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The Brandes Institute

The Future of Retirement Plans


The Brandes Institute Research Paper No. 2013-04

October 2013

This paper can be downloaded without charge from


The Social Science Research Network Electronic Paper Collection:
http://ssrn.com/abstract=2705474

Electronic copy available at: http://ssrn.com/abstract=2705474

Original Research for Inquisitive Investors

The Future of
Retirement Plans
October 2013

WWW.BRANDES.COM/INSTITUTE
BRANDESINSTITUTE@BRANDES.COM

Electronic copy available at: http://ssrn.com/abstract=2705474

Executive Summary
Collectively, Americans are woefully unprepared
financially for retirement. This retirement
problem actually reflects a collection of diverse
issues. This paper identifies the most important
ones: longevity; access; contributions; portability;
behavioral mistakes; funded status; expenses; and
regulation. Our research focuses on solutions for
both plan sponsors and participants.
The Retirement Rule, Benefits = (Contributions
+ Investment Earnings) Expenses, provides a
good framework to evaluate the problems and
assess potential solutions to the pensions crisis.
It also clearly identifies where the move from
defined benefit (DB) to defined contribution (DC)
plans alters the balance of risk and cost from plan
sponsor to participant.
Three generations of American workers have
experienced an amazing transformation of
the employee benefit landscape with changes
that initially provided greater wealth, but
subsequently led to capped or reclaimed benefit
promises. With relatively little public awareness,
but with significant consequences, within the last
few years DC plans have been transformed for
many from supplemental savings to the primary
source of retirement income. Plan sponsors have
experimented with hybrid DB plans (such as
cash balance plans and adjustable benefit plans),
but todays landscape remains dominated by a
shift away from DB to DC with significant impact
for participant benefits.
Various factors are likely to hurt DC participants
financially, including lower contributions, lower
investment returns and potentially their own
poor investment decisions. In the meantime, DB
plan sponsors are still dealing with underfunding
problems. The simple (but not necessarily easy)
solutions include: increase contributions; retire
later; and increase investment returns. The real
solution for the pension community is to find
ways to enable participants to build adequate
retirement income and to do so in a structure
that works effectively for cost- and risk-conscious
plan sponsors.
To help get to and through retirement workers
must participate in and make contributions to

their retirement accounts. But how? We suggest


automatic enrollment and greater education on
how critical contributions are. Limiting choices in
DC plans to assets that better mirror professionally
managed DB plans would help. Guiding workers
to retire later also would have significant benefits.
Concerns over securing retirement assets are
not unique to the United States. We investigated
retirement structures in select developed countries
and share approaches that may have relevance for
the American pension community, including: less
stringent mark-to-market rules to foster a longerterm investment perspective; the introduction
of variable benefit plans; approaches that result
in higher contributions; greater education and
access to annuities as a distribution option for
retirement plans; official retirement age that
is indexed to life expectancy; and automatic
enrollment for plan participants.
Two proposals at the national level aim to fill the
gap for workers who do not have access to an
existing DC or DB plan: NCPERS Secure Choice
and Senator Harkins USA Retirement Plan. Both
use the cash balance plan concept and both aim
to solve the issues of investment risk, longevity
risk and the need for professional management.
There are significant differences between these
proposals, but they could co-exist. The NCPERS
proposal uses a state-by-state approach, while
the USA Retirement Plan proposes a federal
framework. We believe both are sound, and as
long as contribution rates are adequate, these
plans can play an important role in the industry.
Hybrid plans may emerge as viable, long-term
solutions. In theory, DB and DC plans that are
well designed, well-funded and properly invested
can deliver adequate retirement benefits. In reality,
some DB plans and most DC plans do not meet
these objectives. We believe adaptations of hybrid
plans will emerge as competitors to existing DC
plans and alternatives to DB plans if the latter
continue to be phased out by plan sponsors. The
newer hybrid plans require various legislative
changes and regulatory approvals. We support
moves that make these plans easier to implement as
they offer features that address current challenges
for participants and plan sponsors, alike.
PAGE 2

To achieve success, in our view the retirement plan of the future needs these features:
Contribution levels should be high, in the range of 15% of salary each year.
The plan design should use behavioral techniques to encourage participation and raise
contribution rates.
Assets should be professionally managed.
Collectively,
Americans are
woefully unprepared
financially for
retirement. This
retirement problem
actually reflects a
collection of diverse
issues.

Plan assets should be portable across employers.


Longevity risk should be minimized by pooling individual participants assets with others.
Retirement age should be deferred where feasible, increasing both savings and benefits.
Participants should be able to understand in simple terms how well prepared they are for
eventual retirement.
The retirement train is pulling into the station; it is our collective responsibility to get passengers off the
tracks and onto the platform.

1. The Problems for Retirement Planning1


Section 1 Summary: Collectively, Americans are woefully unprepared financially for retirement.
This retirement problem actually reflects a collection of diverse issues. This paper identifies the most
important ones: longevity; access; contributions; portability; behavioral mistakes; funded status; expenses;
and regulation. Our research focuses on solutions that can work for both plan sponsors and participants.
Simply put, the biggest problem facing the workforce today is that collectively Americans are woefully
unprepared financially for retirement. Woefully is the right word: there are potentially a lot of financial
and social woes waiting for future generations of U.S. retirees.
But retirement planning is a highly complex issue. Many factors impact the ability to provide adequate
pensions: economic, political, actuarial and even psychological.
The U.S. pension industry is in crisis, has become a widespread lament among plan sponsors, plan
participants, taxpayers and politicians. Given the potential impact on society as a whole, theres a growing
understanding that theres a big problem that needs to be fixed. This paper aims to cut through the complexity
and identify the most important issues, evaluate some suggested solutions and make recommendations.
In the late twentieth century over half of American workers were covered by DB pension plans.2
Most didnt have to worry about saving for retirement. But now fewer than one in six private sector
employees have access to a DB plan thats open to new contributions, according to the Urban Institute
Retirement Security Data Brief, April 2013. And as well demonstrate, the DC plans that are replacing
them as the main retirement saving vehicle are not filling the gap.
This is a well-covered story, usually presented as a looming problem for workers, retirees and for society
as a whole, with employers and plan sponsors portrayed as part of the problem, not the solution. But
as we describe later, we see a flurry of innovation from plan sponsors aiming to provide adequate
pension benefits at a reasonable cost. The motivation may include fiduciary responsibility but in practice
stems from the need to provide competitive compensation in an open marketplace for employees.
If successful, these innovations may change not only todays apparent trend toward DC, but also reinforce
the importance of the skillsets developed over the years by the DB plan sponsor community.
We note the difference between pensions and retirement. A pension, according to the Merriam-Webster dictionary, is a fixed
sum paid regularly to a person following retirement from service. While pension plan and retirement plan are often used
interchangeably, there is an important distinction. As the dictionary notes, pension implies a regular payment during retirement.
In theory, while a retirement plan could be as simple as a decision to go live with the kids when I retire! More realistically, retirement
plans would include investment accounts such as 401(k) or IRA defined contribution plans, which may have no pension element.
So weve broadened the scope of this research deliberately to encompass retirement planning, not just pensions.
2
Seburn, Patrick W. Evolution of Employer-Provided Defined Benefit Pensions. Monthly Labor Review. Dec. 1991.
1

PAGE 3

Can the solution be


as simple as just
setting aside more for
retirement savings?
Unfortunately not.
But contribution rates
are a good place to
start in understanding
the scope of the
problem.

Can the solution be as simple as just setting aside more for retirement savings? Unfortunately not.
But contribution rates are a good place to start in understanding the scope of the problem. To accumulate
enough money to replace their salary at retirement, people need savings (including any company match)
equivalent to 15% to 20% of their salary every year over their entire career while averaging investment
returns of around 4% annually above inflation on these investments, according to Bob Maynard, CIO
of the Idaho Public Employees Retirement System. And these numbers assume at least 20% of that
retirement income target comes from Social Security payments.
The National Conference on Public Employee Retirement Systems (NCPERS) is in the same camp. In its
report, The Secure Choice Pension, it estimates that a worker 35 years from retirement needs to save
around 12% of salary to replace 80% of income in retirement. This is consistent with Brandes Institute
models that estimate that 15% annual contributions may come close to replacing final salary.
Stacking these objectives against the reality of many workers savings and investments, especially those
reliant on DC plans, reveals a wide gap. Government estimates from the Social Security Bulletin (volume
71, no. 2, 2011) measured the median annual contribution by participants in DC plans in 2006 at around
5.5%. Wealthier savers tended to save more, but not nearly enough. For the highest decile of earners,
the median annual contribution rate was 7%, dropping to a meager 3% for the lowest decile of earners.
Either out of necessity or choice, participants struggle to set aside enough to help their future selves a
couple of decades down the road.
Exhibit 1: The Savings Shortfall: Around 10% a Year in Contribution Levels, as of 2006
Median annual contribution rate for DC plans
Estimated annual contribution to replace final salary
16%
14%
12%
10%
8%
6%
4%
2%
0%
Source: Social Security Bulletin as of 2011, EBRI, NCPERS Secure Choice Pension, Brandes Institute estimates

At the contribution rates in Exhibit 1, a participant might achieve 30% replacement of final salary, instead
of 82% if contributions had been made at the recommended rate.
According to the Employee Benefit Research Institute (EBRI), the average U.S. worker likely will need
$900,000 upon retirement to maintain his or her lifestyle, but, The average balance in all 50 million U.S.
401(k) accounts is just over $60,000. Even people within 10 years of retirement have saved an average of
only $78,000, and more than a third of them have less than $25,000.3
In addition, 43% of workers between the ages of 45 and 54 said they werent currently saving for
retirement at all. Collectively, the difference between what U.S. workers have saved for retirement vs.
what they should have at this point in their lives is $6.6 trillion.4
3

The EBRI 2012 Retirement Confidence Survey, March 2012.

PAGE 4

Exhibit 2: The Income Shortfall: Over 50% of Final Salary, as of 2006


At median annual contribution rate for DC (5.5%)
At recommended annual contribution rate of 15%

90%
80%

43% of workers
between the ages of
45 and 54 said they
werent currently
saving for retirement
at all. Collectively, the
difference between
what U.S. workers have
saved for retirement vs.
what they should have
at this point in their
lives is $6.6 trillion.4

70%
60%
50%
40%
30%
20%
10%
0%
Source: Social Security Bulletin as of 2011, NCPERS Secure Choice Pension, Brandes Institute estimates. Illustration of percentage of final salary replaced
assumes real investment returns of 4% over a working lifetime. It also assumes a 25-year old retiring at 65, inflation and contribution increasing at 3%
annually, costs at 1% annually. This hypothetical example is for illustrative purposes only. It does not represent the performance of any specific product.
Actual results will vary.

