Defined Benefit vs. 401(k) Plans: Investment Returns for 2003-2006

Watson Wyatt has been comparing rates of return between defined benefit (DB) and defined contribution (DC) plans for more than 10 years.¹ This most recent comparison finds that between 1995 and 2006, DB plans outperformed DC plans by an average of 1 percent per year. Earlier studies also found that, over time, DB plans attained higher returns than did 401(k) plans.

During the bull markets of the late 1990s, 401(k) plans outperformed DB plans. But our 2004 analysis of data through 2002 found a reversal of fortune in both the stock market and rates of return, suggesting that DB plans outperform DC plans during bear markets. Our 2008 analysis finds that DB plans outperformed 401(k) plans even in the bull markets of 2003 through 2006.

In 2006, the Center for Retirement Research (CRR) at Boston College analyzed rates of return for DB and 401(k) plans between 1988 and 2004.² Its study yielded results similar to those of Watson Wyatt’s earlier analyses, namely, DB plans earn higher returns than 401(k) plans over time. In their report, Boston College researchers introduced the analysis of returns on a weighted scale, giving plans with larger assets more importance. Looking at returns on a weighted basis is more relevant to understanding the experience of plan participants because, after all, plans with more assets generally have more participants. So in this study, we look at returns measured by both asset- and plan-weighted medians.

Like our earlier studies, this analysis is based on Form 5500 financial and pension disclosure data released by the U.S. Department of Labor (DOL). We also use the same formula to calculate the average rate of return:

Comparisons for Sponsors of Both Plan Types — Plan Size Makes a Difference
As in past studies, we initially include only companies that sponsored one DB plan and one 401(k) plan, each with at least 100 participants. We limit our analysis to these companies to minimize the effects on the results of specific company or workforce characteristics that are uniquely associated with the sponsorship of one plan type. This approach enables us to concentrate on differences in rates of return more strongly and directly associated with different retirement plan types.³

For the first time in this series of studies, we look at median rates of return weighted by plan asset size. Table 1 shows the year-by-year rate of return comparison between DB and 401(k) plans for 1995 to 2006.

Table 1
Asset-Weighted Median Rates of Returns for DB and 401(k) Plans — 1995-2006*

Year	Number of sponsors	DB plan	401(k) plan	Difference
2006	914	12.90%	11.34%	1.56%
2005	2, 584	7.74%	6.69%	1.05%
2004	2,583	11.81%	9.80%	2.01%
2003	2,514	21.35%	19.68%	1.67%
2002	2,085	-8.56%	-10.93%	2.37%
2001	2,239	-3.78%	-6.07%	2.29%
2000	2,058	-0.01%	-2.76%	2.75%
1999	1,472	13.46%	14.41%	-0.95%
1998	2,958	14.25%	15.29%	-1.04%
1997	2,931	18.82%	19.73%	-0.91%
1996	3,034	14.53%	14.10%	0.43%
1995	3,063	21.10%	19.20%	1.90%
Average		10.30%	9.21%	1.09%

* Data for years before 2003 are from earlier analyses of Form 5500 data. The sample size for 2006 is lower than usual because only about 40 percent of Forms 5500 were available from the DOL when this analysis was performed.

Historically, larger plans realize higher returns than smaller plans, because larger plans generally have access to a wider variety of investment options and economies of scale and, in the case of DB plans, more investment expertise. Because this form of measurement emphasizes investment results in larger plans, it more accurately tracks the effects of market performance on the average participant. Measured by asset-weighted median, DB plans outperformed 401(k) plans from 2003 to 2006. Moreover, DB plans substantially outperformed 401(k) plans through the recent bear-to-bull market cycle (2000-2006). Both plan types performed better on the asset-weighted measure than in the plan-weighted analysis discussed later.

In Table 2 we compare rates of return for the largest one-sixth, largest one-half and smallest one-sixth of the plans (based on asset size of the DB plan, to try to control roughly for the size of the plan sponsor) from 1995 to 2006.

