Contributory Defined Benefit Plans: A Pension Fix?

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



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.