that accounts for the vast majority of investment returns. By contrast, retail investors, who manage their defined contribution plans, have a tendency to pour into equities as markets rise and flee them when they swoon. 

Second, DC participants tend, on average, to maintain higher cash balances than their DB brethren, which detracts from long-term performance.  Third, DC plans are apt to pay higher fees than DB plans, because DC plans tend to use more expensive investment vehicles such as mutual funds.

Why has the performance gap narrowed in the past five years?  As DB plans have moved more and more their assets into alternative investments, the fee differential has probably narrowed.  Moreover, in the past couple of years the best asset class has been plain old stocks, so the defined benefit foray into hedged strategies has detracted from short-term performance relative to defined contribution plans.

Even as they disappear, the defined benefit plan is still the superior vehicle for generating retirement savings.  Even more importantly they do a better job of providing security for their beneficiaries, and as we have just seen, generate better investment performance.  Nonetheless, the DB plan is fading rapidly in the corporate sector and is under attack in the public sector.  When Wall Street profits collide with your overall wellbeing, Wall Street will get its profits.

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