Table 2
Comparison of Plan-Weighted Median Returns by Plan Size — 1995-2006

Largest One-Sixth
	DB plan	401(k) plan	Difference
2006	12.53%	11.2%	1.33%
2005	7.20%	6.53%	0.67%
2004	10.60%	9.48%	1.12%
2003	20.65%	19.07%	1.58%
2002	-8.73%	-11.21%	2.48%
2001	-4.10%	-6.10%	2.00%
2000	-0.32%	-2.99%	2.67%
1999	13.11%	16.08%	-2.97%
1998	13.68%	14.7%	-1.02%
1997	18.74%	18.44%	0.30%
1996	14.3%	12.83%	1.47%
1995	23.18%	18.29%	4.89%
Average	10.07%	8.86%	1.21%
Largest One-Half
	DB Plan	401(k) plan	Difference
2006	11.98	11.39	0.59%
2005	6.72%	6.61%	0.11%
2004	9.78%	9.39%	0.39%
2003	18.95%	19.53%	-0.58%
2002	-8.60%	-11.83%	3.23%
2001	-3.94%	-6.77%	2.83%
2000	-0.32%	-3.40%	3.08%
1999	11.87%	15.32%	-3.45%
1998	13.37%	14.62%	-1.25%
1997	17.87%	17.97%	-0.1%
1996	13.9%	12.84%	1.06%
1995	21.54%	17.63%	3.91%
Average	9.43%	8.61%	0.82%
Smallest One-Sixth
	DB Plan	401(k) plan	Difference
2006	10.12%	11.59%	-1.47%
2005	5.42%	6.59%	-1.17%
2004	7.64%	9.23%	-1.59%
2003	14.7%	19.65%	-4.95%
2002	-8.02%	-12.33%	4.31%
2001	-3.51%	-7.43%	3.92%
2000	1.43%	-5.17%	6.6%
1999	9.00%	16.11%	-7.11%
1998	9.87%	13.45%	-3.58%
1997	12.67%	16.43%	-3.76%
1996	10.63%	12.42%	-1.79%
1995	15.18%	16.94%	-1.76%
Average	7.09%	8.12%	-1.03%

Source: Watson Wyatt calculations from Form 5500 data files.

Between 1995 and 2006, returns in large 401(k) and DB plans were higher than those in small plans. Large DB plans outperformed small ones by an average of 3 percentage points. Large 401(k) plans outperformed smaller ones by an average of 74 basis points. Size seems to have less effect on 401(k) returns, perhaps because small DB plans cannot hire as much expertise as bigger plans, while both large and small 401(k) plans often offer essentially the same funds to participants.

Among large plans, DB plans outperformed 401(k) plans by 1.21 percent. Among small plans, 401(k) returns outperformed DB returns by 1.03 percent.

The Effect of Plan Expenses on Rates of Returns
The earlier analysis in this report looked at investment returns based strictly on income performance. DB plans typically report income net of investment expenses. Expenses for 401(k) plans are typically deducted from their investment return; however, they also commonly include administrative costs bundled in. As a result, Form 5500 data may not be fairly comparing DB and DC plans with respect to embedded noninvestment costs captured in the investment income component. This is especially true for mutual funds. While both plan types invest in mutual funds, the funds are most prevalent among 401(k) plans. In 2006, 39 percent of plan assets in 401(k) plans were invested in mutual funds, compared with only 10 percent in DB plans.⁴

Mutual funds for 401(k) plans had an average weighted expense of 72 basis points in 2006.⁵ With 39 percent of 401(k) plan assets invested in mutual funds, it is reasonable to assume that these fees reduce rates of return by 28 basis points. According to Watson Wyatt’s 401(k) fee data, 33 percent of mutual fund fees are actually bundled administrative costs, which results in a 9-basis-point average reduction to reported 401(k) returns attributed to bundled administration costs incorporated in investment company fees.

Between 1995 and 2006, asset-weighted median returns were 1.09 percent higher in DB plans than in 401(k) plans. To make it an apples-to-apples comparison, we add 9 basis points to 401(k) plan returns for implicit bundled administrative costs, which results in a net difference of roughly 100 basis points.

