Yet another study has documented the inferiority of 401(k) plans to defined benefit plans like the Central Pension Fund and the network of defined benefit plans maintained by IUOE Local Unions throughout the United States and Canada. This study was conducted by the National Institute on Retirement Security (NIRS).

In recent years a variety of studies have established that the risks inherent in 401(k) plans render them incapable of providing benefits equal to those of defined benefit plans. However, the NIRS study approached the comparison from a different direction than previous studies. It assumed that both the 401(k) and defined benefit plan could provide the same benefit for the lifetime of a hypothetical worker, and then sought to determine what the cost would be to provide that benefit.

The study found that, because of the economic efficiencies embedded in defined benefit plans, they can provide the same benefit at a cost 46% lower than a 401(k) plan --- almost half the cost.

The NIRS study utilized a model with a hypothetical female teacher who worked 30 years, and retired at age 62 with a final salary of $50,000. The model then sought to provide a lifetime retirement benefit which, when combined with Social Security, would provide the teacher with replacement of 83% of her pre-retirement salary. That is a replacement rate deemed adequate by experts to sustain a comfortable, but not extravagant, retirement. Using this model the retirement plan had to provide a benefit of $26,684 a year. And it had to provide the benefit for life.

To provide that benefit, the study found that a 401(k) plan would require $549,903 of pre-retirement contributions, while a defined benefit plan would require only $354,962 in contributions; 46% less than the 401(k) plan.

Put another way the 401(k) plan would require contributions of 22.9% of payroll each year of the employee’s working career, while the defined benefit plan would require only 12.5% of payroll.

Why is the 401(k) plan so much more expensive? The answer goes back to the three fundamental risks in 401(k) plans that are not present in defined benefit plans. The first is savings risk: the risk that you won’t save enough in your 401(k) account. The second is investment risk: the risk that even if you save enough you won’t invest it properly. And the third is longevity risk: the risk that even if you save enough and invest it properly you will outlive your account.

The NIRS study demonstrated that it is because of the absence of investment risk and longevity risk in defined benefit plans that they require 46% less in savings to provide the same benefit.

Specifically, 26% of the 46% savings comes from the superior investment returns that defined benefit plans enjoy over 401(k) plans, and the remaining 20% comes from the absence of longevity risk in defined benefit plans.

As for investment risk, studies have consistently shown that defined benefit plans annually earn 1% per year higher investment returns than 401(k) plans. In the NIRS model this reduced the cost of the defined benefit plan by 26%.

As for longevity risk, defined benefit plans need only maintain funding for the average life expectancy of their participants knowing that half will live longer than average and the other half will not. However, in 401(k) plans every individual must save for their own life expectancy --- and no one knows what that will be. For instance the hypothetical employee in the NIRS study --- a female at age 62 --- has an average life expectancy of age 85, however that same individual has a 10% chance of living until age 97. Thus the defined benefit plan will project its funding on an average life expectancy of 85. However, the 401(k) participant can’t know whether she will survive to age 85 --- or well beyond.

Because of this longevity risk experts recommend 401(k) participants set aside enough money to have a 90% likelihood of lasting a lifetime. Accordingly, for a 62 year old woman to have 90% confidence of adequate income to last a lifetime, her 401(k) account should have enough money to pay benefits until age 97. The NIRS study found that the funding for this additional longevity adds 20% to the cost of the 401(k) plan.

While the NIRS study is consistent with every other published comparison of 401(k) and defined benefit plans, this one quantifies the cost to provide the same benefit in each type of plan. And once again there really is no comparison. Defined benefit plans win hands down.