"Defined contribution is the right choice for employees and taxpayers, for the state government, and for the financial markets."
Douglas B. Roberts, Michigan state treasurer, and Matthew J. Hanley, treasury legislative specialist, in a March 31 commentary in Others' Views, asserting why Michigan moved away from a defined benefit plan.
State Treasurer Douglas Roberts of Michigan believes moving to defined contribution from defined benefit pension arrangements is a one-way street. Here is how he listed the key benefits of the transition to defined contribution from defined benefit in a recent commentary he co-authored.
Earlier vesting and better pension portability; and
Decentralized investing, including social investing.
More budget discipline;
Greater certainty about future pension costs; and
Bad investment performance now accrues to employees rather than taxpayers.
For financial markets:
The rising economic power of large public pension funds will be reversed.
If Treasurer Roberts has any concerns about defined contribution plans, or even any faint praise for defined benefit plans, he failed to mention them in the commentary.
Is "DB vs. DC" the right question?
Treasurer Roberts makes some important points in his commentary, with which I agree. Strong vesting and portability provisions, transparent costing and explicit symmetry between who benefits from investment gains, and underwrites investment losses, are all elements of good pension system design. However, it seems he misses some other design features that are equally important. Consider these three, for example:
Risk pooling: use the law of large numbers to mitigate individual risks that are diversifiable;
Economies of scale: use size to reduce the unit costs of both investing and benefit administration; and
Dedicated governance: use the "cooperative" principle to define and align the economic interests of retirement system stakeholders, fiduciaries and services suppliers.
In a recent address to the General Assembly of California Public Retirement Systems, I asserted that "DB or DC?" might not even be the right question. The challenge is to design pension systems that are "win-win" for employers and plan members alike. A "win-win" pension system combines Treasurer Roberts' good vesting, portability and transparency features with the three I list above.
A good way to visualize the power of risk pooling is to trace out the employment-savings-retirement cycle of an individual employee. Diversified investment vehicles along the savings path are an obvious example of useful risk pooling. Traditional defined benefit and defined contribution arrangements both offer this kind of diversification during the capital accumulation phase.
However, a retirement system that efficiently pools individual "annuitization risk" never has to shorten its investment horizon. Individual participants in a traditional defined contribution system do not have this luxury. Now, as retirement approaches, investment horizons shorten and investment risk must be reduced as the capital decumulation phase begins. As a consequence, return prospects are reduced as well. The result is that traditional defined contribution systems are unlikely to achieve the gross long-term returns of "win-win" retirement systems, which efficiently pool individual "annuitization risk." Thus traditional defined contribution systems are unlikely to produce as much retirement income per dollar of contribution, unless "win-win" retirement systems are much more expensive to operate. However, as we shall see, "win-win" systems likely do better here too.
Advantages of economies of scale
Any large retirement system can benefit materially from economies of scale. An analogy helps to make this point. Consider setting up a $100 million pension plan for 1,500 plan members. Now grow it by 100 times to a $10 billion plan for 150,000 members. Do you think the investment, benefit administration and governance costs also would rise 100-fold? Of course not. While these costs undoubtedly would rise, it would not be by a factor of 100, but less.
The "cost effectiveness measurement" database of pension fund costs, developed by my firm, permits the direct measurement of this economies of scale effect on the asset side of retirement systems. The average $100 million fund in the CEM database spends $550,000 per year on total operating costs. A 100-fold increase would lead to a $55 million per annum figure.
In fact, the average $10 billion fund in the CEM database spends $25 million per annum, a 45-fold rather than a 100-fold increase. In other words, unit costs dropped by more than 50%, from 55 basis points, to 25 basis points as scale increased from $100 million to $10 billion.
Such a powerful reduction in unit costs has, in turn, a powerful impact on pension costs, reducing them by more than 5% in a typical pension plan.
In-house vs. external costs
Aligning the economic interests of principals and agents is a fundamental tenet of good organizational design. Thus, it is almost a truism to say retirement systems with dedicated processes explicitly geared to produce value for stakeholders are more likely to do so than those that don't have that focus. While there is much more empirical work to be done, the accompanying table presents evidence supporting this proposition.
The California Public Employees' Retirement System administers its $100 billion defined benefit pension plan for about 1 million current and former state employees. TIAA-CREF administers about $160 billion in a blend of participant-owned defined contribution assets, and in assets backing participant-owned annuities, for about 1.8 million current and former higher education professionals. The Vanguard Group has $250 billion in fund assets. The company is mutually owned by its 4 million participants.
It is instructive to compare the total expense ratios or TERs (i.e., total annual investment, benefit administration/record keeping, and governance expenses in relation to total system assets) of these three dedicated systems with those paid by participants in a typical 401(k) defined contribution plan administered by the typical "for-profit" service provider.