Results Differ Looking at Plan-Weighted Returns
As in previous studies, we also compare investment returns giving all plans equal weight. The returns for 1995 through 2006 are shown in Table 3.

Table 3
Plan-Weighted Median Rates of Returns for DB and 401(k) Plans — 1995-2006

Year	Number of sponsors	DB Plan	401(k) plan	Difference
2006	914	11.54%	11.39%	0.15%
2005	2,584	6.36%	6.63%	-0.27%
2004	2,583	9.05%	9.27%	-0.22%
2003	2,514	17.53%	19.68%	-2.15%
2002	2,085	-8.43%	-12.26%	3.83%
2001	2,239	-3.82%	-7.30%	3.48%
2000	2,058	0.00%	-4.28%	4.28%
1999	1,472	11.08%	16.09%	-5.01%
1998	2,958	12.31%	14.27%	-1.96%
1997	2,931	16.47%	17.32%	-0.85%
1996	3,034	12.88%	12.69%	0.19%
1995	3,063	19.53%	17.45%	2.08%
Average		8.71%	8.41%	0.30%

Source: Watson Wyatt calculations of Form 5500 data.

After stronger performances by DB plans during the bear market of 2000 through 2002, 401(k) plans outperformed DB plans in terms of plan-level medians from 2003 through 2005. DB plans slightly outperformed 401(k) plans in 2006. Over the 12-year period, which captures both bull and bear cycles, DB plans outperformed 401(k)s by an average of 30 basis points.

401(k) plans have a wider distribution of returns than do DB plans. Table 4 shows the standard deviation of returns from 1995 to 2006 for both plan types. The standard deviation measures how closely the observations cluster around the mean in a data set. From 1995 to 2006, 401(k) plans had a wider distribution of investment returns in all years except 2002 and 2003. This is not surprising — 401(k) plans have millions of participants with varying financial skills choosing different mixes of investments, while DB plans have more consistent investment styles and performance. Moreover, many 401(k) participants choose asset allocation strategies at the extremes — all equities or all money market funds — and tend to be market-trend followers.⁶ There should be less volatility in the distribution of returns for DB plans.

Table 4
Standard Deviation of Rates of Returns Across Plans — 1995 to 2006

Year	DB Plan	401(k) plan
2006	3.08%	4.96%
2005	2.73%	4.39%
2004	3.43%	4.25%
2003	7.14%	6.05%
2002	6.10%	6.01%
2001	5.27%	6.59%
2000	8.01%	9.36%
1999	12.33%	26.41%
1998	6.42%	8.18%
1997	7.46%	9.71%
1996	5.77%	6.13%
1995	7.69%	10.61%
Average	6.29%	8.55%

Percentage of Equity May Affect Rates of Return
In comparing asset-weighted medians, DB plans consistently outperformed 401(k) plans during the 2003-2006 bull market. But during the earlier 1995-1999 bull market, 401(k) plans outperformed DB plans. This reversal could be due to differences in equity allocations.

As shown in Figure 1, from 1995 through 1999, 401(k) plan participants had a higher and growing allocation to equity in their asset portfolios compared with DB plan participants, so they reaped the rewards of high returns when the market was up. But the difference in returns was less pronounced than one would expect, which might be because DB plan fund managers maximize equity returns through greater diversification or more sophisticated investment techniques.

This advantage to professional investing was particularly evident during the bear market (2000-2002). DB plans had similar or higher allocations to equities, yet they outperformed 401(k) plans during this period. Many 401(k) plan participants seem to have bought high and sold low in the stock market. Some also might have been heavily invested in company stock, and, when the bubble burst at the beginning of this decade, their returns on this form of equity investment were poor.

Hypothetical Case — Real-Dollar Effects of Differential Rates of Return
To take the analysis further, we simulate the growth over the last 12 years of two hypothetical plans — one DB and one 401(k) — in real-dollar terms using asset-weighted returns, as shown in Table 1.