Over the 40 years to yearend 2012, U.S. stocks had gained 9.8% annualized and long-term government
bonds gained 8.9% annualized. But since the start of 2000, U.S. stocks gained less than 2.0% annualized
through yearend 2012, as measured by Ibbotson data. The continuation of the bond bull market has
Exhibit 3: The Assets Shortfall
What the average near-retirement worker* has saved
What the average worker may need for retirement
$1,000,000
$900,000
$800,000
$700,000
$600,000
$500,000
$400,000
$300,000
$200,000
$100,000
$0

Source: EBRI, Social Security Bulletin, NCPERS Secure Choice Pension, Brandes Institute estimates.
*near-retirement defined as within 10 years of retirement age.

led to 10-year U.S. Government bonds yielding less than 3.0% (both at yearend 2012 and into the third
quarter of 2013). As a result, many workers (and many plan sponsors) may have turned sour on equities
due to poor returns, while bond yields are still close to historic lows.5
4

The Retirement Crisis and a Plan to Solve it, a proposal by Senator Tom Harkin, July 2012

PAGE 5

With the combination of low savings rates and


low investment returns, the retirement train
is pulling into the station. And far too many
potential passengers are waiting on the tracks, not
the platform.
Many DB pension
plans, especially in the
public sector, use longterm investment return
assumptions that
appear high compared
to current market
conditions so if those
assumptions are not
met over time, the
plans may prove
to be significantly
underfunded.

In order to fix the problem with pensions, we


must first figure out what actually is the problem.
Like much in life, it depends who you ask! A
review of media, practitioner and academic
opinions quickly reveals a multitude of pension
problems. Every one of them has potentially a
major impact on benefits, funding and/or society
(read taxpayers). None of them has an easy fix
or it wouldnt be on this list.
Aggregating these opinions, we come up with a
broadly defined list of eight factors that encompass
the United States pension crisis.
THE WORKFORCE, EMPLOYERS and
RETIREES

1. Longevity. Retirees whose taxdeferred savings are in investment


accounts providing capital
accumulation but no lifetime income
option face a risk of running out of
money if they live too long.
2. Access. Many workers who dont have
access to any employer-sponsored
retirement plans for tax-deferred
saving may be left totally unprepared
for retirement.
3. Contributions. Workers or retirees who
do have access to tax-deferred plans but
fail to make suitable contributions could
fall short of an adequate standard of
living in retirement.
4. Portability. Workers who move more
frequently may not be well served by
traditional employer defined benefit
pension plans whose benefits are in
some cases not portable.
THE RETIREMENT FUNDS

5. Behavioral Mistakes. Some


retirement plans increasingly push

key investment decisions (allocation


and selection) onto workers and
retirees who (despite increased
availability of basic investment
education) may be inexperienced and
vulnerable to behavioral mistakes
that can cost them dearly in longterm returns.
6. Funded Status. Some state or
municipal DB pension funds are
so underfunded, according to a
Moodys Investors Service Report on
June 27, 2013, that they are (or may
soon be) unable to pay promised
future benefits.
7. Expenses. Administrative and fund
expense costs of many DC retirement
savings plans appear high, especially
in a current environment of low
bond yields and historically low
equity returns.
8. Regulation. Regulatory policies
intended to make DB plan assets
safer could have a contrary effect
by (a) shortening the time horizon
for plan sponsors and reducing their
ability to deliver adequate investment
returns in the long term and (b)
removing incentives to fund benefits,
leading to freezing or closure of many
DB plans, as well as reduced matching
money for DC plans.
Many DB pension plans, especially in the public
sector, use long-term investment return assumptions
that appear high compared to current market
conditions so if those assumptions are not met
over time, the plans may prove to be significantly
underfunded.
And even if those long-term return assumptions
are met, a few of these DB pension funds may
still be dangerously underfunded relative to their
long-term benefit obligations, based on their
existing actuarial assumptions.
With people living longer most DB pension funds
that pay lifetime benefits may have underestimated
the additional cost of this longevity, and so may
be even more underfunded than they appear.

U.S. stock returns represented by data from Ibbotson Associates via Morningstar. Long-term U.S. Government bonds represented
by data from Ibbotson Associates via FactSet through yearend 2005 and the Barclays U.S. Treasury 20+ Year Index from 2006 to
yearend 2012. Historical 10-year U.S. Government bonds yields were drawn from Prof. Robert Shillers website: http://www.econ.yale.
edu/~shiller/data.htm. According to the Shiller data, the 10-year U.S. Government bond yield reached its all-time low (based on
monthly data back to January 1871) in July 2012 when it fell to 1.53%. Outside of this decade, the last time U.S. Government bonds
were at a comparable level was January 1941 when they fell to 1.95%. The yield in August 2013 was 2.57%. The 40-year returns for
stocks and bonds referenced above are for Jan. 1973 to Dec. 2012. Past performance is not a guarantee of future results. One cannot
invest directly in an index.

5

PAGE 6

All of the above factors contribute to the problem. Every topic on this list has generated articles and
arguments regarding dangers and the implications for individuals, employers and even society as a
whole. The problem is complex, and there is no easy solution.

The retirement
problems in the
United States must
include solutions for
both DB and DC plans
and for any other plan
design variations
that evolve.

In this paper, we touch on all of these, but our focus is on finding the solutions that have the broadest
impact on the primary goal: ensuring that adequate retirement benefits are at least within reach for
most workers and retirees. This includes finding approaches that work effectively for both plan sponsors
and participants.

2. A Framework for a Solution


Section 2 Summary: The Retirement Rule, Benefits = (Contributions + Investment Earnings) Expenses,
provides a good framework to evaluate the problems and assess potential solutions to the pensions crisis.
It also clearly identifies how the move from DB to DC plans alters the balance of risk and cost from plan
sponsor to participant.
Retirement Rule: Benefits = (Contributions + Investment Earnings) Expenses B=(C+I)-E
This simple rule provides a framework for evaluating almost all of the problems identified in section 1,
as most of these are directly related to failings in one or more of C, I or E in that equation. Two other
factors must be added to the roster of issues: longevity and portability. These will be considered later in
this research.
The retirement problems in the United States must include solutions for both DB and DC plans and for
any other plan design variations that evolve. As noted earlier, solving means that B (benefits) must be
adequate for the participant to retire.
While the Retirement Rule is a finance equation that can be addressed mathematically, in practice the
design and implementation of realistic solutions involves a complex web of political, economic and
investment issues.
For context, we first look at the U.S. retirement system past and present, and then analyze the current
situation in the framework of the Retirement Rule and the finance/political/behavioral impacts.
Over time, American workers have become increasingly dependent on DC plans as traditional DB plans
are closed or limited. The Retirement Rule is valid for both, but the definitions of each term may differ
and some specific risks are passed to the DC participant that would have been accepted by the sponsor
in a DB plan.
While these are well known, it may be helpful to set them down in a Retirement Rule format as we will
follow this method in our analysis throughout this article. Exhibit 4 summarizes the key differences in
traditional DB and DC plans.
Exhibit 4: Plan Definitions

6
7

Benefits

Contribution

Investment Earnings

Expenses

DB plan

Typically,
Annual pension

Primarily sponsor6

Plan return

Sponsor control

DC plan

Lump sum

Usually sponsor and


participant7

Participant return

Sponsor oversight but


influenced by
participant asset mix

In some cases, participant contributions also may be significant.


Sponsor contributions may be suspended or eliminated during difficult times. For example, in the wake of the Financial Crisis in
2008/2009, 53 Fortune 1000 companies in the United States changed their matching contribution to their employees' savings plans,
as of May 2009, according to Towers Watson.

PAGE 7

Exhibit 5: Which structure poses higher risks or costs: DB or DC?


The answer is different for Plan Sponsors and Participants
Higher risks or costs for PLAN SPONSORS

Over time, American


workers have become
increasingly dependent
on DC plans as
traditional DB plans
are closed or limited.
The Retirement Rule
is valid for both, but
the definitions of each
term may differ and
some specific risks
are passed to the DC
participant that would
have been accepted
by the sponsor in a
DB plan.

Benefits

Contribution

Investment
Earnings

Expenses

Financial Risk

DB

DB

DB

DB

Longevity Risk

DB

n/a

n/a

n/a

Behavioral Risk

n/a

n/a

DB

n/a

Benefits

Contribution

Investment
Earnings

Expenses

Financial Risk

DC

n/a

DC

DC

Longevity Risk

DC

n/a

n/a

n/a

Behavioral Risk

DC

DC

DC

n/a

Higher risks or costs for PARTICIPANTS

Source: Brandes Institute

The bottom section of Exhibit 5 demonstrates


the risk comparison for plan participants, tilted
firmly toward DC plan participants. The financial
risks impact DC plan participants in three ways
(B, I and E). First, in low yield markets, it may
be difficult to annuitize a lump sum at retirement
to provide a meaningful lifetime Benefit. For
example, a 65-year old man seeking to replace a
proportion of his final salary would have to spend
a lump sum of around 16 times every dollar of
lifetime income he needs. (To replace $10,000 of
income a year for the rest of his life, he would
have to spend $160,000. Replacing $20,000 of
income would require spending $320,000.) In
addition, there may be regulatory issues and
tax consequences that make it difficult for many
DC plan participants to convert some or all of
their accumulated assets into annuities. The
Department of Labor and IRS are both moving
to make this easier, but there is still work to be
done, especially for deferred income annuities.8
Secondly, even before behavioral errors, the
playing field is not level for DC participants
relative to their professional DB counterparts in
respect of limited menu choices and lack of scale
economies. Add that to behavioral issues and DC
participants are at a material Investment earnings
8

disadvantage to professional plan sponsors.


Lastly, Expenses of DB plans are generally lower
than those of DC plans, although the difference
should narrow in the United States given that the
recent move to make DC expenses transparent
to participants will bring market competitive
pressures to bear.
The transfer of longevity risk to DC participants
impacts benefits (B), allowing the possibility that
assets will run out during retirement.
This is exacerbated by the behavioral risks in
DC plans. In fact, there are severe participant
behavioral risks in every aspect where the
participant has a direct decision-making role: B, C
and I. Behavioral risk to Benefits can be aggravated
by not annuitizing any of the lump sum proceeds,
or even worse, by spending a material amount
of the proceeds early in retirement (similar to
the lottery effect: when individuals have a much
bigger lump sum than theyve ever seen before,
the temptation may be to spend a chunk of it on
the good life). The behavioral effects are welldocumented regarding investors insufficient level
of Contributions, but adding an extra layer of
complication is that most participants suffer from
behavioral issues that may cause them to fall way
short of success.

