Defined Contributions a Possible Alternative

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I think that it is pretty certain that defined contribution [DC] plans 401(k)s, 403(b)s, 457s, much as they have grown to be dominant, have been a failure.  Many, though not all people like the illusion of control, and seeing their cash balance — makes the pension plan tangible, even if they don’t get what they will really need at retirement.

Pension plan reform has to face three realities.  The first is people don’t know how much to put away for retirement.  I’ll give you a hint: for almost all people, it should be over 10% of your gross pay.  The second is that people don’t know how to invest, so hand it off to advisors who will do it for them, and cheaply.  The third is silent, and leaves a lot of money on the table — most people would be better off taking an annuity from their pension plan than a third party, or trying to manage a lump sum on their own.  This is usually an option only for defined benefit [DB] plans.

On the last point, annuities from insurance companies will almost always be inferior to those from DB plans — the investment policy of the DB plan will likely yield more than the investments of the life insurance company.  The DB plan has more ability to take risk, and its expenses are lower.

And speaking of lower expenses, that’s another reason to replace DC plans.  Not only do DB plans provide better security, they have lower expenses.

But employers don’t want to fund expensive DB plans, particularly in a low interest rate environment.   Fine, that’s not what I am arguing for.  I am suggesting an odd sort of DC plan:

  • Participants can contribute what they wish
  • Employers can contribute what they wish
  • Professionals manage the assets; no asset management by participants.
  • During active employment, the cash balance can transfer with a change of employment.
  • At retirement, it converts to a DB plan, and an annuity is granted, more generous than could be obtained privately.  The retiree does not get the agony of managing a lump sum.

I think this would lead to much better results for plan participants.  The case would have to be made to participants that they have not done well managing their own funds — they will underperform by less through third party managers.  Also, few are good at managing lump sums for income.

This is the sort of plan that would yield better results for most, given that DB plans are out of favor, and participant-directed DC plans lead to high expense lousy results.  Best to have a hybrid plan.  Trustee-directed DC plan for accumulation.  DB plan for distribution.

That’s how I would structure it at present.  Better ideas are welcomed.  Thoughts?

 

By David Merkel, CFA of Alephblog



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.