Company X had $100 million each in DB assets and 401(k) assets at the end of 1994 (see Figure 2).⁷ The balances in both plans remained fairly even through 1999, but starting in 2000, DB assets began to pull ahead. By the end of 2006, Company X’s DB plan held $310 million in assets, while its 401(k) plan had only $273 million — a difference of nearly $37 million or 14 percent.

When the 401(k) Is the Only Plan
One concern about the approach taken in this study thus far is that employees who have both a DB and a 401(k) plan might make more aggressive investment decisions in their 401(k) plans, which could skew the results. So we identified employers that sponsored only 401(k) plans and calculated their rates of return for 1995 through 2006 (see Table 5). The table also shows median rates of return in 401(k) plans for employers that offer both DB and 401(k) plans.

Table 5
Plan-Weighted Median Returns of 401(k) Plans

	Sponsor 401(k) plan only		Also sponsor DB plans
Year	Number of sponsors	Median rate of return for all sponsors	Median rate of return for sponsors w/DC and DB plans
2006	25,355	11.56%	11.39%
2005	40,510	6.87%	6.63%
2004	39,090	9.56%	9.27%
2003	38,032	20.16%	19.68%
2002	34,002	-13.29%	-12.26%
2001	33,414	-8.50%	-7.30%
2000	36,844	-5.91%	-4.28%
1999	23,526	17.32%	16.09%
1998	27,053	13.84%	14.27%
1997	24,281	16.41%	17.32%
1996	21,720	12.63%	12.69%
1995	19,016	17.21%	17.45%
Average		8.16%	8.41%

Source: WW calculations from Form 5500 data files.

Employees without DB plans achieved lower returns in their 401(k) plans than those with both retirement plan types (8.16 percent vs. 8.41 percent). Indeed, this is consistent with evidence from a prior analysis on asset allocation in individual workers’ DC plan accounts.⁸

Results for All Plans Are Similar to Those for the Controlled Group
Rate-of-return results for all DB and 401(k) plans in the Form 5500 database are similar to those for sponsors with one DB and one 401(k) plan (see Table 6). The average sample size for each year of the 12-year period was 33,807 for 401(k) plans and 9,808 for DB plans.

Table 6
Rates of Returns for All DB and 401(k) Plans

	Plan-Weighted median			Asset-Weighted median
Year	DB Plan	401(k) plan	Difference	DB plan	401(k) plan	Difference
2006	11.63%	11.53%	0.10%	13.09%	11.91%	1.18%
2005	6.59%	6.85%	-0.26%	8.11%	6.78%	1.33%
2004	9.25%	9.55%	-0.30%	11.28%	9.46%	1.82%
2003	17.46%	20.04%	-2.58%	20.89%	19.51%	1.38%
2002	-8.23%	-13.09%	4.86%	-8.59%	-11.39%	2.80%
2001	-3.70%	-8.41%	4.71%	-4.16%	-5.98%	1.82%
2000	0.24%	-6.09%	6.33%	0.99%	-3.35%	4.34%
1999	10.91%	17.56%	-6.65%	13.80%	15.15%	-1.35%
1998	12.30%	14.01%	-1.71%	13.99%	15.57%	-1.58%
1997	16.94%	16.45%	0.49%	18.52%	18.71%	-0.19%
1996	13.14%	12.70%	0.44%	14.65%	13.74%	0.91%
1995	19.60%	17.21%	2.39%	22.96%	20.09%	2.87%
Average	8.84%	8.19%	0.65%	10.46%	9.18%	1.28%

Source: Watson Wyatt calculations of Form 5500 data.

The difference between returns in DB and 401(k) plans over the 12-year period is slightly higher for the universe of all plan sponsors than for our subgroup of sponsors with one DB and one 401(k) plan.

As noted earlier, 401(k) returns are an average of 25 basis points higher when the sponsor offers both a DB and a 401(k) plan than when the sponsor offers a 401(k) plan only. The majority of 401(k) sponsors in the Form 5500 data files offer only a 401(k) plan. So the difference in returns between DB and 401(k) plans, comparing the control sample and the overall group, increases by roughly 25 to 35 basis points for both plan- and asset-weighted medians.

