Paper Examines Benefits of Shifting to DC Plan

A research paper examines the benefits of moving from a defined benefit (DB) plan to a defined contribution (DC) plan.

The paper, “Cost Shifting and the Freezing of Corporate Pension Plans,” looks at the benefits of DC retirement plans to both plan sponsors and participants. On the one hand, says the paper’s authors, firms that have frozen their DB pension plans have “reduced their costs of providing retirement benefits to workers even net of increases to 401(k) contributions over horizons ranging from one to 10 years.”

On the other hand, employees of these firms have seen “decreases in the net present value of their retirement benefits, again inclusive of increases to 401(k) plans,” according to the paper.

According to authors of the paper, “Many U.S. corporations have frozen DB plans, replacing [them] with contributions to DC plans. We estimate expected DB accruals from the age-service and salary distributions of a large sample of U.S. corporate pension plans with more than 1,000 employees. Comparing the counterfactual DB accruals to the actual increase in 401(k) and other DC contributions for firms that freeze, we find only partial compensation to employees for the lost DB accruals.”

In terms of the net increase in total DC contributions, say the authors, companies can potentially save 2.7% to 3.6% of payroll per year, and over a 10-year horizon save 3.1% of total firm assets. In addition, employees would “have to value the structure, choice, flexibility, or portability of DC plans by at least this much more to experience welfare gains from freezes.”

The demographics of the plan participants, particularly their age, can play a role in the decision of whether or not to shift to a DC plan. The paper finds that relative to the projected increase in 401(k) contributions for the plans studied, the figures show that for the youngest employees (ages 20 to 34), the increased 401(k) contributions mostly offset the lost DB accruals.

Over a time frame of one to seven years, the paper finds that the most savings are achieved at the expense of the workers that are ages 50 to 65, followed by those ages 35 to 49. For a time period longer than seven years, those ages 35 to 39 bear the greatest cost as a share of payroll.

According to the paper’s authors, “Over 10 years, for employees ages 35 to 49, there is a difference of approximately 17.1% of payroll, while for employees ages 50 to 65 there is a difference of 15% of payroll. The total cost savings for firms (30.7% of payroll) is therefore achieved due to the fact that the increase in DC contributions is small relative to the forgone DB accruals for workers in the 35 to 65 age range, and especially in the 35 to 49 age range.”

When deciding whether to switch over to a DC plan, the authors of the paper caution that it is also important to understand whether “pension freezes are bringing employee compensation more in line with their marginal product or moving it further away.” In making their decision, plan sponsors also need to look at factors such as the impact on the volatility of cash flows, the demand of employees for more portable benefits, and the relative effects of the two types of plans on reported accounting income.

More information about the paper, including how to download a copy of it, can be found here.