The United States of America (US) has seen a sharp drop in the number and size of defined benefit (DB) pensions in the private sector, but these plans continue to be widely used in the public sector, as the majority of states and cities sponsor DB pension plans for their employees.
These pension plans have, however, been marked by a funding problem. It is estimated that unfunded liabilities for US state and city pension plans, the shortfall between the present value of plan assets and future benefits owed, exceeds $5 trillion.
Kieyam Gamieldien, General Manager: Income and Guaranteed Solutions at Old Mutual, notes that decision makers in the US, and around the world, need to explore new ways to deliver a decent retirement to their employees at a more affordable cost. Thus, the challenge is to develop a third type of retirement plan, which manages risk better than a Defined Contribution (DC) plan while operating at the lower costs of a DB plan. This third way has been described as a collective defined contribution (CDC) plan.
“Given South Africa’s history of moving from DB to DC pension plans and applying investment and risk sharing principles in the form of with-profit funds in the DC space, we have expertise and experience that could assist in overcoming the challenge in the US. With-profit principles could well be the best approach to developing the optimal design of a CDC plan. South African industries usually take their lead from the developed world, but in this case the US can look at what we’ve done in South Africa and implement local ideas on a global scale,” he says.
DB funds provide retirees with an income related to their pre-retirement salary, but employers are at significant risk, he explains. “While DC funds mitigate risk for employers it exposes retirees to the risk of insufficient and uncertain retirement income. It is one of the reasons why the public sector unions in the US have remained resistant to DC plans, saying that employees with limited financial knowledge could make poor investment choices, which would leave them at risk for insufficient retirement income.”
“The challenge is therefore to develop a retirement plan that manages the risk for members better than a normal DC plan, while providing reasonable retirement benefits similar to those offered in a DB plan,” Gamieldien states.
Investment and longevity risk sharing are key principles used to better manage the risk associated with retirement outcomes. “These principles are integral to Old Mutual’s smoothed bonus and with-profit annuity solutions. The solutions employ these effective risk-sharing principles and have a proven track record of delivering long-term real returns while reducing the risk associated with uncertain retirement outcomes,” says Gamieldien.
He states that when smoothed bonus solutions faced regulatory challenges in South Africa, Old Mutual investigated various ways to replicate with-profit principles via dynamic investment strategies. “We wanted to develop a dynamic asset allocation solution where the investment risk could be reduced for members of a DC fund. However, our analysis showed that such solutions on its own negatively affected future expected investment returns as well as not dealing with longevity risk. Locally we were able to convince the regulator that the smooth bonus and with-profit solutions were a good alternative to the retirement problem as it leads to improved outcomes for the members collectively, especially during tough economic times.”
“While we don’t advocate that smoothed bonus is the solution for everyone, we simply believe that the smoothed bonus and with-profit annuity principles can be applied to find a good balance by sharing investment and longevity risk especially under a CDC plan,” he notes.
This thinking was recently lauded by the Massachusetts Institute of Technology (MIT) Golub Centre for Finance and Policy where a team from Old Mutual was announced the winner of a contest hosted by MIT to design a collective DC retirement plan for public sector employees.
According to the judges, the winning team’s proposal featured “a clever combination of financial engineering and intergenerational risk sharing. Their model, which allows portfolio managers to take on more risk in stock and bond selection based on the size of an intergenerational reserve fund, produces a higher average benefit for retirees than a static investment strategy.”
The team was also honoured at the GCFP annual conference that was held in September in Cambridge, Massachusetts.