In the good old days, there were Defined Benefit [DB] plans for pensions, and only those. Why were those good?
- The sponsor took care of the investing
- Participants received a level, or inflation-adjusted payment.
- Payments offered longevity insurance — you could not outlive them.
Then, by accident, the 401(k) plan, and other defined contribution [DC] plans came into existence. Employees could invest their money pretax, and make money during the bull markets of the ’80s and ’90s. Many companies terminated their DB plans, and replaced them with DC plans, cash balance plans, etc.
DC plans were attractive to most participants because:
- They could see the value easily — it was expressed in a single number, and a higher number is always better, right?
- The employer match was an obvious source of value.
- Since most of the plans were participant directed, many enjoyed control of the asset allocation, particularly in bull markets.
- The benefits were portable, they did not rely on continued employment with the same firm.
- They could take loans against their balances.
After the bull market of the ’90s, what did participants in DC pension plans lose?
- They weren’t natural investors, so they lost there through underperformance. Fear and Greed led them to lose.
- They lost longevity insurance — it is a lot cheaper to get it early, when you don’t need it.
- As interest rates fell, so did the ability to buy a future income by buying an annuity. Yes, the balance was higher, but you could not earn as much from it with safety.
- Managing a lump sum for income is a very tough task, and one that most average investors are not equipped to tackle.
This is why I would like to propose replacing DC plans with DB plans, but give employees the option of adding more to their DB plans, and making DB plans portable. This would require:
- Making DB plans tax-favored relative to DC plans. Drop the tax-advantaged status for DC plans.
- Have standard transfer assumptions for the valuation of DB plans.
The great advantage of contributory DB plans is that they divide responsibilities/advantages where they are best held:
- Plan sponsors are better at investing than participants.
- DB plans provide longevity insurance.
- If participants want to save more, they can do so, buying streams of future income.
I know this piece is nonstandard — out of step with the current “reality.” If pensions were structured this way, it would save many people a lot of headaches:
- How do I invest?
- How can I lock in a good future income for life?
- How can I get more than what the company is putting aside for me?
Contributory Defined Benefit plans would divide the duties of pensions properly. Participants would decide how much to save, and sponsors would invest and provide longevity insurance. Can you think of a better way to do pensions? I’m all ears.
By David Merkel, CFA of alephblog