Hybrid pension schemes, combining both defined contribution and defined benefit characteristics, are best for governance because they align interest of both employees and sponsors argue David Villa, chief investment officer of the $91-billion State of Wisconsin Investment Board (SWIB) and Sorina Zahan, partner and chief investment officer of Chicago-based Core Capital Management, speaking at Conexus Financial’s Fiduciary Investors Symposium in Amsterdam.
Their study, drawn from two years of research, into benefit design has developed a mathematical framework to compare the different vulnerabilities and returns within defined benefit, defined contribution and hybrid pension schemes. The model is based on option modelling.
SWIB itself is a hybrid plan, with both a defined benefit component and a defined contribution component. It’s this “sensitivity” between DB and DC in a “compromise solution” that allows for real success, they argue.
“We put everyone on an equal footing and compared the cost systems, and asked what do you see?” Zahan says, explaining their research process. “In the US the debate doesn’t ever look at the entire robustness of pension structures. We’ve tried to create a framework that compares these different structures.”
Not surprisingly the study found that DB employees with guaranteed benefits were not as subject to market risk as DC participants.
“If you want to switch from a DB plan to DC plan, make sure DC has robustness from market risk because it is the most vulnerable to market risk,” she told delegates. Their research also shows that DB plans cost less for an employer than DC schemes.
It begs the question, behind the “rush” to change a DB structure that is efficient from a cost perspective into a more costly DC structure.
“The reason is we have not observed the surpluses of DB plans,” says Zahan. “We think the answer is that a lot of surplus is squandered. DB plans are an efficient structure. The one drawback is that they require good governance.” She believes that although DB does carry market risk, with good governance and good regulation these plans are more cost-effective and generators of wealth.
Under its hybrid model, SWIB is strict on sharing any surplus.
“In Wisconsin we give our entire surplus to the employees,” says Villa, whose list of governance sins includes contribution holidays, unfunded benefit increases, unrealistic investment targets and uneconomic investment decisions.
Challenges with wholly DB or DC schemes are also revealed when it comes to shouldering risk. Employees take the risk in DC schemes, yet in a DB scheme employers suffer any loss in value because they will have to pay more in benefits – although they also benefit in value creation.
In what Villa describes as “looking like magic” hybrid plans allocate both upside and downside risk between employees and the sponsor to achieve better alignment of interest and healthy governance. “One of the features of hybrid plans is that value creation and destruction is shared by employees and the sponsor. It produces a much better alignment of interests,” concludes Zahan.