D C plan participants are typically required to make an annual minimum withdrawal, called a Required Minimum Distribution (RMD),
soon after reaching age 70. The RMD is calculated based on the participants age and the account value. But participants who
purchase a deferred income annuity (sometimes called longevity insurance) with a lump-sum premium and hold the contract within
their DC plan (to preserve the tax-deferred status of the premium paid) could still be subject to RMDs even though the contract may
not begin to pay income until they reach age 80 or 85. Participants who do not have additional resources within the DC plan to make
the annual minimum withdrawals would be subject to surrender charges for withdrawing money prematurely from the annuity contract
to satisfy the RMD. The Department of Labor has proposed modifications to required minimum distributions with regard to deferred
income annuities but no changes have taken effect.

PAGE 8

Annual studies by Dalbar show consistently that the average mutual fund investor achieves results well
below the overall market, largely because of following the crowdbuying high and selling low. Their
most recent study, for the 20 years through 2012, shows a shortfall of 4% annually over the past two
decades. Thats actually on the low end of the range seen historically in the Dalbar studies.

In 1940, private
pensions covered 4
million people or about
15% of the active U.S.
workforce. By 1960,
those numbers had
grown to 23 million or
about half of all private
sector employees.9

To be fair, DB plan sponsors are not exempt from the behavioral errors of chasing short-term
performance. Research by Goyal and Wahil in 2008 covering a 10-year period to 2003, showed that plan
sponsors tended to fire managers after they underperformed, and subsequently those fired managers
tended to outperform their successors. Nevertheless, the impact of this factor appears modest compared
to the potential damage individual investors can inflict upon themselves when making their own DC
investment decisions if the Dalbar study is representative of their results.
So there is fairly significant evidence that DC plans fall short of DB plans from a participant perspective.
But this is not new news. Our focus is on evaluating DC, DB and other competing plans to see which,
if any, can provide a solution to the various issues outlined earlier.
In order to provide the right context, we need to start with the past: how did the American retirement
industry get to this state of affairs?

3. A History of DB and DC Plans in the United States


Section 3 Summary: Three generations of American workers have experienced an amazing transformation of the
employee benefit landscape with changes that initially provided greater wealth, but subsequently led to capped
or reclaimed benefit promises. With relatively little public awareness, but with significant consequences,
within the last few years DC plans have been transformed for many from supplemental savings to the
primary source of retirement income. Plan sponsors have experimented with hybrid DB plans (such as
cash balance plans and adjustable benefit plans), but todays landscape remains dominated by a shift away
from DB to DC plans with significant impact for participant benefits.
As the United States economy entered the post-World War II era, robust private sector growth fostered
the development and expansion of employee benefit programs to attract and retain skilled workers.
For working-age survivors of the Great Depression and WWII, this meant fresh opportunity to pursue
much-improved lifestyles based on current real income growth and enhanced retirement benefits.
Demographic realities supported this expansion of income and health-related benefit programsmore
active workers in proportion to inactive or retired workers.
In 1940, private pensions covered 4 million people or about 15% of the active U.S. workforce. By 1960,
those numbers had grown to 23 million or about half of all private sector employees.9 As the number of
active workers continued to exceed the number of actual retirees, growth in employer-provided medical
care and retirement medical care also grew substantially. By 1980, defined benefit (salary replacement)
retirement plans had grown further to cover 60% of private sector employees, and an even higher
proportion of the public sector.
In return for these tax benefits, the corporate sponsors of these plans assumed both investment risk
and longevity risk for the benefits that were defined in the plan formulas. Regardless of capital market
returns (which were also strong during this period and fostered a sense of complacency among plan
sponsors with regard to advance funding of these benefits), most workers did not have to worry about
the security of their promised benefits. Even though many would also participate as private investors in
U.S. equity and debt markets, most workers could ignore capital market valuations and volatilityand
spend more of their current income in support of a fulfilling lifestyle. When a few plans did fail (e.g.,
Studebaker), Congress stepped in to provide protection via ERISA and creation of the Pension Benefit
Guaranty Corporation (PBGC).
9

Seburn, Patrick W. Evolution of Employer-Provided Defined Benefit Pensions. Monthly Labor Review. Dec. 1991

PAGE 9

In 1985, the
Department of Labor
reported there were
114,000 DB plans in
the United States.

This corporate-centered paternalism continued


unabated for 50 years. Government entities at
the local, state, and national level developed
similar retirement income and medical coverage
programs (albeit on a smaller scale) to attract and
retain workers. In the context of the Retirement
Rule, Investment earnings were relatively high,
Expenses were controlled, and the aggregate
Contributions made by the plan sponsors were
manageable as the participants were fewer and
younger (and hence lower paid) when compared
to the demographics of plans in the more recent
decades. As a result, the economic impact of the
Benefits paid was acceptable; certainly not at the
top of the agenda for corporate management.
B=(C+I)-E was solvable for many decades.
In the 1980s a new form of retirement income
savings was introduced broadly in the U.S.
markets, based on the Revenue Act of 1978 which
created 401(k) plans. Instead of a defined benefit,
these plans relied on defined contributions from
participants and their employers. Companies
promoting these plans to their workers stressed
the supplemental nature of the new benefit and
promoted participation by offering matching
grants (essentially free money) to those who
signed up. The primary goal was attracting and
retaining skilled workers in the face of steady
economic growth.
Investment menus for these defined contribution
plans initially were limited and largely focused on
capital preservation. However during the 1990s
average exposure to equities grew, fueled by the
bull market euphoria. By 1999 when the internet
bubble was well underway, EBRI statistics put the
average 401(k) exposure to equities at 55%, with
another 19% in company stock. These levels fell
during the 2000s and by 2011 equities represented
only 39% of 401(k) allocations, with company
stock down to just 4%.
While these plans exposed participants to
investment risk, and raised awareness of the
variability of capital market yields and total
returns, in the early years workers took comfort
from the fact that their portfolios were taxdeferred and that the resulting benefit was truly
just a supplement to their promised DB payout.

With Investment earnings low given the lack of


exposure to equities and Contributions limited,
Benefits = (C+I)-E could hardly be other than
supplementary. But that was not seen to be a
problem as workers would not be relying on
these DC plans as their primary means of support
in retirement. And by the late 1990s, the equity
euphoria gave many participants the idea that
their DC savings could comfortably fund their
retirement on their own if need be.
But beginning in the late 1990s, even before the
tech bubble, corporate plan sponsors (well ahead
of their public plan peers) began to realize that the
economics and demographics of DB plans were
moving against them, even with the associated
tax benefits. Accounting rules made fluctuations
in DB plan values increasingly apparent to readers
of the income and balance sheet disclosures of
corporate performance. This was only a potential
for disaster while asset prices were rising. But if
they should ever fall (and post 1999 they certainly
did) corporate plan sponsors took the brunt.
At the same time, actuaries were pushing plan
sponsors to recognize the economic reality of
longer expected lifetimes for both men and
women. This combination of rising portfolio
volatility and increasing longevity risk would
prove toxic to the now broadly available DB
plan benefits for American workers. In 1985, the
Department of Labor reported there were 114,000
DB plans in the United States. By 2012 this had
fallen to 38,000. The Bureau of Labor Statistics
noted in 2012 that only 15% of private sector
employees were covered by an open DB plan
where they could accrue benefits, and in most of
these cases, many of the ancillary medical and life
insurance plans have also disappeared. For the
public sector the number remains high, at 85%, at
least for now. Nominal asset growth of DB plans
continued to build, but corporate management
began to curtail worker eligibility, beginning
with non-union salaried employees and gradually
extending to union workers.
A key strength of the DB plan from the participant
perspective has always been the sponsor
contribution. While employees can and often
do make voluntary contributions, these sponsor

PAGE 10

A key strength of the


DB plan from the
participant perspective
has always been the
sponsor contribution.
While employees can
and often do make
voluntary contributions,
these sponsor
contributions generally
have been sufficient to
support actuarially the
level of benefits.

contributions generally have been sufficient to


support actuarially the level of benefits. Closing
a DB plan and offering a DC plan instead does
not have to reduce the sponsor contribution,
but in practice, this is often the case. The
employer contribution in a DC plan is frequently
wholly or partly dependent on the participants
contribution, via matching. And employees
generally undercontribute. Leading Canadian
actuary Malcolm Hamilton notes another reason
for employers to reduce contributions: many
participants tend to undervalue their pension
benefits in his view, so it is logical for sponsors
to find more cost-effective ways of compensating
them. Brandes Institute Advisory Board member
and former pension fund executive Bill Raver
notes that pressure remains on plan sponsors
to reduce headcount in their plans (and hence
cost). This can be done by buy-outs or by offering
portability as a proactive move by the sponsor.
In fact a weakness of the traditional U.S. DB plan
from the participant perspective has been the lack
of portability. While this is theoretically permitted
in DB plan design, most sponsors did not include
this feature except for a small number of multiemployer plans. So any employee changing jobs
would typically leave their old benefit frozen
and start again in a new plan with the new
employer. In an era of lifetime employment and
few job changes this was not a critical weakness
as employees might still accumulate substantial
benefits in perhaps two or three DB plans.
However, the increased voluntary and involuntary
job mobility that has become the workplace norm
in recent decades has made this weakness much
more damaging.
The lack of DB portability has two elements to
it. First, can the accrued benefit (or equivalent
assets) be moved to a new plan? Second, if not,
assuming identical contributions and results,
does the participant suffer financially from
accumulating pension benefits under several
plans rather than consolidating into one? The first
question is one of convenience and practicality.
Its a lot easier to manage one pension pot than
several. The second question has more financial
impact. By moving jobs periodically, participants
in traditional final salary DB plans may lose out

compared to the few who stay put throughout


their career (assuming that plan also stays put). A
greater number of plans to manage may enhance
the likelihood of behavioral mistakes. More
plans may mean greater costs and many plans
go unclaimed as participants lose track of them
over time.
The portability that is built into DC plan structures
has been a clear advantage for that structure and in
the list of pros and cons of DB versus DC plans, it
ranks near the top of the pro-DC list. Separately
from job moves, in recent years DB plan sponsors
have however supported portability when it
can be used as an incentive for participants to
move from their DB plan to a newly introduced
DC plan.
Late in the 20th century, some large corporations
experimented with DB designs that increased
portability but importantly from the sponsor
perspective reduced the sponsors investment risk.
The first of these designs was the cash balance
plan. Other plan designs have been introduced at
an increasing pace. Generically they are usually
referred to as hybrid plans, as they combine
features of both DB and DC plans, although most
are legally structured as DB plans.
Cash balance plans were first introduced in
the mid-1980s. As sponsor concerns over DB
plans grew during the 1990s, they appeared to
address the main sponsor concern of funding
an increasingly large and volatile liability. While
legally defined as DB plans, they had a key feature
of a DC plan: a reported account balance for each
participant. These plans had the desired effect for
sponsors of curtailing the growing uncertainty
in future dollar benefits due to investment risk.
However, unless participants took their benefits
as a lump sum on retirement, the plan had to
provide an annuity and so was still exposed to
longevity risk. Furthermore, the new cash balance
plans did little or nothing to relieve corporations
of the increasing burdens of accounting and
government regulation surrounding DB plans.
So the early versions of cash balance werent a
full solution for sponsors. They certainly werent
accepted as a solution by DB plan participants who
were being switched into cash balance plans.

