Defined-Benefit and Defined-Contribution Plans of the Future

Defined-benefit pension plans are in decline. What went wrong? The lessons the investment community learns from this decline will help us create better plans in the future—plans that incorporate desirable features of both defined-benefit and defined-contribution plans.Two main causes explain the decline of defined benefit (DB) pension plans. One cause starts with the confusion between what benefits are worth (calculated by discounting benefits at bond yields) and what constitutes the best estimate of the long-term funding target (where discounting includes an equity risk premium). This confusion led to overly generous benefit promises. And with funding based solely on the best estimate, without an additional reserve for investment risk, benefits became underfunded when the risk premium did not arrive. The second cause is legislation that, on the old-fashioned assumption that most corporations last forever, permitted underfunding to continue.The next generation of DB plans will look different from yesterday’s plans. The benefit will probably start as a career average (possibly enhanced periodically by a catch-up provision). It will be valued and funded on the basis of bond yields, with a full funding requirement. There will be no benefit confiscation on an employee’s early death or termination; the benefit will transparently be the reserve held for the employee and will be communicated to the employee each year. Investment risk will require an additional reserve.Future defined contribution (DC) plans will have “autopilot” features—default options designed to mimic desirable DB features, such as extended coverage, contributions increasing with age and pay, and a sensible investment policy that is professionally executed. Other arrangements will be able to convert the employee’s account into postretirement income less expensively than through individual annuity purchases.When we have transparency of DB and DC plans, we will be able to see that retirement income guarantees are expensive. We will have to make individual decisions about bridging the gap between what we wish for and what pension plans can help us achieve. That situation is no different from the past, but perhaps we will confront it more explicitly in the future.Reprinted from Financial Analysts Journal, vol. 63, no. 1 (January/February 2007): 26–30. Author affiliation is accurate as of the original publication date.