Pension Scholar: DB vs. DC Debate is 'Dysfunctional'

The Director of the Rotman International Centre for Pension Management thinks it’s time to quit the DB vs. DC argument, and come up with a new breed of pension plan.

(September 20, 2012) – Traditional defined-benefit (DB) and defined contribution (DC) plans both fail to meet plan sponsors’ dual goals of adequacy and affordability, according to Keith Ambachtsheer, head of the University of Toronto’s Rotman International Centre for Pension Management.

“The time has come to stop defending the indefensible,” Ambachtsheer writes in a just-published article for the Rotman International Journal of Pension Management, which he also heads.

He argues that one of DB plans’ oft-touted advantages—that they provide simple and complete contracts between retirees, employees, and employers—doesn’t hold water: “The value of the guarantees embedded in DB contracts is often understated by using discount rates that embody the assumption that projected risk premiums will become realized risk premiums. In game theory terms, this is a mechanism for shifting wealth to current plan participants from whoever is underwriting the embedded payment guarantees. These “paper” wealth transfers are eventually realized through demands that benefits be increased in good times, and by enforcing the embedded payment guarantees unwittingly made by guarantors in bad times. The seriously underfunded condition of many public-sector plans today is finally forcing public-sector employers to recognize these fundamental design problems of traditional DB plans.”

Where DB plans by nature tend to become excessively expensive, he argues, DC plans tend to fall down on both the affordability and adequacy fronts.

Want the latest institutional investment industry news and insights? Sign up for CIO newsletters. 

The Teachers Retirement System of Texas (TRS), a $107.4 billion DB plan, came to the same conclusion about DC earlier this month. At the behest of the Texas Legislature, the fund studied a potential switch to DC and hybrid structures. According to the pension’s models, switching new members to either a self-directed or pooled defined contribution plan would increase unfunded liabilities by $14.7 billion, or 61%. “It is important to understand why the alternative plans modeled by TRS are more expensive than the current defined benefit plan to provide the same level of benefits,” TRS’ report explained. “The main reason for the expense difference is that most alternative plans do not generate the same level of investment returns as the defined benefit plan.”

While Texas Teachers’ doesn’t seem keen on restructuring any time soon, Ambachtsheer did come up with a set of design questions for modern employment-based pension plans:

1) How much is the employee/employer willing to pay to achieve that target pension?

2) What is a reasonable prospective net real investment return that can be assumed on a conservatively invested portfolio of retirement savings today? What additional reward for risk taking is it reasonable to project?

3) What respective lengths of the work and post-work periods should be assumed in funding the plan? How is retirement-age flexibility best built into the plan design?

4) To what degree, and how, should uncertainties about net real returns, inflation, and longevity be mitigated? If the plan offers guarantees, what are the mechanisms through which these guarantees are priced and enforced?

In conclusion, Ambachtsheer makes the point that many major pensions, and Texas Teachers’ would surely qualify, are well-governed, modern and high-performance organizations. These institutions, he argues, would be better off dropping the DC vs. DB debate and focus on crafting plan structures that “strike an intelligent balance between the dual goals of adequacy and affordability.”

Read Ambachtsheer’s whole article, titled “The Dysfunctional ‘DB vs. DC’ Pensions Debate: Why and How to Move Beyond It,” here.

(September 20, 2012) — A panel of European investors has urged regulators to avoid bowing to pressure from lobby groups and maintain a push for stringent auditing rules that protect and inform potential and existing shareholders.

European institutional investors and investor associations – including the UK’s Universities Superannuation Scheme, RPMI Railpen, Local Authority Pension Fund Forum, and others, representing €750 billion in assets – have written to European Commissioner Michel Barnier to highlight concerns over the watering down of what they see as much‐needed reforms to the European audit industry.

The group said that in their current state the proposed reforms played into the hands of audit firms and companies, rather than helping potential and existing investors fully investigate accounts and reports and evaluate their holdings.

The letter highlights three main areas that the reforms either needed to tackle or would put shareholders at a disadvantage:

For more stories like this, sign up for the CIO Alert newsletter. 

1. Improved Audit Committee transparency – investors need to know what the critical areas of debate have been between auditors and corporate audit committees.

2. Audit firm rotation at least every 15 years – regular audit firm rotation ensures a “fresh pair of eyes” and provides a necessary check on the incumbent audit firm’s work.

3. Limited non‐audit services – while some non‐audit work by audit firms may be permitted, it potentially threatens auditor independence. Non‐audit fees should therefore not exceed 50% of audit fees.

At the end of last year, associations representing corporations across Europe complained that reform proposals had gone too far and would unfairly punish business.

In December, several of these associations approached Commissioner Barnier, saying the proposals were unnecessary and would pile on costs for European businesses. These claims were echoed by the world’s largest auditing companies.

Today’s letter from investors hit back at these claims: “We are aware, of course, that the large audit firms have invested in an intense lobbying effort to weaken or reverse important reform proposals. We believe that it is vital that policy makers do not lose sight of the purpose of the audit. The audit is intended for shareholders, to permit them to rely on accounts as a basis for monitoring executives’ performance. The audit is not for executives, and it is not for the auditors.”