June 26, 2006 01:00 AM

Strategists: Don't cook the DB goose

‘Bad defined benefit plan is better than a good DC plan’

Vince Calio

A defined contribution plan shouldn't be used for retirement income, two leading investment strategists say.

M. Barton Waring, managing director of client strategy at Barclays Global Investors, San Francisco, and Laurence Siegel, director of investment strategy at the $10.7 billion Ford Foundation, New York, assert that defined benefit plans are more efficient at providing retirement savings than defined contribution plans. Their working paper, titled "Don't Kill the Golden Goose," is under consideration to be published by the Harvard Business Review.

The paper comes at a time when some of the largest and most established corporations increasingly are considering freezing — or already have frozen— defined benefit plans in favor of defined contribution plans. These include Verizon Communications Inc.; Northwest Airlines Corp.; UAL Corp.; International Business Machines Corp.; and Nissan North America.

Industry experts predict that many more corporations will freeze their defined benefit plans because of looming legislative pension reform that would implement stricter pension funding rules, as well as potential changes to the Financial Accounting Standards Board's Statement 87 that would require companies to put the actual funding levels of their pension plans on to their balance sheets.

"We regrettably but reasonably conclude that few employees can ever expect a secure and prosperous retirement, with reasonable income replacement, using the defined contribution-plan structure alone," Messrs. Waring and Siegel wrote in their paper. "We are kidding ourselves when we even speak the phrase ‘defined contribution retirement plan.' They aren't retirement plans at all, but modest savings plans."

Four reasons

The paper lists four reasons defined benefit plans are more cost effective and efficient than defined contribution plans:

• In a defined benefit plan, mortality risk is shared by the overall participants. Put simply, when calculating liabilities, a corporation can determine the average life expectancy of participants. Those who die before the average age help pay the benefits for those who live beyond it. In a defined contribution plan, mortality risk is placed solely on the shoulders of the individual participant.

• It's cheaper for a pension plan to buy annuities than it is for an individual to do so.

• Separate-account fees for pension plans are significantly less than fees from mutual funds typically offered in defined contribution plans.

• Assets in pension plans are overseen by skilled financial professionals, while individual defined contribution plan participants might not have the financial background to properly manage assets.

"When a DC plan replaces a DB plan, those (advantages) are gone," said the authors in the paper.

Addressing expense

Messrs. Siegel and Waring also try to debunk the statement that defined benefit plans will be too expensive to run if regulatory changes are made. The paper advocates that a corporation align at least some of its pension assets to its liabilities, and add a layer of alpha on top of that.

Additionally, if a pension plan is too expensive from an administrative standpoint and in terms of liabilities, the paper advises corporations to renegotiate the terms with participants, rather than simply kill the plan.

For example, if a corporation determines accrued pension benefits for workers by using a 2.5 multiplier times years of service, then the corporation could lower that to 1.5, according to the paper.

"You can make it so that a defined benefit plan costs whatever you want it to," Mr. Waring said in an interview. "If it costs too much, it doesn't mean you have to terminate it. You can renegotiate the terms of the plan. A bad defined benefit plan is always better than a good defined contribution plan — there's room to control cost."

‘A bit harsh'

Jan Jacobson, director of retirement policy for the American Benefits Council, a Washington industry trade group that studies retirement issues, said that while the paper made some good points, "it was a bit harsh on defined contribution plans."

She added the paper doesn't take into account the "developing innovations" to DC plans. "For example, in commenting on the ‘mortality risk' that Mr. Waring and Mr. Siegel talk about, some plans already do offer annuity platforms with institutional pricing. These developments are just going to accelerate," Ms. Jacobson said.

She cited automatic enrollment in lifecycle funds and institutional pricing of fees as other innovations.

"Yes, these innovations are available, but nobody's using them," said Mr. Siegel in an interview. "In Australia, there is a 9% mandatory contribution in private defined contribution plans (by both employer and employee). Only in the U.S. is the mandatory contribution exactly 0.00%."