Targeting a Better Way to Save for Retirement
(Bloomberg) -- Let’s run through some fun retirement-savings jargon: DB, for defined benefit, means a traditional pension plan. The monthly payout is defined from the start and guaranteed by the plan sponsor. DC, for defined contribution, is an individual retirement account such as a 401(k). The amount of money you put in is defined by you, and maybe your employer chips in a match. After that, good luck!
A lot has been written in recent years about the drawbacks of both systems. DB plans require providers to take on big, long-term risks, which private employers in the U.S. have generally decided they don’t want to do anymore and some state and local governments have done an awful job of managing. DC plans put all those risks on the shoulders of individual workers and retirees, with predictably mixed results.
It sounds like there ought to be a middle way, right? There is, and it’s being developed mainly outside the U.S.
A name I had previously heard for these middle-way schemes is collective defined contribution, which doesn’t exactly roll off the tongue and has an acronym that in the U.S. has already been claimed by the Centers for Disease Control. The Financial Times called them “target benefit” plans in an article this week on their possible rise in the U.K., but “TB” is already taken, too. So my new favorite term for these plans, which I learned Tuesday from John Kiff of the International Monetary Fund, is “defined ambition.” As Niels Kortleve, innovation manager with the Dutch pension fund manager PGGM, put it in a 2013 article in the now-defunct Rotman International Journal of Pension Management, DA plans usually start out looking a lot like DB plans, with a target benefit based on salary and years of service. Then comes the twist:
The main difference for DA contracts is that when asset value and longevity change, the benefits are adjusted downward in poor times and upward in good times. This should happen through well-communicated preset rules, such that all stakeholders know beforehand what will happen in each situation and how it will affect their contributions and benefits. If life expectancy increases, the retirement age can increase and retirees’ benefits can be adjusted accordingly. In the case of a negative shock in financial markets, the benefits can be lowered.
Dutch pension funds were forced by their regulators to make such adjustments during and after the global financial crisis, although not exactly with “well-communicated preset rules.” The funds mainly just stopped adjusting pension benefits for inflation for a couple of years, although a few also had to make small cuts in nominal benefits. Since then the pension funds and the government have been working on better defining and communicating the rules.
There are a few target-benefit plans in Canada, too, although a bill to encourage their wider use has run into lots of opposition. In the U.K., Royal Mail PLC, which recently froze its DB plan, is looking to shift its many workers to something along the lines of DA. In the U.S., a few union-run multi-employer pensions have moved in recent years to variable defined-benefit plans in which payouts are to some extent dependent on investment returns. But DA is as yet not a big theme here.
Instead, private employers have been moving to take at least a few DC responsibilities off their employees’ hands by automatically deducting money from paychecks (unless the employee opts out) and plunking it into target-date funds, while state and local governments that still offer DB plans have been under lots of pressure to shift workers at least partly to DC. At the national level, Social Security is a DA plan of sorts, but not an optimally designed one. That is, retiree benefits will under current law be reduced to match payroll tax revenue after the Old-Age and Survivors Insurance Trust Fund runs out of money, which is currently projected to happen in 2035, but most people assume Congress will step in and make changes before that.
The advantage of DA over DB is that it’s more sustainable. The advantage of DA over 401(k)-style DC is that pension funds generally achieve higher investment returns than individual retirement accounts. That’s partly because they’re run by professionals, partly because those professionals can make long-run illiquid investments of a sort not available in most 401(k) plans, and partly because the administrative costs are usually much lower. The administrative costs are kept especially low when, as in the case of the major Dutch funds, the pension funds are gigantic member-owned cooperatives. Two researchers for the Dutch central bank found in a 2007 study that “the administrative costs of collective pension schemes offered by pension funds constitute only a fraction of the operating costs of private pension schemes offered by insurers (over the last five years an estimated 4.4% versus 12.9% of the gross contributions).”
In the U.S., the shift to individual DC in the private sector is so far along that it’s hard to imagine how DA plans could gain much of a foothold there. But for troubled state pension funds, and maybe even for Social Security down the road, the idea of building in some flexibility while not giving up on the bulk provision of retirement income seems really sensible.
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