This article originally appeared in the January 20, 2014 print issue of Pensions & Investments as, “Misdirected impulse to shift from DB plans.”

Pension funds benefit from economies of scale, expertise, risk pooling and long time horizons

Although often assumed to save money, defined contribution plans are inefficient compared with defined benefit plans, which benefit from risk pooling, economies of scale and higher investment returns.

Admittedly, private-sector employers that switched en masse to defined contribution from defined benefit plans often were motivated by cost considerations and the desire to shed long-term liabilities, but that’s only because switching plans gave them the opportunity to shift these costs and risks onto workers. Cost shifting isn’t cost saving, and overall costs went up even as retirement security plummeted.

In a Jan. 6 Other Views commentary in Pensions & Investments, Andrew G. Biggs, Josh McGee and Michael Podgursky argue that transition costs shouldn’t stand in the way of switching government workers to 401(k)-style or hybrid plans from traditional defined benefit programs. This is like arguing that it’s not a hassle to switch to an expensive, unreliable cellphone plan from an inexpensive, reliable one. Why would you even want to?

The impulses that drove the shift to DC plans in the private sector don’t exist in the public sector. Public-sector workers already contribute to their pensions, so there’s no reason to change plan type simply to allow more cost sharing. And because state and local governments almost never go out of business, government entities are well suited to taking on long-term pension obligations — as long as cities and states keep up with required contributions, which most do.

Switching plans does not save taxpayers money — even if, as Messrs. Biggs, McGee and Podgursky claim, transaction costs are minimal. DB pension plans are more cost-effective than DC and hybrid plans in the short and long run because of higher net investment returns and costless risk pooling. These are not minor differences: Participants and employers need to contribute almost twice as much to 401(k)s as to traditional defined benefit plans to ensure a similar income in retirement.

The authors of the commentary suggest that pension funds’ higher returns are a mirage caused by ignoring risk and clinging to the fallacy, disproved long ago by Paul Samuelson, Nobel laureate economist, that investment risk disappears over long time horizons. This is simply false. Research has consistently shown that pension funds earn higher risk-adjusted net returns than 401(k) participants because of professional expertise and economies of scale.

Although pension funds should be able to take on more risk than individuals saving for retirement, this is not founded on a naïve embrace of the fallacy of large numbers, but rather the fact that pension funds pool the savings of overlapping generations of workers, allowing them to smooth the retirement outcomes of workers who retire during bull and bear markets. This gives pension funds good reason to be less risk-averse than individual savers, although in fact 401(k) participants now have a greater share of their assets invested in equities than pension funds.

Messrs. Biggs, McGee and Podgursky appear to take the high road when they bemoan the “misleading” practice of focusing on short-term over long-term costs. But a careful reader will note that the only mention of reducing long-term costs comes from a faster repayment of unfunded liabilities, which they simultaneously deny would result from a switch to a DC or hybrid plan, and, conversely, claim that even if true would “produce even larger savings in the long term.”

Proponents of switching to DC and hybrid plans who bemoan a focus on short-term costs have no one to blame but themselves, because the most compelling argument for drastic change is the idea that state and local governments are in fiscal distress after the Great Recession and can no longer afford to provide retirees with secure retirement benefits.

The only way to save money in the short or long run is to slash benefits, not switch plans. Even these savings will prove ephemeral, because there’s no reason to think government workers — who are already paid less than comparable private-sector workers and highly value pension benefits — would agree to additional cuts without offsetting increases in pay or a negative impact on recruitment and retention. This is especially true since pension benefits already have been pared to the bone in many cities and states.