Sharing and caring
Currently, employers bear the investment risk in defined benefit (DB) pension plans while employees bear the risk in defined contribution (DC) type plans.
Recent equity market performance, longevity risk and the impact of international accounting rules have persuaded many employers to introduce a DC alternative to their DB plans.
This has shifted investment risk from the employer to employees. Yet most employees do not have the professional skills, or the inclination, to choose their own investments.
The result is that they are likely to make inappropriate choices and end up with a pension pot that is far below their expectations.
Some pension fund experts have suggested that a more dirigiste or ‘paternalistic’ system is needed where the employee is guided in his or her investment choice.
One idea, promoted in the US and Canada (see US Report, page 39), is that there should be an ‘autopilot’ arrangement whereby an employee’s contributions are invested automatically into the appropriate funds.
In this arrangement, employees do not need to make a choice to secure a pension. A contributory pension plan is guaranteed to provide an adequate annuity.
Is this the way forward? Should pension providers design a ‘third way’, an alternative to the DB and DC schemes that are currently available?
The majority view of the pension fund managers and administrators who responded to our survey is that something new is needed, whether it is a autopilot DC plan, a hybrid DB/DC plan, or a so-called ‘third way’.
Once again, the message is that the US does not necessarily have the answer to Europe’s pension problems. Pension fund consultant Keith Ambachtsheer has suggested that most of Europe’s occupational pension problems would be solved if their pension plans looked like the DC schemes designed by TIAA-CREF, the pension provider for US academics.
Yet some countries, notably Switzerland, believe they have already squared the circle and produced a DC scheme with some of the risk-bearing features of a DB scheme.
Generally, there is a feeling that polarisation of pensions into a system where either the employer or the employee bears a disproportionate amount of the risk is unhelpful.
Most managers believe that people should not be expected to design their own pensions. Ambacht-scheer’s suggestion that expecting people to build their own pensions is unreasonable gains support from four out of five of our respondents. The conclusion is that people should leave pension building to the pension professionals.
Yet there is support for the idea that people should have the option of building their own pension. “Allowed, yes. Obliged, no,” is a common response. Two in three managers agree with the proposition that people should be able to build their post-retirement income stream by themselves.
However, one pension fund manager suggests that such discretionary management should apply to their own rather than their employer’s contributions.
Pure DC plans, typified by the 401(k) plans in the US, are not seen as the way forward. Two-thirds of our respondents think that DC plans are too risky for employees. Nor does the suggestion that people can make the right investment choices if they are given sufficient information gain much support. Only two in five managers think that information is the key.
One manager wonders why investment choice for employees should matter if the professionals running the pension fund are doing their fiduciary duty. “Why give every member their own choice when collectively the company or trustee should have better knowledge, broader experience and the benefit of economies of scale?”
There is strong support for a new type of pension plan, something other than DB and DC, with three in four managers backing this proposal. A minority feel that we do not need new pension designs. All we need to do is modify the ones we already have, they say. “There are various way to organise both types of plan,” one manager observes.
Another possibility is a ‘hybrid’ pension plan that combines the advantages of DB with DC plans. Five out of six managers approve of this.
Indeed, managers of pension plans in Switzerland point out that that they have already cultivated their own DB/DC hybrids. “We already have such a plan in our company,” says one. “The capital is invested by the pension fund. The benefits are generally paid as pension, not as a lump sum so the retirees are not forced to invest their money by themselves,” says another.
Almost all our managers like the idea of a ‘third way’ in pension design. One pension fund manager sketches out a possible scenario: “There are ways to share the risk with DB through providing, say, a cash sum at retirement that the member has to convert into an annuity. In this way the employer keeps the pre-retirement investment risk and the employee keeps the post-retirement risks – for example, an improvement in longevity.”
There are some dissenters, however. One manager suggests: “Instead of the proposed ‘third way’, which sound rather like the DC lifestyle defaults, we should consider shared cost, as opposed to a balance of cost, arrangements in DB, such as we already have in an industry-wide scheme like the railways pensions scheme.”
DC default arrangements, whereby people do not choose how to invest their contributions are automatically routed into the appropriate lifestyle funds, have been dubbed ‘autopilot’ schemes. Originally developed by the US Treasury and researchers in the 1990s, they have been marketed by pension providers like Vanguard.
A clear majority of our respondents - two out of three - like the idea of autopilot plans. “It is better than leaving it entirely in the hands of the DC plan participants,” one manager comments.
Some would support the idea only if members of the plan could opt in or out, however. One manager suggests: “The difficulty with these is not everyone retires when the company or trustee expects to retire and not always when the individual expects. For example, redundancy, ill health or the need to care for another can mean changes of plan at short notice.”
Others say that DC schemes should include trustee arrangements “to ensure that only appropriate ‘autopilots’ are used if at all”.
DB schemes have their own problems, principally the conflicts of interest between the sponsoring company and the employees about the ownership of fund surpluses – and deficits.
An obvious solution is to insist on 100% funding at all times. Two out of three managers agree that this would be desirable. Yet they are realists. “Plans will never maintain 100% funding. They will go over and under,” says one.
Another points out that employees’ approach to surpluses and deficits tend to be asymmetric. “Members need to stick to the rules. They should not make claims on the surplus while expecting the employer to meet the deficit. There has to be more sharing of the risk and rewards.”
It should be possible to split the share of both deficit and surplus between the parties, is one suggestion: “Why not share the cost or surplus between the employer and employee, say two-thirds and one-third, so that contributions go up or down together?”
Another, more basic problem is the issue of solidarity. Most managers in our survey agree that DB plans depend for their survival on intergenerational solidarity, in the sense that every participant in a DB plan - active members, pensioners and the sponsoring company - must share the rewards and risk.
Opinion is divided on what a weakening of solidarity would mean for the future of DB pensions. The assumption is that future generations will refuse to pay the pensions of the older generation.
However, one manager points out that this is only one view of the contract between generations: “It is commonly understood that intergenerational solidarity means young people need to pay for older people. I strongly disagree with this approach. Given the demographic changes, intergenerational solidarity must also imply that elder people create and leave surpluses for the younger ones.”
What is needed is a pension plan that creates no conflicts of interest between its stakeholders – the company, its shareholders, its employees, active members of the pension scheme and retired members. A very substantial majority, seven out of eight managers, concur with this.
Yet some of our respondents point out that supporting this idea is the equivalent of voting for motherhood and apple pie. “Wouldn’t we all like to live in an ideal world?” one manager comments dryly. And, in terms of pensions as with everything else, that is still some way off.