Over the years there has been much discussion of the relative merits of defined contribution plans vs. defined benefit plans, and their close (but more portable) cousins, cash balance plans. Defined benefit pension plans are oft maligned in the public press, despite having served the retirement needs of millions. But defined contribution plans receive little to no comparable scrutiny for their own rather glaring vulnerabilities.
Defined contribution plans are more costly for the plan sponsor, less rewarding for most employees and retirees, and do not offload investment risk onto employees nearly to the extent that most advocates believe. As a consequence, most defined contribution plan sponsors will find that they pay more, and most defined contribution participants will have less for their retirement.
The problems with defined contribution plans are numerous. But most of these problems will not be obvious until we next see a material bear market (which may already be in progress). Consider the following:
Asset allocation. Ten years ago, defined contribution plans primarily were concentrated in guaranteed investment contracts and company stock, an atrocious violation of fiduciary standards. Any defined benefit plan sponsor would have faced litigation for using this mix of assets. Now, after the most breathtaking bull market in U.S. capital markets' history, employees finally are channeling the vast majority of their money into stocks, after they already have risen. Defined benefit plans have migrated into slightly heavier equity allocations during the course of the decade, but from a starting point that already was more than 60% in equity and equitylike assets a decade ago. The consequence is that defined benefit plans have enjoyed the bull market, while most defined contribution investors have not participated nearly as fully. If the decade ahead delivers a negative risk premium for stocks (e.g., through a serious bear market or protracted sideways movement), which some market scholars believe is reasonably likely, defined contribution investors will be harder hit than the defined benefit funds. Why does this happen? Simple. Retail investors are more prone to momentum investing and chasing last year's successes than the more experienced defined benefit plan managers.
Risk transfer. There is a widely held view that defined contribution plans transfer pension risk to the employees. There is no question that upside risk is transferred to the employees. The employees own these assets. However, in a severe bear market, the assets in the typical defined contribution portfolio will not suffice to fund a reasonably comfortable retirement. So, one or more of three things will happen:
* Large numbers of employees will be forced to live out their retirement years with far less than they had expected, or
* Some of the well-run companies that manage to maintain solid profitability in a recession will supplement their employees' defined contribution assets, in order to avoid pushing long-term employees into a squalid retirement, or
* Employees will work far longer than they expected, leaving the companies with a problem of too many aging employees who strenuously do not wish to retire on the lifestyle that their diminished defined contribution assets could afford them.
Litigation risk. In the event of returns that are substantially less than suggested in the literature that has been circulated to defined contribution participants over the years, or substantially less than passive returns, our litigious society might suggest remedies other than the above. Again, this brings into question the whole notion of risk transfer; sponsors may bear more of the downside risk than they expect.
Performance incentives. A well-run defined benefit plan can provide the employer with a contribution holiday. By its very definition, a defined contribution plan cannot ever provide a contribution holiday. This, in turn, means the defined benefit sponsor has a powerful financial incentive to seek strong portfolio returns, because that can lead to direct cash flow benefits, which can improve competitive positioning within one's peer group. The defined contribution fund faces powerful financial incentives to do nothing unconventional (anything unconventional and unsuccessful will trigger controversy, at least, and perhaps litigation), and therefore to produce utterly conventional results to their employees.
Costs. In addition to typically costing far less in long-term contributions by the fund sponsor than a defined contribution plan, a defined benefit plan has objective costs that are far lower than defined contribution plans. Fees, administrative costs and so forth, are typically at least twice as high in the defined contribution world than in the defined benefit world.
Prospective returns. In today's markets, the sensible expectations for future returns are far, far below the returns we have grown accustomed to seeing recently. The defined benefit plan pension officer can recognize this and respond appropriately, both from the vantage point of investment policy and from the vantage point of setting expectations for management. The defined contribution plan administrator faces powerful pressures to offer employees advice based upon extrapolating past returns. This can lead the defined contribution investor into seriously inappropriate asset allocation decisions.
For all of these reasons, we think the mammoth shift to defined contribution from defined benefit is ill-conceived and dangerous. The genesis for defined contribution plans was the reluctance of sponsors to provide portability, something all employees want. This, in turn, precipitated legislative changes that make it very easy to set up a new defined contribution plan, and very difficult to set up a new defined benefit plan, or to recapture the benefits of any defined benefit program if results are strong. Legislators are notorious for not looking beyond the immediate first-order impact of their decisions. They achieved portability, but at what cost to the sponsors, the retirees and the economy?
The simple reality is unfortunate: no matter how grave an error the migration to defined contribution has been for the future retirees, for the fund sponsors and for the economy at large, it is a shift that has become inevitable. It can only be reversed through tangible demonstration of the painful "second-order effects" of defined contribution investing; these will not become obvious until we have a serious and prolonged bear market. Then, our legislators will seek to "fix" the defined contribution crisis they have imposed on us.
Robert D. Arnott is managing partner of First Quadrant LP, Pasadena, Calif.