- A defined benefit pension plan promises a retirement income stream for participants (based on various criteria, such as working income and years of service), and contributions are levied during their working careers based on the actuarial assumptions of the plan sponsor. The contributions and benefits may be adjusted over time if there are developments that do not match embedded assumptions (particularly lifespan and investment returns).
- A defined contribution pension plan does not offer any promised retirement income stream, rather the worker contributes a defined amount into a personal fund, and this creates a portfolio of financial assets that are used to generate a retirement income. The contributor to the plan typically has to decide how to invest the assets, within a range of allowed options. Although this term is usually reserved for plans that are offered by firms to their employees, I would also lump in the various retirement savings tax shelters (for example, RRSP's in Canada) that are offered by governments.
A key difference between the two types is the personal ownership of the retirement assets. In a defined benefit plan (which is a going concern), workers will only receive an income until they die (although can be benefits for surviving spouses). After their death, they have no further claim on the pension assets. This means that the plan acts as a form of insurance scheme; those who pass away earlier will draw less benefits, allowing the longer-lived to have a higher income. By contrast, there is no pooling of assets in defined contribution schemes; any assets left in the pool revert to the estate of the deceased.
Advantages And Disadvantages Of Defined Contribution Plans
There have been a few major problems with defined contribution plans:
- the funds offered to employees had too high expenses leading to inadequate returns;
- employees have chosen very unsatisfactory portfolio weightings (particularly shares of their employer, which is disastrous if the firm fails);
- the worker has no clear idea how large a contribution is needed to meet a target retirement income.
The first two problems are not inherent problems of defined contribution plans, as low cost index funds are easily provided, and the framework set up in such a way so that portfolios are relatively sensible. (I realise that it may be hard to find agreement on what a "sensible" portfolio is; in some corners of the internet, the most sensible portfolio is seen to be guns, gold and canned goods.) However, the final problem is inherently difficult, given the uncertainty about the lifespan of an individual, working income over a career spanning decades, and investment returns.
That said, if a person has a high enough saving rate while having a steady income over their career, they would most likely end up with a retirement portfolio that can easily fund their retirement income needs, and leave a nest egg for their heirs. In other words, the insurance provided by pooling within a defined benefit pension is not needed if you over-insure yourself.
From the perspective of a policy maker, defined contribution plans look acceptable if the private sector is able to provide portfolio management at a reasonable price, systems are designed to steer people away from insane portfolio allocations, and contribution levels are adequate. If these conditions were met, the only real problem might be the tendency of the system to generate wealth inequality over time. (Since defined benefit pensions provide no benefit to heirs, wealth is not built up in a family over generations,)
Unfortunately, contribution levels have been generally too low, and so developed societies now have increasing numbers of people heading into retirement with inadequate retirement portfolios. This had been covered up by the rise in home values, but the housing crash in the United States laid bare the extent of the problem. (The Canadian housing market is still running on fumes.) Since contribution levels were a personal decision and is supposed to be based on rational expectations, I would view this as a market failure, which is an embedded characteristic of defined contribution plans.
One could debate whether this is in fact a policy problem that must be addressed; if one has a "devil take the hindmost" philosophy, it might be perfectly acceptable that people who did not make precautionary savings should have a crash in post-retirement income. Moreover, in a country like Canada, should we prioritise replacing the income of middle class households, when those incomes are significantly higher than those of the working poor? This is a rather awkward situation, which is why I am unconvinced that there is any particular clean solution in this field.
There are various schemes in place to prevent this low contribution situation; compulsory contribution levels (which I believe has been the situation in Australia), or the latest fad in policy making: "nudges." Although this may be able to reduce problems, I see two main issues.
- Forcing people to buy products from favoured suppliers creates plenty of potential conflicts of interest. Many fans of free market economics would be horrified at a scheme to force people to spend a fixed amount on fruit and vegetables from favoured suppliers, even though it might improve public health outcomes. However, many of the same people are perfectly happy to see the state force people to buy financial products from favoured firms.
- If the state sets a minimum contribution level, it has also created the expectation that this level of contributions will provide an adequate retirement income. But if the minimum level is too low, you will end up with a lot of angry elderly voters.
Defined Benefit Pensions As The Solution?The three problems outlined above can be eliminated by a well-run defined benefit pension scheme. The plan sponsor will ensure that expenses and the portfolio allocation are reasonable, and has to ensure that the contribution levels are adequate to meet promised benefits. This was seen during the golden era for pension schemes in the 1945-1980 interval. However, the private sector has moved away from defined benefit schemes, as they are extremely difficult to offer in the current environment. Meanwhile. the government cannot easily step in to offer them as a result of hidden political risks within such schemes. I expect to address these issues in later articles.
- My earlier article on the "golden era" of pensions.
- Leo Kolivakis writes extensively about pension issues at The Pension Pulse blog.
(c) Brian Romanchuk 2015