Conclusion
Achieving consistently high investment returns in volatile financial markets is challenging. The shift from defined benefit plans to 401(k) plans has raised concerns about whether today’s workers will have sufficient resources for a secure retirement. In a defined benefit plan, the sponsor assumes the investment risk and, generally, the responsibility for providing lifetime retirement income. With 401(k) plans, however, it’s up to employees to invest wisely and build up enough savings to last a lifetime.

Our most recent comparison of investment returns finds that between 1995 and 2006, DB plans outperformed DC plans by an average of 1 percent per year. In terms of asset-weighted medians, DB plans substantially outperformed 401(k) plans through the recent bear-to-bull market cycle (2000-2006). Over the 12-year span from 1995 to 2006, DB plans outperformed 401(k) plans through all the ups and downs of financial markets by an average of 109 basis points. 401(k) plans have more administrative expenses, which are bundled into fees and deducted out from returns, which could explain a portion of the performance difference. Once these bundled noninvestment-related expenses are added back in to rates of return, however, DB plans still outperformed 401(k) plans by 100 basis points.

In terms of plan-weighted medians, 401(k) plans actually outperformed DB plans during the 2003-2005 bull market, while DB plans outperformed 401(k) plans in 2006. Comparing investment returns using both plan- and asset-weighted methods does not change the fact that, on average, DB plans outperformed 401(k) plans over the 12-year analysis.

Trustees for DB plans have a fiduciary responsibility for investment performance. They or the professionals they hire also usually have considerable financial education, experience, discipline and access to sophisticated investment tools — advantages not typically shared by individual participants in 401(k) plans. These advantages help DB plan investors maximize their returns and maintain well-diversified portfolios, so they can generally ride out market fluctuations more smoothly than 401(k) plan participants. Time will tell whether 401(k) participants will learn to manage their new investment responsibilities more effectively to ensure adequate retirement income in the future.

Plan sponsors and regulators have implemented devices and strategies to help offset the knowledge gap between institutional and individual investors, such as the recent regulation that defines default investments for participant-directed plans. In the absence of investment direction from a 401(k) plan participant, the regulation allows the fiduciary to invest the participant’s assets in a qualified default investment alternative, which must be a life-cycle/target date fund, a balanced fund or a professionally managed account. These default investments may help mitigate the risk many 401(k) employees incur by failing to rebalance their assets over time. While these results do not reflect the effects of the new “autopilot” investment options, future analyses will investigate whether these widespread design changes will help close the gap in returns.

¹ Earlier analyses appear in “Investment Returns: Defined Benefit Versus 401(k)” (Watson Wyatt Insider June 1998); “Defined Benefit vs. 401(k) Returns: The Surprising Results” (Watson Wyatt Insider, January 2002); “Defined Benefit vs. 401(k) Returns: An Updated Analysis” (Watson Wyatt Insider, September 2003); “Defined Benefit vs. 401(k): The Returns for 2000-2002” (Watson Wyatt Insider, October 2004).
² Center for Retirement Research, “Investment Returns: Defined Benefit vs. 401(k) Plans,” CRR Issue Brief, September 2006, Number 52.
³ Investment returns for all DB and 401(k) plans yielded results similar to those for the one-to-one comparison group.
⁴ U.S. Board of Governors of the Federal Reserve System, Flow of Funds data (2007).
⁵ Investment Company Institute, “The Economics of Providing 401(k) Plans: Service Fees and Expenses” (Research Fundamentals, November 2006).
⁶ “Influences on Workers’ Asset Allocations in Defined Contribution Accounts” (Watson Wyatt Insider, January 2008).
⁷ The hypothetical return illustration assumes a balance of cash inflows and outflows to the plan during this period.
⁸ “Influences on Workers’ Asset Allocations in Defined Contribution Accounts” (Watson Wyatt Insider, January 2008).