PAGE 11

According to the
Federal Reserves Flow
of Funds Accounts,
there were assets of
$4.3 trillion in DC plans
as of March 2013, with
another $5.8 trillion in
IRAs. This compares to
$2.6 trillion in private
sector DB plans, and
another $5.0 trillion in
public sector DB plans.
So of the $17.6 trillion
total, DB plans are
now the minority with a
43% share of the total.

Legal challenges were mounted by participants


against the IBM and Xerox plans among others,
in essence claiming that their benefits were being
reduced illegally.10 From the sponsor perspective,
reducing liabilities (i.e. future benefits) was a
central element in the change, but the lawsuits
hinged on whether the changes contravened
pension law: while cash balance plans acted like
DC plans in some ways, they were legally defined
as DB plans and regulated as such.
Court decisions in the early 2000s went against
the plan sponsors, even though some were
eventually overturned on appeal. While the
suing participants won the battle (switches to
cash balance plans were blocked as they were
held to provide a less valuable benefit than DB
plans), participants in aggregate lost the war.
The enthusiasm for cash balance plans among
large corporations was significantly dampened,
and ironically led to more, rather than fewer,
terminations of DB plans.
However, the passage of the Pensions Protection
Act in 2006 resolved some of the issues on legal
status of cash balance plans, and opened the door
to a resurgence of interest, especially from the
small-business segment. More on this later in the
section The Retirement Gap: Proposed Solutions.
Some sponsors of DB plans are now moving
to other variations on the theme of sharing
investment risk with the participants. Pioneered
by consulting actuarial firm Cheiron, adjustable
plans are DB plans where the participants benefit
varies directly with the actual performance of
the plans assets, typically on a yearly basis. As
such some of the investment risk is moved to
the participant while maintaining the pooled
longevity risk and professional investment
management advantages of a traditional DB plan.
Early adopters of the adjustable plan approach
include corporate (e.g. the New York Times)
and multi-employer plans (e.g. Greater Boston
Hospitality Employers Local 26). Because the
adjustable plan concept is new, early adopters

10

are still waiting for IRS approval, and if this is


not granted, the sponsors seeking to introduce
adjustable plans would likely revert to a DC format
instead. Separately, another concept that allows a
varying benefit within a final salary DB structure
is on the drawing board. This is the DoubleDB
plan, patented by actuary Ed Friend, which locks
in the contribution rate by the sponsor but allows
the benefit (as a multiplier of final salary) to vary
depending on investment results. We are not
aware of any sponsors as yet who have adopted
Double DB.
In asset terms, so far cash balance and adjustable
plans have had only a small impact on the DB/DC
debate and the large-scale shift from DB to DC
plans has continued unabated. Companies have
encouraged this shift from DB plans by expanding
the investment menus of DC plans, increasing the
level of company match monies, and promoting
broader worker participation in lockstep with
the freezing or termination of the DB plans
that previously supported these same workers.
According to the Federal Reserves Flow of Funds
Accounts, there were assets of $4.3 trillion in
DC plans as of March 2013, with another $5.8
trillion in IRAs. This compares to $2.6 trillion in
private sector DB plans, and another $5.0 trillion
in public sector DB plans. So of the $17.6 trillion
total, DB plans are now the minority with a 43%
share of the total.
The gradual nature of the shift and the complex
nature of the debate mean that public awareness
has lagged reality. A good example of this denial of
reality is contained in the EBRI Issue Brief (#369,
March 2012, p31): As a cautionary note, although
57 percent of workers surveyed said they (or their
spouse) expect to receive benefits from a defined
benefit plan in retirement, only 32 percent report
that they and/or their spouses currently have such
a benefit with current or previous employers. We
can only wonder where the other 25% think their
benefits will come from!

Walsh, Mary Williams. Xerox Reaches Settlement With Retirees on Pension Suit. The New York Times. Nov. 15, 2003.

PAGE 12

4. Focus on the Problems

Even for those who


contribute actively
to DC plans, the
longevity and
behavioral risks
associated with
DC plans (see
Exhibit 2) potentially
leave another gap
between adequate
replacement income
levels and the likely
outcome for
most retirees.

Section 4 Summary: Various factors are likely to hurt DC participants financially, including lower
contributions, lower investment returns and potentially their own poor investment decisions. In the
meantime, DB plan sponsors are still dealing with underfunding problems. The simple (but not necessarily
easy) solutions include: increase contributions; retire later; and increase investment returns. The real solution
for the pension community is to find ways to enable participants to build adequate retirement income and to
do so in a structure that works effectively for cost- and risk-conscious plan sponsors.
This shift from DB to DC plans combined with the low-return market environment has a major impact
on Benefits, especially for DC participants. Contributions have gone down (as participants have generally
not used even the modest maximum limits allowed). Investment earnings from equities have been poor
in recent years and the record low level of bond yields pose the risk of negative future returns (both
nominal and real) from bonds. With C and I down, the money available for Benefits that are supported
by C+I-E are likewise down. By getting out of the DB Business, plan sponsors no longer make up the
difference. Participants have taken on the responsibility of picking up this tab, even if many havent
realized it yet.
Even for those who contribute actively to DC plans, the longevity and behavioral risks associated with
DC plans (see Exhibit 2) potentially leave another gap between adequate replacement income levels and
the likely outcome for most retirees.
The discussion on fixing the pension crisis appears ever more complex. But we believe the key drivers
that can remedy many of the failings are quite simple. Using the Retirement Rule, we can move forward
from the historical context and see that any serious solution must include two elements:
Save more: increase C
Earn better returns: increase I
(While reducing Expenses would also help, its impact is likely to be small relative to the other two, so we
have excluded it as a meaningful solution).
Note that a solution for the participant is not the same as a solution for the plan sponsor. For a DB
plan sponsor, the preferred solution for many is to close or terminate the plan, or to pay to transfer the
liabilities to an insurance company. This may solve the problem for the sponsor. However, even if this
solution preserves the already-earned benefits for the participant, it leaves a gap to be filled in respect of
pension benefits based on future earnings.
On the sponsor side of the equation, there is also the well-publicized and debated issue of underfunding.
With stagnating asset values and low bond yields, funding gaps have increased in recent years. This is
meaningfully impacting private sector DB plans which use a high quality corporate bond yield as the
liability discount rate.11 Record low yields have reduced the level of funding, and contributed to the
desire to get the pension liabilities off the balance sheet. Changes in bond yields, especially from recent
low levels, can have a significant impact on private sector plan funding ratios. Estimates by consultants
Mercer on the aggregate pension funding ratio of the companies in the S&P 1500 show the ratio climbed
from 74% at the end of 2012 to 86% by May 2013.
Public sector DB plans have more flexibility in selecting their liability discount rate, and tend to use less
conservative assumptions than their private sector peers. Underfunding is a major problem for some,
but not all, large public DB plans. For example, a June 2013 report from Moodys estimated that while
the fifty states are in aggregate 74% funded on published data, when adjusted to take into account market
11

A ccording to guidance at the IFRS Foundation/IASB website (ifrs.org), the organizations Interpretation Committee did not specify a
credit rating, noting that the discount rate should be determined by reference to market yields at the end of the reporting period
on high quality corporate bonds. While acknowledging that the general interpretation of this rule is understood not to be bonds with
a credit rating below AA, The Interpretations Committee discussed this issue in several meetings and noted that issuing additional
guidance on or changing the requirements for the determination of the discount rate would be too broad for it to address in an efficient manner. For more information: http://www.ifrs.org/Current-Projects/IASB-Projects/Employee-Benefits-Discount-Rate/Pages/
Project-summary.aspx

PAGE 13

risks (for example by changing the liability discount rate to that used by private sector plans), the funding
ratio drops below 50%. Moodys numbers show a wide range between best and worst states in terms of
funding ratio and overall pension burden (Nebraska, Wisconsin and Idaho top the Moodys rankings as
having the lowest pension burden). There is debate in the industry over the validity of these assumptions
and methodologies but this is beyond the scope of this paper.
The reality is that a
pension plan is
deferred compensation.
As part of the overall
compensation package
for employees, it
can be an important
element in recruiting,
retaining and
motivating employees.
Its financial impact is
often underestimated
by workers.

The take-away from our perspective is that both private and public sector DB plans will be dealing with
underfunding issues for the foreseeable future, and this will continue to undermine the rationale for
sponsors to maintain their traditional DB plans.
For a DC plan sponsor, there is no problem as the whole premise of the DC industry is that the risks
and consequences of inadequate contributions, poor investment earnings and longevity are all largely
handed to the participants.
Can plan sponsors solve their own pension crisis simply by this financial pass the parcel technique of
dumping the problem into the laps of their employees (and ultimately on society as a whole which could
need to support a growing number of destitute retirees)? We dont think so. The reality is that a pension
plan is deferred compensation. As part of the overall compensation package for employees, it can be
an important element in recruiting, retaining and motivating employees. Its financial impact is often
underestimated by workers. Employer-sponsored DC pension arrangements may be seen as increasingly
unattractive in coming years as todays retirees run out of assets. Then the competitive power of an
effective pension plan may be an even more visible and valuable management tool for the plan sponsor.
The real solution for the pension community is to find ways to enable participants to build adequate
retirement income and to do so in a structure that works effectively for cost- and risk-conscious
plan sponsors.

