Nov 09 2010
Collective DC Contract Changes Are Long Overdue
Collective DC plans are basically DB plans without a guarantee from the sponsor or anyone else outside the plan to make up for any deficits. Without that guarantee, the total value of participant benefits is entirely dependent on the value of the plan's assets, and the value of the benefits of individual participants will be dependent on how contributions and asset returns are distributed.
Typically, younger participants are more affected by changes in returns than older employees, and when pension plans are underfunded, the value of their new accruals will be less than contributions paid. As a consequence, they may end up with lower benefits than they are currently assuming. They are not only exposed to financial market risk as far as their own accruals are concerned, but also bear (at least some of) the risk of the older participants, and their risk will get bigger as the plans get more underfunded.
Collective DC plans fail to adequately inform participants about their risk exposure. Moreover, they may allocate more risk to participants than they can actually bear. The lack of transparency and the imbalances between participants' exposure to risk and their risk-bearing capacity is unsustainable, and the house of cards will inevitably collapse once (especially) younger participants realize what is going on.
To prevent this, pension contracts need to be changed. Existing pension rights need to be cut, and future rights need to be made contingent on future returns. New contracts should not only tell participants about their shortfall risk compared to their income needs but also customize that risk and integrate ways of managing it. This obviously requires some degree of risk differentiation.
Although many market experts are aware of the need to come up with new pension contracts and understand the urgency of the issue, few people have come up with clear proposals. One of the few exceptions to date is Eduard Ponds' proposal to differentiate equity risk across age cohorts and reduce it as cohorts approach their retirement date.
Eduard deserves praise for coming up with his ideas, and for presenting them long before many people saw the need for such proposals. We don't believe, however, that his solution is the right one. His proposal is essentially that target date funds be used on a collective basis, and target date funds used collectively come with the same disadvantages that they have in any other context.
A better idea would be to link the new contracts to a managed account solution that targets a pre-established stream of retirement income. Dimensional Fund Advisors' soon-to-be-launched offering, for example, called Dimensional Managed DC, is designed to provide a DB-like benefit—an inflation-protected income stream for life—while managing the risk that this benefit won't be achieved. Unlike DB plans, this solution allows mass customization at low cost, even for participants who don't opt out of the defaults offered to them.
A change in pension contracts is long overdue. Any further postponement exposes participants in Collective DC plans to undue risk. With innovations like Dimensional Managed DC coming onto the marketplace, plan sponsors no longer have any reason to delay.
Typically, younger participants are more affected by changes in returns than older employees, and when pension plans are underfunded, the value of their new accruals will be less than contributions paid. As a consequence, they may end up with lower benefits than they are currently assuming. They are not only exposed to financial market risk as far as their own accruals are concerned, but also bear (at least some of) the risk of the older participants, and their risk will get bigger as the plans get more underfunded.
Collective DC plans fail to adequately inform participants about their risk exposure. Moreover, they may allocate more risk to participants than they can actually bear. The lack of transparency and the imbalances between participants' exposure to risk and their risk-bearing capacity is unsustainable, and the house of cards will inevitably collapse once (especially) younger participants realize what is going on.
To prevent this, pension contracts need to be changed. Existing pension rights need to be cut, and future rights need to be made contingent on future returns. New contracts should not only tell participants about their shortfall risk compared to their income needs but also customize that risk and integrate ways of managing it. This obviously requires some degree of risk differentiation.
Although many market experts are aware of the need to come up with new pension contracts and understand the urgency of the issue, few people have come up with clear proposals. One of the few exceptions to date is Eduard Ponds' proposal to differentiate equity risk across age cohorts and reduce it as cohorts approach their retirement date.
Eduard deserves praise for coming up with his ideas, and for presenting them long before many people saw the need for such proposals. We don't believe, however, that his solution is the right one. His proposal is essentially that target date funds be used on a collective basis, and target date funds used collectively come with the same disadvantages that they have in any other context.
A better idea would be to link the new contracts to a managed account solution that targets a pre-established stream of retirement income. Dimensional Fund Advisors' soon-to-be-launched offering, for example, called Dimensional Managed DC, is designed to provide a DB-like benefit—an inflation-protected income stream for life—while managing the risk that this benefit won't be achieved. Unlike DB plans, this solution allows mass customization at low cost, even for participants who don't opt out of the defaults offered to them.
A change in pension contracts is long overdue. Any further postponement exposes participants in Collective DC plans to undue risk. With innovations like Dimensional Managed DC coming onto the marketplace, plan sponsors no longer have any reason to delay.