Pozen: Creating a Third Type of Retirement Plan

Creating a Third Type of Retirement Plan

The US has witnessed a huge decline in the number and size of defined benefit pensions in the private sector.  Companies have been unwilling to commit to a defined benefit schedule for their retirees after the accounting rules required that the unfunded liability of these plans be shown on the company’s balance sheet.

By contrast, defined benefit pension are still prevalent in the public sector – at all levels of government in the US. Unfortunately, the unfunded liabilities of these defined benefit pensions in the public sector are huge – in 2014, for example, the average state pension plan had only 70% of the assets on hand to meet promised benefits.

Indeed, some pension experts would argue that these unfunded liabilities for public defined benefit plans are significantly understated because they utilize unduly optimistic assumptions about investment returns over the next 30 years. In the public sector, this assumption is, on average, above 7% per year, although the yield on a 30-year US Treasury bond – the standard risk-free investment – is far below 3%.

Nevertheless, public sector unions understandably resist the move to a defined contribution plan, such as a 401k plan, since it would shift the risk of underfunding from the public employer to its employees. Moreover, the costs of administering and investing a defined contribution plan are much higher than those of a defined benefit plan.

Thus, the challenge is to develop a third type of retirement plan, which manages risk better than a defined contribution plan, while operating at the lower costs of a defined benefit plan. I call this third way – a collective retirement plan.

The key to a collective retirement plan is to invest all employer and employee contributions in one collective pool – with the investment strategies of defined benefit plans, and hence with much lower costs than most defined contribution plans. This type of collective retirement plan would have several key advantages.

First, the investing of a collective pool will cost a fraction of the expenses of the average mutual fund offered in a 401k plan.  That’s because collective investing can be done by pension experts at institutional rates for one large and diversified pool. By contrast, the mutual funds in a 401k plan are retail products with relatively high expense ratios based on accounts of relatively small size.

Second, the costs of administering a collective retirement plan will be a fraction of those costs for a defined contribution plan. That’s because employees would not need to be educated about the 20 investment choices typically offered by most 401k plans. Instead, employees would presumptively contribute a specified percentage of their salaries to the collective retirement plan, unless they expressly opted out.  Each employee would have assets attributed to his or her account as an accounting matter, but not actual assets – which would be held in the collective pool.

Third, the investment choices of a collective retirement plan will be superior to those of the average participant in a 401k plan. Many participants put all of their plan contributions into inappropriate vehicles for long-term investing for retirement – such as a money market fund or a risky stock fund. Furthermore, plan participants often change investments too frequently, incurring costs that erode returns.

Instead, in a collective retirement plan, independent experts would construct an investment portfolio with a reasonable return at a relatively low risk.  In my view, that portfolio for most of the accumulation phase should be a balanced fund, with roughly 60% of its assets in a diversified US stock index fund and the other 40% in a diversified US bond index fund – rebalanced each year. Such a portfolio has earned a return over 6%, with relatively low volatility, during most long periods appropriate for retirement investing such as 20 or 30 years.

Finally, a collective retirement plan would not require the employer, a state or city, to recognize an unfunded pension liability on its balance sheet. Rather, the investment risk associated with the plan would be managed by the trustees of the collective retirement plan based on a contingent reserve and other measures. In specific, the trustees would establish a “probable” benefit schedule for retirees based on the amount and timing of their contributions, plus the contributions of their employer. That schedule would assume a 5% annual return on plan investments and a cost-of-living adjustment based on the consumer price index.

How would the collective retirement plan mitigate the risk that it could not deliver the “probable” benefit schedule? To begin with, the assumed investment return of 5% is below the 6+% historical return of the balanced portfolio described above, and much below the 7+% assumed return of most defined benefit plans in the public sector.  At the same time, the collective retirement plan would have much lower costs than any defined contribution plan.

As a result, the trustees of the collective retirement plan could gradually establish a reserve of 3% to 7% of the plan’s asset as a contingent reserve. That reserve, invested in US Treasuries, could be drawn down if needed to meet the “probable” benefit schedule if there were a shortfall in the returns of the balanced portfolio over successive long periods. If the portfolio’s return plus the reserve were still insufficient to meet the “probable” benefit schedule, there would have to be a decrease in that schedule spread across all generations of employees in the plan.

What would happen when a cohort of employees reached retirement age? In my view, the assets attributed to each retiree’s account in the plan should be divided into two parts. About 15% should be used to buy a life annuity for the employee, starting at age 80, so that he or she would never outlive their retirement benefits. That annuity would also substantially reduce the longevity risk of the collective retirement plan, since it is difficult to estimate how long retirees will live beyond 80. Such a longevity annuity would be the presumptive use of 15% of their plan assets for all employees at retirement, unless they chose expressly to opt out.

The rest of the retiree’s assets should be put into a second collective pool, dedicated to an appropriate cohort of retirees by age. That collective pool should have a different investment strategy than the balanced fund during the accumulation phase. In specific, the investment strategy should be designed to meet the benefit schedule for that retirement cohort, subject to a contingent reserve and a cost-of-living adjustment. Any shortfall in investment returns would be met first by drawing on the reserve and second by waiving the cost-of-living adjustment for a few years.

In short, most defined benefit plans in the public sectors are going down an unsustainable path. However, if we want to avoid pension crises like the ones in Detroit and Illinois, we cannot expect public sector unions to accept the investment risks and high costs of the typical defined contribution plan. Instead, we need to create a new type of pension plan, which can be gradually implemented with due regard for grandfathered benefits.

Although a collective retirement plan is not perfect, it is much less risky and much less costly than the typical defined contribution pension. While a collective retirement plan cannot provide “guaranteed” benefits at retirement, it can offer reasonable assurances that the benefit schedule would be met in most instances. And the promised benefits of many public sector plans are not in practice “guaranteed.”

Nevertheless, despite all these advantages, the success of a collective retirement plan will depend on finding an optimal plan design and figuring out appropriate investment strategies given various market scenarios. The plan would also require serious analysis of how to invest the assets of each retiring cohort, based again on different market scenarios. These tasks are where financial centers and academics generally can make a tremendous contribution.

Bob Pozen is currently a Senior Lecturer at the MIT Sloan School of Management, and a member of the GCFP Advisory Board. He has extensive experience in business, government and journalism, and has written extensively on financial policy issues.