5. The Elements of a Solution


Section 5 Summary: To help get toand through retirementworkers must participate in and make
contributions to their retirement accounts. Automatic enrollment would help, along with improved
participant education on how critical contributions are. DC participants can help themselves by retiring
later, and would be helped further if they could be moved away from a broad and confusing menu of
investment choices, and towards collective investment pools that mirror professionally managed DB plans.
Of the three elements discussed in the previous section, better return (increased I) is only partly under
the control of the sponsor or participant. With the risk-free bond rate still near historical lows, high
future returns may be difficult to attain, certainly for the industry in aggregate. This means the solution
for Investment returns has to be in one of two places. One is to increase the skill level of investors,
which realistically is only possible by moving a higher proportion of assets to professional management.
The other is to reduce the behavioral mistakes made in investment selection, timing and management.
Training participants in this area is not an industry-wide solution. While some individuals may benefit,
the impact on the broad mass of participants is essentially a zero-sum game.
We believe the only feasible approach to solving the behavioral issues is to structure the rules and
constraints in such a way to minimize the ability of participants to harm their long-term financial future
even if this flies directly in the face of the DC industry trend toward more choice. In short, professionally
managed DB plans are already focused on the Investment return; all that can be done for DC participants
in aggregate is to constrain choices towards an appropriate DB-style portfolio.
Remember that the returns target needs to be achieved over very extended periods. (Recalling from earlier
in this paper, Bob Maynard suggested a target of 4.0% annually above inflation.) For a typical worker, his/her
retirement planning horizon is multiple decades, spanning both career and retirement. History is reassuring
PAGE 14

over such extended timeframes. As shown in


Exhibit 6, since 1926, the annualized real return
over rolling 40-year periods has averaged 5.1% for
a simple 65/35 equity/bond portfolio, rebalanced
annually. In only four of the 48 rolling, 40-year
periods since 1926 were returns less than the target

We also looked at average annualized real returns


for this 65/35 portfolio over rolling 10-year
periods; the worst 10-year period return was
-2.3% and returns failed to reach that 4.0% target

Exhibit 6: 40-Year Real Returns for 65% Equity, 35% Bond Portfolio (1926-2012)
8%
Annualized 40 Year Rolling Real Returns

Retiring later is the


most effective way of
coping with reduced
benefits in the DC
construct. This implies
deferring the pension
or portfolio drawdown,
but most importantly,
implies that the
individual continues
to work.

4.0%, with the lowest (1940 to 1979) at 3.8%, just


short of that 4.0% goal.

7%
6%
5%
4%
3%
2%
1%
0%
Dec-65

Oct-73

Aug-81

Jun-89

Apr-97

Feb-05

Dec-12

Source: U.S. stock returns represented by data from Ibbotson Associates via Morningstar. Long-term U.S. Government bonds represented by data from
Ibbotson Associates via FactSet through yearend 2005 and the Barclays U.S. Treasury 20+ Year Index from 2006 to yearend 2012. Performance is for the
period Jan. 1926 to Dec. 2012. Past performance is not a guarantee of future results. One cannot invest directly in an index. Rolling periods represent a
series of overlapping, smaller time periods within a single, longer-term time period. For example, over the illustrated 87-year period, there are 48, 40-year
rolling periods, with the first one running from 1926 through 1965, the next from 1927 through 1966, and so on. There are 78, 10-year rolling periods with
the first one running from 1926 through 1935, the next running from 1927 through 1936, and so on.

in 22 of the 78 periods studied (28.2%). Thus,


taking a much longer-term perspective has helped
investors achieve targeted real returns. Maynard
looked back even further and found that the
65/35 portfolio delivered an average annualized
real return of 4.2% over rolling 55-year periods
between 1865 and 2010.
Reducing Benefits should not be seen as a
solution for DC participants, although for many
this will be the reality of retired life. In the DB
world, promised pensions are unlikely to be
reduced although in some instances this is being
challenged in the courts. For example, recent
Chapter 9 municipal bankruptcies in California
(Stockton and San Bernardino) and Rhode Island
(Central Falls) have raised the question of the legal
standing of DB plans relative to other municipal
creditors. The bankruptcy of the City of Detroit in
July 2013 may prove to be the landmark test case
in terms of size.

Retiring later is the most effective way of coping


with reduced benefits in the DC construct.
This implies deferring the pension or portfolio
drawdown, but most importantly, implies that
the individual continues to work. Every year of
retirement deferral then has a double impact: no
drawdown on assets combined with additional job
income. This is more feasible for some than others,
depending on type of work, health and willingness
to continue in the workforce. Currently this is
primarily an individual decision. To make this
part of an industry-wide solution, the national
retirement age must rise along with longevity.
Retiring later can have a powerful effect on
retirement income. It provides more years of
contributions, allows the assets additional years
to grow and a higher annuity rate applies to the
older age when retirement eventually occurs.
Take our hypothetical 25-year old from Exhibit 2,
contributing at the median 5.5% over a working
lifetime. Even with a respectable 4% real return
PAGE 15

The United States is


among those countries
effectively reducing
benefits by pushing the
retirement age higher.
The Social Security
full-benefit retirement
age is rising from 65
towards 67 for those
born in 1960 or later.

before costs, the lifetime savings resulted in


only 30% of final salary at age 65 using current
annuity rates. By delaying retirement to age 70,
his retirement assets would have grown enough to
provide 42% of his final salary at that age. To get
42% of final salary at the original retirement age
of 65 only by adjusting the lifetime contribution
rate, then that contribution would need to have
been over 8.5%, up from the original 5.5%.
But empirical evidence is clear that workers are
reluctant to take later retirement even when
there is a clear economic advantage to doing so.
Behavioral scientist Professor Richard Thaler
noted in The New York Times (July 16, 2011) that
at least 95% of those eligible for Social Security
start claiming benefits by age 66 (and about half
of those claim reduced benefits when first eligible
at age 62) when many people could realize a
substantially higher monthly benefit amount
by delaying claiming age until 70, even without
assuming any additional contributions. Even
though some of this preference for immediate
cash is likely a result of economic necessity, there
is still a clear preference by retirees to take less
today rather than much more tomorrow.
The United States is among those countries
effectively reducing benefits by pushing the
retirement age higher. The Social Security fullbenefit retirement age is rising from 65 towards
67 for those born in 1960 or later. It is always
difficult politically to increase retirement ages on
a national basis. In the United States, this has been
achieved by dodging the baby-boomer voting
demographic and phasing in a higher retirement
age only for those young enough not to feel any
immediate impact. In the United Kingdom a
more durable solution may have been found as
the retirement age is being indexed to longevity
improvement in the population. France is moving
the other way. Citing social justice, the Socialist
government has reduced the retirement age back
to 60 from age 62 where the prior administration
had raised it!
So now were back to a focus on Contributions.
This element has the most direct impact of the
three, and is the one that is most under the control
of participants and sponsors. A sufficient increase
in contributions could in theory go a long way

toward solving the problem for the younger


generations of workers.
The questions for plan participants hoping to boost
retirement income with higher contributions are:
Can they afford to sacrifice any
current income for a potential
deferred benefit?
Should society motivate them to do so
with high tax exemptions
on contributions?
And even with tax breaks and
affordability, will they in reality make
those contributions?
The power of increased contributions is high,
especially at younger ages. The Retirement Plan
Solution (Ezra, Collie and Smith, published by
Wiley Finance) shows that over a typical 40-year
career, each dollar of contributions on average
generates nine dollars of eventual spending power.
However, as shown in Section 1 of this paper, the
shortfall between todays median contribution
and the likely amount needed is so great that a
significant behavioral shift will be needed to have
any impact.
Changing behavior in this context is a
challenge, but may not be impossible. Voluntary
contributions to DC plans have been framed in
participants minds in the era when these plans
were supplemental top-ups, not the primary source
of retirement benefits. Annual contributions of
4-6% have become accepted norms, consistent
with the median DC plan contribution of 5.5%
cited in Section 1.
The goal must be to change the mindset so that
accepted norms move towards 15-20%. The two
most effective ways of achieving this goal are
likely to be:
1. increase participation through wider
use of automatic enrollment
2. increase contribution rates by
anchoring participant decisions
on a higher number as the norm
for contributions
Professors Richard Thaler and Shlomo Benartzi
authored the 2004 paper Save More Tomorrow
suggesting how to increase contributions using
behavioral techniques. The essence of the program
PAGE 16

is straightforward: people commit in advance to allocating a portion of their future salary increases
toward retirement savings. The authors essentially enabled apathy as a positive force by automatically
increasing contributions faster than pay rises unless an enrolled participant opts out of the Save More
Tomorrow arrangement.

...The Canadian
industry has pioneered
the path towards
variable benefits in
North America, moving
away from the pure
defined benefit model,
and sharing some of
the pre-retirement
investment risk with
the participant.

Behavioral methods have also proved successful in raising overall contribution rates elsewhere. We look
at lessons from some other countries in the next section. In sum, given that Investment returns are
substantially tied to the fate of the markets, the only major variable in the Retirement Rule that is under
our control is Contributions. For any long-term solution, for Benefits to be adequate, Contributions
must rise.

6. Lessons from Outside the United States


Section 6 Summary: Concerns over securing retirement assets are not unique to the United States.
We investigated retirement structures in select developed countries and share approaches that may have
relevance for the American pension community, including: less stringent mark-to-market rules to foster a
longer-term investment perspective; the introduction of variable benefit plans; approaches that result in higher
contributions; greater education and access to annuities as a distribution option for retirement plans; official
retirement age that is indexed to life expectancy; and automatic enrollment for plan participants.
While the post-World War II baby boom generation is a common factor across many developed nations,
its retirement problems and those of succeeding generations are by no means identical. It is outside the
scope of the paper to review the worldwide pensions industry, but we can learn from the experiences and
solutions applied elsewhere.
We have described the U.S. pension system as being in crisis. While its hard to find a developed country
that has no problems at all with its pensions system, there are countries that provide good examples of
how to avoid problems escalating to a crisis level.
We look at Canada, Australia, and the United Kingdom. Sharing a common language, and some common
background in culture and pensions approach, these three countries have developed differences in their
pension systems that appear to have avoided the crisis potential of a systematic breakdown.
Canada: A Stronger Benefits Safety Net

Canadas basic old age pension is complemented by the Old Age Security (OAS), which is paid out
to low-income retirees. With the social safety net, the need for replacement income in retirement is
materially lower than in the United States. Canadian pension expert Zev Frishman (member of the
Brandes Institute Advisory Board and EVP of Open Access Ltd.) estimates based on statements made
by leading Canadian actuaries that the replacement need for final salary for many if not most Canadians
may be around 50% compared to the 80% typically assumed in the United States.
Effectively, this reduces the strain on the Benefits element of our Retirement Rule, Benefits =
(Contributions + Investment Earnings) Expenses, B=(C+I)-E.
The need for high Contributions is therefore less than for the United States. In fact, because of the
means tested component of government pensions, those who contribute higher amounts towards their
retirement may actually be worse off, with claw-backs in benefits that offset the additional savings.
As a result, some of the pension failings that are common to both Canada and the United States are
less impactful in Canada. This includes the fall in funded status of DB plans and the problems for those
employees who dont have access to an adequate DB or DC plan.

PAGE 17

Many Canadian
DB plans allow a
commuted benefit to
be transferred to a
qualified DC plan when
an employee leaves.

