The Benefit of Defined Benefits

David Madland compares defined benefit and 401(k) plans, and shows that in uncertain times, defined benefit plans are the safer bet.

San Francisco firefighter Tom O' Connor is one of millions of public employees in California who contribute to a so-called
San Francisco firefighter Tom O' Connor is one of millions of public employees in California who contribute to a so-called "defined benefit" system that invests their money in stocks, real estate, and private equity funds to pay out upon retirement. (AP/Jeff Chiu)

The recent economic downtown and stock market decline have damaged many Americans’ plans for retirement and clearly demonstrated that 401(k) plans place significant risks on workers. In just the past year, the value of stocks in 401(k) plans and individual retirement accounts, or IRAs, fell by $2.0 trillion according to new research from the Center for Retirement Research at Boston College. Younger workers may have time to recover their losses, but those near retirement, or already in retirement, often don’t have the luxury of time and may be forced to make unattractive choices to meet day-to-day living expenses—working more, turning to family or public assistance, or living in poverty.

Defined benefit retirement plans have also lost significant value, but people with defined benefit plans are more cushioned from Wall Street’s volatility. Defined benefit pension plans are not risk free and are not always better than 401(k) plans for every worker. In fact, the ideal plan would combine elements of both 401(k) plans and defined benefit plans. But the current financial crisis illustrates some of the strengths of defined benefit pensions.

Defined benefit pension plans—especially public and multiemployer plans that have broader funding bases than single-employer pensions plans—are designed to weather a volatile stock market. This is because defined benefit plans provide better time diversification of financial market risks than 401(k) plans. Economists have shown that because defined benefit plans are able to continuously invest the assets of a group of workers rather than ramp up and down during one person’s lifetime, defined plans can more effectively capture the excess returns that come from investing in stocks over long periods of time—to the benefit of employees, employers, and taxpayers.

Defined benefit assets are furthermore overseen by professional money managers who are less likely to make the kinds of poor investment decisions that individuals often make in volatile times, such as buying high and selling low, or failing to diversify. And defined benefit plans are not subject to the high fees that 401(k) account holders often pay. By combining the effects of professional management, lower fees, and risk pooling, actuaries have determined that DB plans are much more efficient than 401 (k) plans and that they provide pension benefits at a far lower cost.

Despite these advantages, pension plans—especially state plans for public sector employees—have been under attack by conservative interest groups and state legislators. A new research paper published by the University of Pennsylvania’s Pension Research Council that I co-authored examines this attack on state pensions and finds that a movement has emerged to dismantle public pensions. The movement is not based on sound economics or public dissatisfaction, but rather is fueled by partisan politics and organized ideological interest groups.

Read the full research paper and learn more about public pensions: The New Intersection on the Road to Retirement: Public Pensions, Economics, Perceptions, Politics, and Interest Groups

Learn more from the Center for American Progress Action Fund’s American Worker Project.

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David Madland

Senior Fellow; Senior Adviser, American Worker Project