The mantra of advocates of the switch to DC plans from DB is loud and consistent: “These changes need to be made to cut the cost of retirement benefits.”
Truth be told, these initiatives are not really about cutting cost — they are about cutting benefits, with lower cost being a byproduct.
Consider the following basic retirement benefit financing formula:
Benefits = Contributions + Investment Income - Expenses
This formula of B = C + I - E is equally applicable to defined benefit plans and defined contribution plans.
Now assume that individually managed asset accounts in DC plans can consistently earn the same return and for the same fees as professionally managed large pools of DB plan assets. Next, assume the administrative expenses associated with individually managed DC plan accounts are the same as the administrative expenses per person for large numbers of participants in DB plans. While these assumptions are unrealistic, they will facilitate understanding what happens when the “cost” of the plan is reduced by switching to a DC plan from a DB plan. Cost is represented by “contributions” in the formula above.
1) investment income net of fees (I) does not change,
2) administrative expenses (E) remain constant and
3) contributions (or costs) (C) decline,
4) the only remaining variable, benefits (B), has to be smaller.
In reality, net investment rates of return on individual DC accounts would logically be expected to be lower than the return on professionally managed DB plan large asset pools. Furthermore, administrative expenses for individual account plans would logically be expected to be higher per person than administrative expenses for DB plans. Even if the cost (contributions) remained the same after the switch to a DC plan, both of these realities would result in benefits being lower. If contributions (costs) are also lowered in connection with the switch, benefits become just that much smaller.
So, when you hear someone say they want to reduce costs by switching to a DC plan from a DB plan, just understand that what is really being said is that they want to reduce benefits and convert pooled risk to individual risk.
If the goal were to keep benefits approximately the same, it would be necessary to increase cost in connection with a switch to a DC plan from a DB plan.
It is certainly possible to overcomplicate this matter with bells and whistles and smoke and mirrors but, in the final analysis, it really is this simple.
Epilogue: It's probably worth noting that there are some who do stand to gain from a switch to DC plans:
Administrative service providers and asset managers will likely make more money;
Corporations won't have to put up with those pesky DB plans that vote their proxies; and
The federal government will collect much more in premature distribution taxes.
These might not be intended consequences but they are consequences just the same. n
Gary Findlay is executive director of the Missouri State Employees' Retirement System, Jefferson City.