Portability of accrued benefits in DB plans has been


noted as a major issue in the United States but is
less of a problem in Canada. Many Canadian DB
plans allow a commuted benefit to be transferred
to a qualified DC plan when an employee leaves
(and this is more commonly done than in the
United States). Commuted values are based on
Actuarial Standards Board formulas. Portability
may come at a price, but at least the employee has
the choice of deciding whether to accept this price
of transfer.
In the Investment element of the equation,
Canada has both pluses and minuses. On the
positive side, the large Canadian public sector
DB plans include some of the world leaders in
investment technique, plan management, and
governance. Ironically, the Canadian penchant
for increased pensions safety tends to constrain
these funds into meeting short-term mark-tomarket accounting targets in direct opposition
to their long-term real return strategies. At the
other end of the spectrum, individuals DC plans
not only suffer from the same behavioral choice
failings as their U.S. counterparts, but labor under
a much heavier expense burden for those forced
to use retail mutual funds.
In terms of plan structure, the Canadian industry
has pioneered the path towards variable benefits
in North America, moving away from the pure
defined benefit model, and sharing some of the preretirement investment risk with the participant.
The Ontario Teachers Pension Plan was a leader
in Canada in making one-off adjustments
in this way, with benefits adjusted for example
through deferred indexation or a later retirement
age, or contributions increased. The goal was to
share the impact of any underfunding between
sponsor and participant, while preserving the
longevity pooling, investment management and
low-expense advantages of a DB plan.
DB pension plans that use specific formulas to
tie changes in contributions and benefits to levels
of underfunding are being considered in several
Canadian provinces (pension plan supervision
and regulation is handled at the provincial, not
federal level). These are known as Shared Risk
Pension Plans (SRPPs) as they share the investment
risk between sponsor and participants. These are

already in existence in New Brunswick which has


passed enabling legislation. Saskatchewan, British
Columbia and Quebec are also working through
the enabling process.
The SRPPs have some similarities to new plan
structures proposed in the United States (see
Section 3 and Section 7), but are primarily
appropriate for larger plan sponsors due to the
high fixed cost that makes them (like a traditional
DB plan) rather expensive for small businesses to
set up. So they dont provide a solution for those
small businesses or for workers not covered by
other pension arrangements. This segment of
the market may be helped by the introduction
of Pooled Registered Pension Plans (PRPP)
which apply a variable benefits concept similar to
those proposed in the United States. But as with
SRPPs, the pace of progress depends on enabling
legislation at the provincial level.
Australia: Pushing Contributions Higher

The Australian approach has focused on the


Contribution element. In 1992, the Superannuation Guarantee (SG) was introduced,
with a modest mandated minimum employer
contribution of 3% of salary, applicable to all
employees. SG was designed to supplement the
government-funded old-age pension system.
By 2009, this minimum contribution had been
increased to 9%, and is scheduled to reach 12%
by 2019. The Australian government and pension
industry have very publicly placed emphasis on
the need for high contribution levels, and that
has helped influence individual contributions.
Typically around half of all contributions are
voluntarily made by participants.
Australian research firm Rainmaker notes that
twenty years ago when SG was introduced,
pension assets were $150bn. Now they have grown
ten-fold, to around $1.5 trillion, and Rainmaker
projects this total of pension assets (known as
super, the abbreviation of superannuation) to be
closing in on $8 trillion in another twenty years.
As well as a focus on contributions, theres also
a strong emphasis on the Investment return
element. Employer and participant contributions
are generally directed into professionally managed
funds, which compete on returns and expenses.
PAGE 18

... a 2013 mid-year


survey by the U.K.s
Department of Works
and Pensions looked
at actual experience
across nearly 2 million
workers and found an
opt-out rate of only
9%, a rather more
encouraging response.

While Australia is among the world leaders in


funding and managing the accumulation phase
of retirement planning, less emphasis has been
placed on the decumulation phase. If participants
use a managed drawdown strategy in retirement,
then there is a real risk of money death (running
out of assets during the retirees lifetime). For tax
reasons, Australia has a very undeveloped market
in annuities for private individuals. So there is less
public consciousness of the need for annuities, yet
a greater need for the super industry to focus
on provision of income rather than lump sums
in retirement. This is particularly true for those
at or approaching retirement age now. They have
had fewer years to accumulate the mandatory SG
contributions, which were set at a much lower rate
in the early years of the 1990s. Australian workers
now under 50 will typically be well-funded when
they reach retirement age, but thats less true for
the Baby Boom generation.

major step in taking the periodic political debate


over funding the state system off the public stage.
Mandatory auto-enrollment in a pension plan was
introduced in the United Kingdom in 2012, and is
being rolled out gradually toward full coverage by
2018. All employees earning above a minimum
level who have no other pension coverage must
be enrolled and those who do have coverage
elsewhere can opt-in. Mandatory minimum
contribution levels started at 2% of salary in 2012
(of which 1% is from the employer), and will
gradually rise to 8% by 2018 (at least 3% from the
employer). The contribution levels are modest
in comparison to the Australian SG pension,
for example, but the concept of auto-enrollment
puts the behavioral pressure on the participant to
decide deliberately not to save.

Two interesting developments are worth attention:


indexing of retirement age, and auto-enrollment
as the mandatory default position.

A research survey of close to 5,000 private and


public sector workers by U.K. insurer Aviva in early
2013 indicated that even with very low minimum
contribution levels, the reaction is mixed.
Of those not yet auto-enrolled, just over a third
claim they will opt-out, with the most common
reason being they cant afford to contribute. On
the other hand, around the same proportion say
they will stay opted-in. But a 2013 mid-year
survey by the U.K.s Department of Works and
Pensions looked at actual experience across nearly
2 million workers and found an opt-out rate of
only 9%, a rather more encouraging response.
To reinforce the power of auto-enrollment, the
U.K. system provides that those who opt-out
can only do so for three years. After that, the
system automatically opts them back in, unless
they again make a decision to opt out. Only the
most determined or the most cash-strapped will
resolutely fail to save!

Similar to the situation in the United States,


increased longevity puts financial pressure on
the government to raise the national standard
retirement age. In the past decade, several Pension
Acts have been passed that (among many other
provisions) set out a gradual rise over coming
decades in retirement age in line with improved
mortality, for example lifting the male retirement
age from 65 (currently) to age 68 by 2044.
Currently under consideration are proposals
to index the retirement age to improvements in
mortality. If these are successful, this could be a

Much advanced work on pension plan design


(in the United Kingdom and elsewhere) is being
coordinated or produced by the Pension Institute,
affiliated with the Cass Business School at City
University in London www.pensions-institute.
org. We close this section with a quote from the
conclusion of their 2013 paper Good Practice
Principles in Modeling Defined Contribution
Pension Plans, by David Blake and Kevin Dowd, as
it summarizes well the reality facing the industry,
not only in the United Kingdom, but in the United
States and much of the rest of the world.

United Kingdom: A Behavioral Approach to


Benefits and Contributions

The U.K. pension system shares some of


the problems that afflict the U.S. system: an
underfunded DB plan sector, low voluntary
contributions, job-hopping and lack of
portability for DB accounts. As in the United
States, many corporate DB plans are being closed
to new entrants. The United Kingdom has led
the United States in pension buy-ins and buyouts, where the liabilities are moved off the plan
sponsors balance sheet and taken over typically
by insurance companies.

PAGE 19

Applying these principles will often have uncomfortable implications for plan members. They will often
show that if members want to have a particular standard of living in retirement, then they will be making
insufficient contributions to their pension plan, following a recklessly conservative investment strategy,
planning to retire too early, or some combination of these. Practitioners have told us that revealing this
reality to members might put them off contributing to a pension in the first place. We would argue that it is
much better to be realistic about the future than to hide your head in the sand.
The NCPERS Secure
Choice Plan explicitly
uses the cash balance
plan as its model,
but given the legislative
negotiations of
state-by-state
implementation, the
final versions may vary
in some respects.
The Harkin Plan sets
out a legislative outline
on broad principles,
leaving the private
sector to implement
within that outline.

7. The Retirement Gap: Proposed Solutions at the National Level


Section 7 Summary: Two proposals at the national level aim to fill the gap for workers who do not have
access to an existing DC or DB plan: NCPERS Secure Choice and Senator Harkins USA Retirement Plan.
Both use the cash balance plan concept and both aim to solve the issues of investment risk, longevity risk
and the need for professional management. There are significant differences between these proposals, but
they could co-exist. The NCPERS proposal uses a state-by-state approach, while the USA Retirement Plan
proposes a federal framework. We believe both are sound, and as long as contribution rates are adequate,
these plans can play an important role in the industry.
Since the 2008-9 financial crisis, proposals to solve the pensions crisis have been suggested by a number
of sources, both from within the pension industry and from the political area. Some have been focused
on specific local problems, for example where municipal or state funds have fallen to such low levels of
underfunding that benefits are threatened. But two proposals have focused on a national scale, aiming
to remedy the shortfall in eventual pension benefits as workers are moved from defined benefit plans to
defined contribution plans as we have discussed. They also aim to provide pension benefits for employees
who are not covered by either DB or DC plans.
Note that neither of these proposals addresses the problems within existing DB or DC plans. They focus
on adding a broad-based pension solution that will sit on top of those existing DB and/or DC plans
with the goal of bringing eventual retirement income closer to an adequate replacement rate to maintain
retirees living standards as they age.
In September 2011, the National Conference on Public Employee Retirement Systems (NCPERS)
proposed Secure Choice Pensions in a detailed white paper. (www.retirementsecurityforall.org/
document.php?f=plan)
In July 2012, the U.S. Senate Committee on Health, Education, Labor & Pensions under the Chairmanship
of Senator Tom Harkin (D-Iowa) proposed Universal, Secure and Adaptable Retirement Funds (USA
Retirement Funds) www.harkin.senate.gov/documents/pdf/5011b69191eb4.pdf
The NCPERS proposal is in the process of being adopted by a number of states. California has enacted
enabling legislation (SB-1234, the California Secure Choice Savings Trust) but additional steps are
needed for implementation. According to Hank Kim, Executive Director of NCPERS, Oregon has also
taken initial steps, while Vermont, Ohio and Maryland are in the early stages of a similar process.
Senator Harkin has stated his intention to move forward with the USA Retirement Funds proposal
(the Harkin plan) during 2013. He has also announced he will retire from politics at the end of 2014;
this would presumably be his main agenda until then.
There are strong similarities between the two proposals: they both aim to provide a solution to fill the
same perceived gap in pension coverage. Importantly, these proposals are not for additional DB or DC
plans. They both borrow concepts from the cash balance plan concept that ran into practical difficulties
when introduced by corporate plan sponsors in the private sector (see Section 3). The cash balance
concept and other hybrids between DB and DC plans fit well with todays pension needs. Despite the
rocky start from a legal perspective, the Pension Protection Act of 2006 clarified the legal status of these
plans and now, cash balance plans have become the fastest growing segment of the pension market,
PAGE 20

While for a corporate


cash balance plan,
portability means ease
of moving the account
to a new pension plan
when changing jobs,
the Harkin and Secure
Choice Plans go one
step further as multiple
employer plans. They
allow participants to
stay in the same plan
in many cases even if
they do change jobs.

doubling in assets in the decade to 2010, according


to Department of Labor statistics. However, while
they are now close to $1.0 trillion in assets, these
plans are still small compared to the nearly $8.0
trillion in traditional private and public sector
defined benefit plans.

balance plan, portability means ease of moving


the account to a new pension plan when changing
jobs, the Harkin and Secure Choice Plans go one
step further as multiple employer plans. They
allow participants to stay in the same plan in many
cases even if they do change jobs.

