Comparing DB and DC Returns
A recent study comparing Defined Contribution (DC) to Defined Benefit fund (DB) returns concluded that “DC Plans Have Come a Long Way!”  Citing lower costs, improved diversification – thanks primarily to Target Date Fund (TDF) prevalence and less company stock concentration – the authors state that DC plan performance in the 10 years ending December 31, 2016 trailed DB plan performance by less than one-half of a percentage point (0.46%, annually), as compared to nearly 2 percentage points (1.8%, annually) in the 10 years ending December 31, 2005. Calling this narrowing gap “good news for plan participants,” the authors imply that an appropriate measure of the success of the DC plans is their performance relative to DB plans. In this note, we explain that DB and DC returns are not comparable for two important structural reasons. First, DB plans have very different return objectives from DC accounts, and as such are invested differently – and this difference will grow over time as single-employer DB plans “de-risk” investments by shifting from equities to bonds as funded status targets are met. Second, DB plans are usually professionally advised and frequently utilize investment vehicles such as non-US equity and real estate, which may underperform US stocks when the latter are rising rapidly. Indeed, it is surprising that DC plan performance, in aggregate, continues to trail DB plan returns during periods of strong public stock market performance.
While lower costs and increasingly “automatic” diversification through TDFs have undeniably been good for 401(k) investors, the narrowing of the historically large performance gap in favor of professionally-managed DB plans over 401(k) accounts is more likely due to the bias of the latter toward public equities – mainly U.S. stocks, driven by TDF popularity – and the impressive returns of US equities relative to most asset classes since the financial crisis. Additionally, as corporations continue to “de-risk” their pension plans and aggregate DB asset allocation becomes more conservative over time (fewer stocks, more bonds), any return comparison during equity bull markets will be increasingly less favorable – and less relevant. In this section we compare the 10 year return of a typical pension plan to that of a typical 401(k) account, using an end date of September 30, 2017 – the most recent for which private equity returns are available. Willis-Towers Watson reports that the average asset allocation for US pension plans at the end of 2016 was: 49% public equities (US and foreign), 22% fixed income (including riskier bonds, such as high yield debt), 27% “other” (including “alternatives” such as private equity, real estate, infrastructure, and hedge funds) and 2% cash. As shown in the table below, the 10-year trailing return on a benchmark portfolio, weighted accordingly, and incorporating reasonable allocation assumptions (see note) as of September 30, 2017 was 4.9%. Meanwhile, Vanguard reports that the average asset allocation for a 401(k) account at the end of the same period was 71% public equities (US, and some foreign), and 29% fixed income and principal preservation including cash). Fidelity reports similar allocations.The 10-year trailing return on a mix weighted according to these averages was 5.3%, also shown below.
401(k) investors’ large allocation to U.S. equities afforded a performance “advantage” – a term we use reluctantly for aforementioned reasons – to DC plans, while diversifiers favored by professionally-managed DB funds generally underperformed US equities during the period. Asset classes such as international stocks, real estate (REITs), and hedge funds, which are widely used in professionally-advised DB funds, underperformed the US public equities to which 401(k) investors allocate so heavily, as shown in the table below.
DC plans have without question “come a long way”; lower costs and automatic features have improved diversification and results. However, to compare their performance to pension fund returns and draw conclusions about the effectiveness of the defined contribution retirement system is misguided. Single employer pension funds are invested more conservatively by design, and will become increasingly conservative as corporate funds step up “de-risking.” And all pension funds have access to “diversifiers” that 401(k) plans have been slow to adopt; diversifiers which often trail public equities in strong bull markets. Despite the significant structural advantage to DC plans during a period of mostly rising US stock prices, and notwithstanding the lagging relative returns of some diversifiers favored by pension funds, 401(k) investors still failed to match the performance of structurally-more-conservative pension funds. To us, this is the most telling result of any performance comparison.
For more information or questions about this post feel free to contact, Marc Fandetti, at email@example.com
 CEM Benchmarking Inc., DC Plans Have Come a Long Way!, February 2018.
 Deloitte, Pension Risk Transfer, 2014.
 Willis Towers Watson, Global Pension Assets Study 2017, 2018
 24% Russell 1000 , 24% MSCI ACWI ex. US , 22% Barclays Gov/Credit Bond Index, 10% CA LLC US PE index , 10% Wilshire REIT, 10% HFRI Fund Weighted Composite.
 The Vanguard Group, How America Saves 2017, 2017.
 Fidelity Investments, Quarterly Trends Q4’17, 2018.
 50% R1000, 21% MSCI ACWI ex. US, 29% Bar Gov/Credit Bond index.