Commentary: Advantages of pooling are too great to ignore

More than 50 million working Americans have no workplace retirement plan, and many states are developing "Secure Choice" legislation, creating publicly run defined contribution systems to address this problem. Similarly, many states are moving from defined benefit plans for public employees to create another form of publicly run DC plans. The creation of Secure Choice systems helps solve a pressing problem, and moving toward DC plans from DB plans may help alleviate liability pressure on states.

But these systems are failing to take advantage of pooling to create safer and sounder retirement systems. Pooling is the great benefit of defined benefit pension plans. It is even more important than the plan sponsor guaranty. If states can use the benefits of pooling in collective defined contribution plans, they will leave employers less exposed to long-term liabilities, and they will leave employees with more security in retirement.

Collective DC systems pool assets and investments; they pool longevity risk; they pool sequence of payments risk (the risk that the markets will be terrible when an individual retires); and they pool the benefits of a long-term investment policy even after the participant turns 65. These plans already exist in the Netherlands and elsewhere — and they work.

In a DB plan, the CIO and investment team pool assets and investment policy. They invest with an outcome in mind: not a pot of money, but the ability to pay each retiree a pre-determined pension, usually something like 60% of average pay over a period of years.

In a 401(k), however, participants are on their own, deciding asset allocation and rebalancing time frames. Managers must be selected from the platform the employer has selected. And when participants reach a certain age, they must begin depleting the savings whether or not it's needed.

The power of pooling longevity risk is simple: Those who die early subsidize those who live long.

When a chief investment officer invests the assets of a DB plan, she is using actuarial formulas to target a final payout. She can confidently estimate, through actuarial large numbers analysis, how long individuals in her plan will live.

This allows her to plan properly what her needs will be for liquid assets when payments are due, and for less liquid riskier assets that can be used to meet liabilities that are further away.

An individual in a DC plan is alone. If she takes time to look up actuarial tables and sees that the average age of death is 85, she might make a rational plan to spend down her funds until she dies at 85. But what if she gets to 85 and is in good health. She took the time to plan actuarially but she wasn't in an actuarial situation. She was in an individual situation. She has to plan to live to be 100! And if she does get to 100 she'll have to plan for 110!

DC plan participants face another risk, the sequence of payments risk.

This is the risk that every individual in a DC system faces: What if the markets crash right before she retires? Many individuals faced this very question at the end of 2008 and the beginning of 2009. According to the Employee Benefit Research Institute, the average 401(k) account balance of those age 55-64 with more than 20 years in their plan decreased by 25% in 2008. Someone who retired then would have 25% less to live on in retirement.

But in a collective DC plan, a professional CIO and staff would have stayed focused on the long term, so they could pay benefits to the 2008 retiree and to the thousands of participants who were still decades away from retirement.

The plan would pay the 2008 retiree the pension he was due. Just like the "risk" of living too long can be pooled for everyone, the risk of retiring at the "wrong" time can be pooled and shared equally. The pooled plan is not going to pay more to person who is lucky enough to retire when markets are up, or less to the person who retires when markets are down.

Imagine an individual who just turned 65 and takes her $100,000 and buys an annuity. This gives her the benefits of actuarial pooling with others who have also bought annuities from that insurance company. It is surely safer than going it alone. But her funds will be invested in mostly bonds, and she will receive a payout of approximately $5,000 a year. She can receive it for life because she is pooled with others who did the same thing.

Now contrast that scenario with the benefits of a pooled long-term investment policy in a DB or collective DC plan. Instead of going to "all bonds" when this individual retires, the CIO is still investing for the long term. He is still investing on behalf of employees who are 30 years old and may have 40 years of accumulation ahead of them.

The CIO of a DB or of a collective DC plan is a perpetual long-term investor. So when individuals retire, he keeps investing for the long term. If returns are weak when the retiree is in her 70s, the CIO has decades of market ups and downs still to go before the 30-year-olds retire. And when they retire, there will be more 30-year-olds behind them.

Interestingly, in the DC world, target-date funds have become a very important tool for individuals. But if an investor's TDF holdings were pooled with other assets under the CIO's control, the individual investor benefits from the fact that for the CIO, there is no target date.

The most powerful characteristic of defined benefit pension plans is not the sponsor guaranty; it is the profound benefits of pooling. As policymakers consider the various options for Secure Choice legislation and public DC plans, they should be sure that this kind of pooled system is always one of the options available.

Charles E.F. Millard served as director of the Pension Benefit Guaranty Corp. from 2007 to 2009. He is currently managing director of the Kiski Group Inc. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.