The NCPERS Secure Choice Plan explicitly uses


the cash balance plan as its model, but given
the legislative negotiations of state-by-state
implementation, the final versions may vary
in some respects. For example, one variation
on Secure Choice that could be implemented
immediately without needing legislative change
would be a simplified version, limited to employers
with fewer than 100 workers.

We focus now on the similarities and differences


between the Harkin and Secure Choice proposals.

The Harkin Plan sets out a legislative outline on


broad principles, leaving the private sector to
implement within that outline. So while these
two new proposals draw on elements of the cash
balance plan, the eventual results may not strictly
fit the cash balance plan definition.
However, there are similarities at the heart of
these plans, addressing investment risk, longevity
risk and the need for professional management:
A reported account value that
varies over time representing each
participants share of the total assets
of the plan
Assets are pooled and professionally
managed by the plan, not
the participant
The default benefit at retirement
is a lifetime annuity (even if some
part of the benefit may be taken as a
lump sum)
But most cash balance plans protect participants
from some investment risk by crediting a specified
rate of return to participant accounts. And if the
assets fall short over time, its up to the sponsor
to make up the difference. Both these proposals
build in flexibility to vary the benefits depending
on actual performance of the plan and the Harkin
plan quite explicitly takes employers off the
hook in terms of any fiduciary responsibility to
make up funding shortfalls.
Most hybrid plans offer superior portability over
traditional DB plans. While for a corporate cash

Common Factors:
Design

Primarily designed for the private


sector with an emphasis on small
and mid-sized employers who do not
provide adequate pension plans
Complements existing DB and
DC plans without the intention of
replacing or changing them
Multiple employer coverage (this is
a pioneering concept and distinct
from multi-employer plans such
as Taft-Hartley plans that cover
union employees regardless of
specific employer)
Portable on changing jobs
Transparent account values with
immediate vesting of contributions
Requires legislative change, including
amendments to ERISA
Management

Independent trustees, drawn from


public and private sectors (also
including retirees for USA plan)
Professionally managed investments
Seeking economies of scale in fees
and expenses relative to individual
pensions (e.g., 401(k) or IRA)
Contributions

Employers must contribute at a


minimum level, and can choose to go
higher
Employees are not mandated to
contribute but can choose to do so

PAGE 21

Benefits

Provides a lifetime pension as the default benefit


The eventual pension benefit may vary depending on investment returns and other factors

Both proposals
allow employees to
make additional
contributions, but these
will be subject to the
same behavioral factors
that already impact
401(k) contributions.

While the broad concepts are similar, there are important differences in the proposals. The Harkin plan
envisages a mandatory nationwide approach, covering all eligible workers (i.e. those offered inadequate
or no pension plans). The NCPERS proposal aims to leverage the existing state-level public pension
fund infrastructure to offer similarly managed pension funds to employers and their workers. Exhibit
7 illustrates some key differences between the two proposals. Note that the NCPERS Secure Choice
Pension is explained in detail in its proposal, while the Harkin/USA approach is only outlined in its
proposal, with detail expected when Sen. Harkin introduces a legislative proposal later in 2013.
EXHIBIT 7: Comparison of Harkin Plan and NCPERS/Secure Choice

Managed by
Supervised by
Employer fiduciary liability
Once started, pension guaranteed
at that level as minimum
Number of plans
Subsidizes low income workers
Employers not offering an adequate
pension plan must participate

Harkin/USA

NCPERS/Secure Choice

Private sector

Public sector
(in parallel with existing funds)

Federal

State

None

Some (on withdrawing from a


fund when it is underfunded)

No

Yes

Set by market competition

50 (one per state)

Yes

No

Mandatory, through
payroll deduction

Voluntary

Source: Brandes Institute

Comment on the Proposals

The concept of filling the retirement gap with this type of broadly available hybrid plan proposal is a
sound one in our view. Given the early stage of these proposals, it is not clear which would be a better
solution, and we would expect the proposals to be modified as the political process unfolds. The two
approaches are not mutually exclusive, and could co-exist well in a competitive market. Tax policy will
also be a major factor in determining eventual success, especially any decisions on the maximum level
of deductible contributions.
When we look through the prism of the Retirement Rule (B=(C+I)-E), the strengths and weaknesses of
these proposals are much clearer.
Both Harkin/USA and NCPERS/Secure Choice use the common attributes with a DB-type plan structure
to provide improvements in Investment returns (through professional management) and Expenses
(through economies of scale). Critically, both proposals include portability, which is a real weakness of
traditional DB plans in todays world of rapid job changes.
The NCPERS/Secure Choice proposal provides for the professional investment management of assets
alongside existing State pension systems. It is implied (but not explicit) that the asset allocation policies of

PAGE 22

In the NCPERS/Secure
Choice proposal,
expenses are expected
to be kept in line
with the state plans
with which they
combine investment
and administrative
expenses. For the
Harkin/USA proposal,
the expense control
mechanism is market
disclosure.

the Secure Choice funds would be similarly longterm focused as are those State funds. While Secure
Choice is already moving toward implementation
in some states, the Harkin/USA proposal still has
to go through the political process. While its goal is
bi-partisan approval, some aspects of the proposal
may be contentious.
The Harkin/USA proposal would turn the asset
management role over to private sector firms
under the guidance of independent trustees.
These independent boards are central to longterm success. If they function effectively, the USA
funds would be run with the necessary long-term
investment goals and allocation policies that are
required to meet adequate real return targets. If
the boards are ineffective or their independence is
subsumed to the influence of the plan providers,
then long-term success will be elusive.
In the NCPERS/Secure Choice proposal,
expenses are expected to be kept in line with the
state plans with which they combine investment
and administrative expenses. For the Harkin/
USA proposal, the expense control mechanism is
market disclosure. Competition between private
sector plan managers should help keep expenses
down, especially if as expected, transparency in
fee comparisons are mandated in the proposed
legislation. However, the possibility of an
oligopoly of a few large and dominant investment
firms may offset this.
But the bigger issue once again is Contributions.
As we have seen, this is a key determinant of the
long-term success for any pension plan. While
the Harkin/USA proposal includes a mandatory
employer contribution, it does not specify the
rate. The NCPERS/Secure Choice proposals
illustrations use contribution rates of 5% and 3%,
which may be realistic but even the 5% level does
not move the dial enough to be the primary
source of pension benefits. That illustration
suggests that a 25-year old working for forty years
would be able to replace only 29% of final salary
with the Secure Choice benefit. Social Security
could provide a similar amount, but the balance
needs to be filled by additional personal savings.

NCPERS advocates that a total of at least 18%


of salary be contributed toward any individuals
retirement from all sources, including Social
Security as well as pension plans.
Both proposals allow employees to make
additional contributions, but these will be subject
to the same behavioral factors that already
impact 401(k) contributions. We believe that any
eventual successful solution will require a total
contribution rate of at least 15% of salary through
employer and employee contributions (including
any amounts contributed to 401(k), IRA or other
DC plans).
Comment on Whats Not in the Proposals

Its also important to understand what these two


proposals do not address. They are both quite
clear that they aim to complement existing DB and
DC programs. So any inherent problems inside
those structures are unaffected. As we explained
earlier, these problems are much more prevalent
in DC plans, and are focused primarily on the
Contribution and Investment return elements.
The good news is that the Contribution shortfall
within a DC structure may be much less damaging if
either or both of these hybrid proposals eventually
become widely available. For a chronically undercontributing DC participant, inclusion in such a
plan may boost his/her total contribution level
materially. That of course assumes the new plan is
not used as an excuse by the participant to lower
or eliminate contributions to the DC plan. Apathy
may then be the participants friend!
For Investment returns though, the behavioral
risks remain embedded within DC plans. Even
if contribution rates are maintained or increased,
it has been demonstrated that participants
investment choices and timing are generally
adversely impacted by behavioral factors with the
result of reducing long-term investment values.
We propose a simple solution for this Investment
return problem. If and when such a nationwide
system of hybrid plans is set up, any participant
should be allowed to roll part or all of his/her assets

PAGE 23

in any DC plans into one of these plans. While the participant still has investment risk, the behavioral
impact of investment choices could be removed, the expense level may be lower, and longevity risk for
the participant (a big problem for DC plan participants) could be reduced or possibly eliminated.

8. Evaluating Hybrid Plan Solutions


The newer hybrid
plans require various
legislative changes and
regulatory approvals.
We support moves
that make these
plans easier to
implement as they offer
features that address
current challenges for
participants and plan
sponsors, alike.

Summary of Section 8: Hybrid plans may emerge as viable, long-term solutions. To achieve success, these
plans must:
Structure management of investments and operational costs to provide adequate long-term
returns, and contain expenses
Provide pooling of longevity risk
Allow portability in an era when changing jobs is the norm
Use behavioral techniques to encourage participation and raise contribution rates
Enable participants to understand in simple terms how well prepared they are for eventual
retirement
The newer hybrid plans require various legislative changes and regulatory approvals. We support moves that
make these plans easier to implement as they offer features that address current challenges for participants
and plan sponsors, alike.
We have argued that any solution must deal with the Retirement Rule elements: I, E and particularly C.
But as a practical matter, the structure of any broad solution must be:
appropriate and practical for both public and private sectors
supported and encouraged by government (federal, state and local)
reinforced as opposed to hindered by behavioral biases (both of participants and sponsors)
In general, recommendations by political and industry experts all aim to boost contributions and
investment returns, while containing costs. But as the saying goes, The devil is in the details.
Our assessment of the two national-level hybrid proposals in Section 7 is that they have a good chance
of success as long as the contribution levels are high enough to allow the math of the Retirement Rule
to work.
But as explained in Section 3, these are not the only approaches that use hybrid structures. Cash balance
and adjustable plans in the United States and Shared Risk plans in Canada all offer a route for plan
sponsors to maintain key pooling elements of the traditional DB plan while shifting some or all of the
investment risk to participants and hence reducing the risk to sponsors.
It may be that the broadening category of hybrid approaches will provide an effective long-term solution
for the industry. We suggest five criteria that need to be incorporated in such a solution.
Specifically, how well do the plans:
1. Structure management of investments and operational costs to provide adequate long-term
returns and contain expenses
2. Provide pooling of longevity risk
3. Allow portability in an era when changing jobs is the norm
4. Use behavioral techniques to encourage participation and raise contribution rates
5. Enable participants to understand in simple terms how well prepared they are for
eventual retirement
PAGE 24

Traditional DB plans didnt meet all these criteria (for example #3), but as previously noted, traditional
DB is increasingly unavailable as a retirement option. DC plans generally struggle with numbers 1 and
2, and need to do better with numbers 4 and 5.

