I like Defined Benefit Pension Plans. I have one. I wish everyone could have one. They have many advantages.
But, I have reluctantly come to the conclusion that they suffer from a major flaw.
To understand the major flaw of defined benefit pension plans, consider the following scenario.
Imagine that you own a successful and growing business that now has 100 employees, with an average age of 30, earning an average of $50,000 each. You have just finished another year of record profits and growth. You announce to the employees that you are willing to fund a pension plan by contributing 10% of wages over and above their $50,000 average wage.
You and the employees now set out to discuss the benefits of the pension and how the plan should work.
The employees want to know how much the pension might pay out. You calculate that if the money can earn a real return of 2% and based on 35 years service from age 30 to 65, the pot of money for such an employee will amount to $255,000 at age 65 and will fund a pension of $12,800 per year until age 90. And, that is in real 2016 dollars. And you emphasise that a 2% real return can be pretty much locked in with safe investments so the employees will be able to count on the funds growing enough to support that $12,800 per year pension.
Still, the employees are not too impressed. They ask what return could be expected from a more typical balanced investment approach with about 60% of the investments going into equity stocks. You reply that an expected real return of 4% would be reasonable but is not guaranteed. You inform the employees that at that return they could expect to fund a pension of $23,600 per year after age 65 and lasting until age 90. But, you point out that this is only an expectation and that if the real return varies much from 4.0% on average over the 60 years until they are age 90 then the pension amount that the money can fund could be far lower or far higher than $23,600.
The employees decide that they really like the expected $23,600 pension amount from the balanced portfolio a lot more than the $12,800 from the safe fixed income investments.
The employees then ask if you the employer could guarantee them the $23,600. That way, they could access the higher returns associated with equity investments but they would not face any risk. You laugh and say, no, you are asking for the far higher returns of equities but you don’t want to take any of the risk. You want guarantees like you were 100% invested in government bonds and at the same time you want the higher returns expected from equities.
The employees say, yes, that is how Defined Benefit plan pensions work. The pension is based on the expected return from a balanced investment pool consisting usually of about 60% in equities. But the pension amount is guaranteed.
You realise at that point that the typical Defined Benefit pension plan is deeply flawed in that the pensioners are being guaranteed amounts based on the expected return from risky investments without taking any of the risk. If the employer pays all of the contributions then the employer takes all the risk. If the contributions are split between the employer and the employees, which is often the case, then the active employees and the employer share the risk of inadequate returns. If the returns are lower than expected then the contributions must rise. Once an employee is retired on a defined benefit pension then they face no further risk as long as the pension plan remains solvent. Pensioners on a defined benefit pension plan are never expected to face a decline in their pension even if the plan’s returns are lower than expected.
Defined Benefit plans have many good features. But placing all the risk with the employer is too onerous. Sharing the risks between the employer and the active employees has also turned out to be too generous to the pensioners. Defined Benefit plans that share some of the risk with pensioners are more realistic.
I have addressed the feature of a more realistic and sustainable pension plan in a separate article.
End
Shawn Allen
September 18, 2016