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The Retirement Plan Solution: The Reinvention of Defined Contribution by Matthew X. Smith, Bob Collie, Don Ezra

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Chapter 4. Investment Returns Are All-Important

The magnitude of the role played by investment returns in retirement provision has long been understood within the defined benefit (DB) system. As long ago as 1989, one of the authors modeled DB plan growth and found that "80¢ or more comes from investment returns; contributions account for the remaining 20¢ of each benefit dollar."[34] The same paper found that "for any one plan member, the largest part of the investment return ... accrues during the payout stage." DB investment programs are accordingly built around the realization that return generation is a key element in the cost-effective provision of pension benefits.

Exactly the same is true in a defined contribution (DC) or 401(k) plan. The dynamics are similar but not identical; instead of a series of cohorts of different ages with new entrants replenishing the system as older participants retire and eventually die, there is only a single life to consider in a DC plan. Neither investment risk nor longevity risk is pooled in DC as they are in DB plans that do not make lump-sum distributions. And, unlike in DC, contributions in DB tend to be back-loaded (there is a significantly higher cost attached to the accrual of a DB pension at advanced ages than at younger ages).

The result is that the 80-20 split of DB looks more like 90-10 in DC. The finding that the bulk of the investment return is earned during the payout stage remains true in a DC world but takes on added significance ...

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