The DB Retirement Income Advantage

In this article, we briefly discuss why employer-sponsored DB plans can provide — for the same account balance — annuities that are 15-30% larger than a participant in a 401(k) plan can purchase — what we call the "DB annuity advantage."

In our last two articles, we have reviewed how much retirement income participants under the four basic retirement plan designs – DC/401(k), traditional (annuity-based) DB, “traditional” (fixed interest rate credit) cash balance, and market-based cash balance – have been able to generate over the last five years. To do that, we tracked performance (in terms of “retirement income purchasing power”) over the period 2021-2025 under these plans, based on three critical financial risk factors: asset returns, interest rates (which drive the cost of retirement income, e.g., annuity purchase rates), and inflation.

To put everything on an apples-to-apples basis, we started with a 1/1/2021 opening account balance/lump sum of $186,826 – enough for a 55-year-old participant in the DC plan to buy a commercial, age-65 life annuity of $1,000 per month.

As we noted in our article on DB participants, that starting balance will, in a DB plan, convert to a life annuity of $1,297 per month – almost 30% larger than the annuity provided in the DC plan at that time.

When you lay DC outcomes on top of DB outcomes, it looks like this:

You will notice that, e.g., the shape of the line describing MBCB performance is roughly the same as the shape of the line describing DC performance, but there is a consistent 15-30% spread between those two lines. That spread is what we’ve called the “DB annuity advantage.”

Bottom line: if you care about how much retirement income a participant gets, they get much more (in effect, more “bang for the buck”) out of a DB plan.

Why DB Plans Provide Bigger Annuities

The employer-provided defined benefit plan was more or less invented as a cheaper alternative to insurance company-provided annuities. DB participants have access to much more cost-effective retirement income than their DC counterparts, for several reasons:

1. Individual versus group mortality underwriting, or “the law of large numbers.” A 65-year-old retiree is expected to live to age 86.1 but faces a 25% chance of living to age 92 and a 5% chance of living to age 98, and insurer pricing must reflect these possibilities. For a group of 100 retirees, however, there is only a 5% chance that the average age at death exceeds 86.8. Employers have unique access to group underwriting to provide retirement income to employees via DB plans, explaining the bulk of the DB retirement income advantage.

2. Adverse selection. Only DC participants with the longest life expectancies are likely to seek out commercial annuities. Insurers anticipate this tendency and reflect it in their pricing.

3. Other costs faced by commercial insurance carriers include:

   • acquisition costs

   • regulatory overhead

   • profit margin

None of This Means You Get Rid of Your 401(K) Plan

As our first article makes clear, DC does a very good job of asset accumulation. All that we are talking about here is the annuity conversion premium that applies if/when the participant converts her account balance to an employer-provided DB plan annuity. That can be accomplished by transferring (at the time of annuity conversion) her account balance from the 401(k) plan to an employer-sponsored DB plan.

None of this means participants must annuitize

Indeed, depending on the circumstances, there will be participants – perhaps, as is currently the case, a majority of them – who will never annuitize, preferring the flexibility of holding/drawing down assets and its attendant risks to converting to a nominal fixed income annuity payment, with its exposure to inflation, liquidity limitations, and (generally) no legacy.

* * *

This DB retirement income advantage has shown up in our first two articles and will continue to be a factor in our analysis.