A constant whispering in the hallway of pension plans is how to prepare for the inevitable move from a defined benefit to defined-contribution structure. But fiduciaries shouldn’t be scared, the game’s the same, at least psychologically.
In the US, state governments are starting to address the issue, with Washington State recently introducing legislation whereby all new members will go into defined contribution. It’s yet to pass but its introduction seems inevitable.
There is also a review of the Dutch pension system which includes tackling the issue of the extent to which defined contribution is appropriate.
Most people seem nervous about it, or maybe any change makes people cautious. But it’s not that scary.
As one of the delegates at the ICPM conference in Toronto put it to me, management of defined contribution and defined benefit are the same thing, you are managing to a liability, it’s just that for defined contribution it is the individual.
Australia’s pension system is a mature defined-contribution market, with its mandatory contribution a key component of its success.
The benefit of defined contribution, if you will, from an investment point of view, is it doesn’t have the restrictions imposed by accounting and regulatory rules.
Typically this allows more freedom in the amount of growth assets, and while naturally risk management remains critical, volatility is more readily absorbed.
But while defined-benefit funds need to manage to meet the liabilities of the fund (or the company), defined-contribution funds also have their own liabilities of sorts. This manifests in the required income stream of a retiree, and that in turn is determined by the lifestyle, age and wealth of the individual.
These issues are tackled in an interesting article by Russell’s Don Ezra, in the latest edition of the International Journal of Pension Management.
Both structures have their merit, but importantly neither should be used as a solution to the problems of the other.
Defined-benefit structures work, at least when the promised payout is reasonable and well-thought-out. Moving to a defined-contribution structure is not a panacea to the contribution and benefit mismatch that many defined benefit funds are facing. And, it shouldn’t be debated in this context.