It seems inevitable that


over the long-term,
traditional DB plans
will play a declining
role in retirement
planning at least
for private sector
employees. It is by no
means inevitable in our
view that DC plans will
take over as the only
or even the dominant
alternative.

Hybrid plans, including the two national-level proposals, are structured to score well on the first three
criteria. Depending on how they are implemented, they also have the potential to satisfy the last two
criteria as well. It is likely that implementation will bring greater awareness of the hybrid concept, and
may even redefine the DB vs. DC debate into a real three-way contest.
The national-level proposals clearly state that they aim to supplement existing DB and DC plans,
not replace them. However cash balance plans are already rapidly stepping into the gaps vacated by
traditional DB plans, and adjustable plans also may gain popularity. It seems inevitable that over the
long-term, traditional DB plans will play a declining role in retirement planning at least for private sector
employees. It is by no means inevitable in our view that DC plans will take over as the only or even the
dominant alternative.
But we are still at an early stage in this contest. Except for cash balance plans, the hybrid approaches
are still not widely used, and require more development work as well as various legislative changes and
regulatory approvals before they are cleared to be significant challengers to the dominance of traditional
DB and DC. Exhibit 8 summarizes their status.
In a free market (assuming no regulatory bias or impediments), long-term success should go to the
structures that provide the best outcomes for both participants and plan sponsors. Hybrid plans appear
to be well-designed in this context. As detailed earlier in this paper, most of todays DC plans need
significant improvement to meet the needs of participants for adequate retirement benefits. Design
improvements are feasible: pooling longevity risk through annuity features, improved participation and
contribution rates, and avoidance of behavioral investment errors. But they are not inevitable, nor is the
dominance of DC in retirement saving.
EXHIBIT 8: Hybrid Plan Approaches in North America
Status

Jurisdiction

Legal approval
needed?

Investment risk borne


by participant

Harkin/USA

Outline proposal

Federal

Yes

All

NCPERS, Secure
Choice

Detailed proposal

States

Yes

Partial

Established

Federal

Approved

Partial

Canadian SRPP

Newly introduced

Canada provinces

Yes

Partial

Adjustable

Newly introduced

Federal

Yes

Partial

Double DB

Detailed proposal

Federal

Yes

Partial

Plan type

Cash balance

Note: descriptions of these plans can be found in earlier sections as follows: Harkin/USA and NCPERS Secure Choice, Section 7; Cash Balance, Section 3;
Canadian SRPP, Section 6; Adjustable and Double DB, Section 3.
Source: Brandes Institute

PAGE 25

9. The Brandes Institute Advisory Board Perspective

We believe adaptations
of hybrid plans will
emerge as competitors
to existing DC plans
and alternatives to DB
if the latter continue
to be phased out by
plan sponsors.

Summary of Section 9: In theory, DB and DC plans that are well designed, well-funded and properly
invested can deliver adequate retirement benefits. In reality, some DB plans and most DC plans do not meet
these objectives. We believe adaptations of hybrid plans will emerge as competitors to existing DC plans and
alternatives to DB if the latter continue to be phased out by plan sponsors. Regardless of plan structure, we
believe the following six recommendations are needed to give participants the opportunity to reach their
retirement goals:
Contribution levels should be higher, in the range of 15% of salary each year.
Assets should be professionally managed.
Plan assets should be portable across employers.
Longevity risk should be minimized by pooling individual participants assets with others.
Retirement age should be deferred where feasible, increasing both savings and benefits.
Cost control and disclosure must be emphasized, not only for DC plans, but for any new hybrid
design that aims to compete successfully for retirement savings.
The retirement train is pulling into the station; it is our collective responsibility to get passengers off the
tracks and onto the platform.
The Brandes Institute Advisory Board includes nine external members with extensive experience in
the retirement and fund management industry worldwide. All have been involved in this research and
we are grateful for their input and opinions. A list of Board members is available at www.brandes.com/
Institute/Pages/BIBoardAndStaff.aspx and we thank all of them for their detailed and thorough work in
providing guidance and reviews for this paper. However, the views expressed in this section are those of
the Brandes Institute and should not be taken as personal or professional views of any specific Advisory
Board member.
In conclusion, we reiterate that regardless of plan structure, we believe that the most effective way to
address the pension crisis must include a determined focus on the Retirement Rule (B=(C+I)-E). Here,
we summarize our central arguments and offer recommendations related to:
1. Contribution Levels

4. Longevity Risk

2. Professional Management

5. Retirement Age

3. Portability

6. Expenses

For existing DB and DC plans, neither rates a top grade in all six of these areas. DB plans fail on
portability in the United States. With increasing numbers of DB plans closing, the DB plan structure is
no longer widely available as a contribution mechanism. And while DC plans score well for portability,
they generally fall short to some degree on most of the other criteria.
Nevertheless, we believe that in theory, either DB or DC plans, IF well-designed, well-funded, and wellinvested, can deliver adequate retirement benefits. In reality, some DB plans and most DC plans do not
meet those conditions.
So can hybrid plans fill the gap? At present the only approved and viable contender among
hybrid plans is the cash balance structure, as other hybrids are still at a very early stage in the
introduction/approval process. Nevertheless, we believe that adaptations on this theme may prove
to be real competitors to DC plans, as traditional DB plans continue to decline in availability over
the long term. The impact will likely be felt first in the private sector given the rapid erosion of
traditional DB plans in that sector, but ultimately may gain wider acceptance with public plans
as well.
PAGE 26

Regardless of which structure wins out, we


believe contribution levels remain a key part of
a true solution. Even if hybrid plans can provide
a workable replacement to todays DB and DC
plans, unless participants and/or sponsors make
adequate contributions, the effort is in vain.
We believe contribution
levels remain a key
part of a true solution.
Even if hybrid plans
can provide a workable
replacement to todays
DB and DC plans,
unless participants
and/or sponsors make
adequate contributions,
the effort is in vain.

Our 6-Point Recommendations


1. Contribution Levels: Current levels are
inadequate, especially when they are voluntary on
the part of the employee or employer. In addition,
many workers dont even have access to employersponsored tax-deferred retirement plans. We
support any efforts to increase contributions. In
particular we advocate behavioral solutions that
use participant inertia to increase contributions
rather than avoid them. That suggests a default
option of enrolling employees where plans are
offered and requiring employees to opt out
(rather than requiring employees to opt in). As an
example, we endorse Save More Tomorrow by
Professors Richard Thaler and Shlomo Benartzi
that increases saving by arranging for employee
contribution rates to rise automatically over time.
2. Professional Management: Investment policy
and implementation should be managed by
professionals wherever possible. While some
individuals may have the necessary expertise and
temperament to manage their savings effectively,
the vast majority do not, leaving them vulnerable
to behavioral and other mistakes that can
significantly reduce their long-term returns. We
believe a target of at least 4% real annual returns
is vital to helping investors toward a reasonably
secure retirement. And reaching that target is
more likely by creating an avenue for most workers
to access professional management. If the Harkin/
USA and/or NCPERS Secure Choice proposals
become reality, we urge allowing transfers from
existing DC plans into these hybrid plans.
3. Portability: This feature is important, especially
for younger generations in a world of frequent job
changes. While DB plans could in theory offer
portability, in practice most do not, at least not
in the United States. Transparent account values
are a feature of DC plans and the different types of

variable benefit plans. We believe that portability


is a must for any future pension structures.
4. Longevity Risk: The risk of running out of
assets during ones lifetime is a growing concern.
It has not yet hit its stride in terms of financial
impact as the massive baby boom generation is
still in its early retirement years. It will become
a much bigger issue over the next two decades.
Hybrid plans, including the Harkin/USA and
NCPERS Secure Choice proposals, seek to
substantially reduce longevity risk, even though
in some cases eventual lifetime income could be
more variable than in a traditional DB plan. There
are other strategies that healthier and wealthier
individuals may choose to reduce longevity risk;
for more information on these, please see the
Brandes Institute paper, Boomers Behaving Badly.
5. Retirement Age: Deferring retirement
generally increases savings and potential benefits.
For the average American worker, five years of
additional work can raise a pension benefit by the
same amount as an additional 3% in contributions
over a whole career (see Section 5).
6. Expenses: While not the most critical
factor, expenses must be carefully considered
and incorporated into an effective solution.
Transparency of costs is helpful: what you cant
measure, you cant manage.
Recent advances in expense disclosures in DC
plan costs are a positive, and we would encourage
transparency of costs in hybrid plans as well.
Economies of scale should also benefit cost
control, both in operational and investment
management expenses.
For those of us involved professionally in the
retirement industry, whether plan sponsors,
trustees, legislators, investment advisers,
consultants or other service providers, we have the
experience and training to see how this pension
crisis is likely to develop over the coming
years. We have a duty to suggest and implement
practical solutions. As we said in the introduction
to this paper, the retirement train is pulling into
the station. And its our collective responsibility
to get the passengers off the tracks and onto
the platform.

PAGE 27

The Barclays U.S. Treasury 20+ Year Index is an unmanaged index consisting of U.S. dollar-denominated, U.S. Treasury-issued securities. The Index represents public obligations of the U.S. Treasury with a remaining maturity of at least 20 years. The index is a total return index which reflects the price changes
and interest of each bond in the index.
This material was prepared by the Brandes Institute, a division of Brandes Investment Partners. It is intended for informational purposes only. It is not
meant to be an offer, solicitation or recommendation for any products or services. The foregoing reflects the thoughts and opinions of the Brandes Institute.
The information provided in this material should not be considered a recommendation to purchase or sell any particular security. It should not be assumed
that any security transactions, holdings or sector discussed were or will be profitable, or that the investment recommendations or decisions we make in
the future will be profitable or will equal the investment performance discussed herein. Strategies discussed herein are subject to change at any time by
the investment manager in its discretion due to market conditions or opportunities. Please note that all indices are unmanaged and are not available for
direct investment.
All illustrations are hypothetical. Your actual results may vary. No investment strategy can assure a profit or protect against loss.
Withdrawals from tax-deferred retirement plans, such as traditional 401(k) plans and IRAs, are typically taxed as ordinary income and, if taken prior to age
59 , may be subject to an additional 10% federal tax penalty. Withdrawals must begin by April 1 of the year after the year in which you reach age 70 1/2.

The Brandes Institute


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OCTOBER 2013

Annuities have fees and expenses, and they carry a certain level of risk. Any guarantees are contingent on the claims-paying abilities of the issuing company.
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if the contract is surrendered before age 59 , you may be subject to a 10% federal income tax penalty. The earnings portion of annuity withdrawals is
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