While precise 401(k) plan TER data (which should also include any additional sales or other fees paid by the employer or participants) is not readily available, there is industry consensus that a typical TER is in the 100 basis points area, at least for the non-guaranteed investment contract, non-company stock component.
This is about four times the average TER of the three dedicated governance systems. At the same time, I know of no evidence to suggest that the risk-adjusted gross returns of the "for-profits" are higher than those of the "dedicateds."
Is the four times higher costs for a typical 401(k) pension plan housed with a "for-profit" service provider simply an economies of scale effect? Not likely. Many of the "for profit" service providers have total assets under management, and numbers of participants, which are in the same league as those of the three dedicated governance systems. Nor are we looking at a purely "DB vs. DC" expense effect. Among the three dedicated systems, one is purely defined benefit, one is purely defined contribution, and one is a hybrid, doing some of each. Is there some other economic rationale that could explain the difference in "total expense ratios"?
Why are 'for profit' fees higher?
There is, in fact, an economic rationale that explains why the TERs of many of the "for profits" are materially higher than the TERs of the "dedicateds," and why increased competition won't bring them down.
The rationale is based on an economics framework that recognizes the importance of (a) the degree of alignment of the economic interests between agents and the principals on whose behalf the agents are acting, and (b) the role asymmetric information between buyers and sellers plays in how a goods or services market functions.
The "for profits" do not only have the financial interests of their clients to worry about, but also the financial interests of the owners of the investment firm. This causes no problem of course, unless the need to serve two masters leads to a possible misalignment of economic interests.
In normal competitive markets with equally well-informed buyers and sellers, the pricing mechanism ensures a balance of interests. If the firm tries to increase profitability by raising prices above the "market" price, the clients leave for alternate suppliers. Conversely, if the clients drive too hard a bargain, the owners will lose money and leave the business.
Unfortunately, the market for active investment management services is not a "normal competitive market with equally well-informed buyers and sellers." True, there is no shortage of either buyers or sellers. However, there is material inequality in knowledge about the true nature and value of the services being offered. In the vast majority of cases in this market, the sellers know a great deal more about the services they are selling than the buyers.
For example, the sellers generally know financial markets are highly efficient, while buyers generally don't, or at least don't fully understand the implications. This reality motivates sellers to price and sell their services as though financial markets were not highly efficient (i.e., "Come with us if you really want performance!").
As a consequence, active management fees generally are too high for the value they produce, and generally are immune to price competition. When most buyers (mainly individual mutual fund investors, but also many pension fund fiduciaries) become disappointed with their active management results, they simply switch to other managers with better recent performance results. Unfortunately, in a close to efficient market, past performance is a poor predictor of future performance. So the vicious circle continues.
The real value of a dedicated system
In this context, the real value of having a dedicated governance function in retirement systems is clear:
It demands the retirement systems' governing fiduciaries sort out the economic interests of system stakeholders.
It requires evenhanded consideration of the financial interests of all classes of system stakeholders.
It leads to the hiring of in-house expertise that understands the true nature of financial markets and its implications for structuring the investment management function, as well as sell-side professionals do. In other words, it creates the condition of equally informed buyers and sellers necessary for the market for investment management services to perform its proper pricing and resource allocation functions.
It also leads to a healthy reconnection of corporate ownership and control in the economy. With large scale, dedicated pension system governance, there is a direct economic payoff to pension funds to correct value-destroying behavior by investee corporation managements. Now it might be more cost-effective to change the board of a corporation than to sell the stock. Thus the existence of well-governed and well-managed large pension funds in an economy creates a more accountable, responsive, value-creating corporate sector in that economy.
These observations and conclusions are not just theory. There is little doubt that the 25-year movement in the United States toward large-scale retirement systems with dedicated governance functions has made a major contribution to the high levels of effectiveness and efficiency at which America's financial markets and public corporations operate today.
While making this contribution, these systems are managing their own "businesses" cost effectively, creating value for their own stakeholders in the form of higher net returns and pensions.
Not a one-way street after all?
Given all of the above, I believe Treasurer Roberts would do well to rethink some of the "to DC from DB" arguments he laid out in his P&I commentary.
Undoubtedly, enhancing vesting and portability provisions, and creating greater cost transparency and greater stakeholder symmetry between who benefits from gains and who underwrites losses, are all laudable goals.
But if in the process of getting there he jettisons the benefits of risk pooling, of large scale economies, and of dedicated governance, the public servants and taxpayers of Michigan may be taking one step forward, and two backward.
Keith P. Ambachtsheer is principal of KPA Advisory Services Ltd., Toronto. His commentary is derived from The Ambachtsheer Letter.