Developing a third type of retirement plan

Editor's note:

This piece originally appeared in Real Clear Markets.

Since 1980, the U.S. has experienced a sharp decline in the number of companies and their employees participating in defined benefit pension plans. In such plans, the employer is legally obligated to provide its employees with a defined schedule of retirement benefits. But these plans became disfavored after companies were required to disclose their unfunded liabilities for promised retirement benefits.

By contrast, defined benefit pensions are still prevalent in the US public sector, in states and cities.  Unfortunately, the unfunded liabilities of these defined benefit pensions in the public sector are huge. In 2016, for example, the total unfunded liabilities of state defined benefit plans approached $1 trillion.

Nevertheless, public sector unions understandably resist the move to a defined contribution plan, such as a 401(k) plan. In such a plan, employees (and sometimes their employer) contribute to tax-advantaged accounts, which are invested according to the employees’ choices. However, the employees bear the risk that their contributions and investments do not generate enough retirement income.

Thus, the challenge is to develop a third type of retirement plan, which manages risk better than a traditional defined contribution plan, while operating at the lower costs of a defined benefit plan. I call this third way a “collective retirement plan,” based on a model from the Netherlands.

The key to a collective retirement plan is to invest all employer and employee contributions in one collective pool – with the investment strategies of defined benefit plans, and therefore much lower costs than most defined contribution plans. This type of collective retirement plan would have several key advantages.

First, a collective pool will cost a fraction of the expenses of the average mutual fund offered in a 401(k) plan. That’s because collective investing can be done by pension experts at institutional rates for one large and diversified pool. In addition, collective investing would save on the administrative costs of explaining various investment alternatives to employees.

Second, the investment choices of a collective retirement plan will be superior to those of the average participant in a 401(k) plan.  Many participants put all of their plan contributions into inappropriate vehicles for long-term investing for retirement – such as a money market fund or a risky stock fund. And many participants have an uncanny ability to shift investments at just the wrong time.

Instead, in a collective retirement plan, independent experts would construct an investment portfolio with a reasonable return at a relatively low risk and cost. In my view, that portfolio should be a balanced fund, with roughly 60 percent of its assets in a diversified US stock index fund and the other 40 percent in a diversified US bond index fund – rebalanced each year. Such a portfolio has earned a real return over 6 percent, with relatively low volatility, during most periods of 20 to 30 years – the appropriate investment horizon for a retirement plan.

Third, a collective retirement plan would not require the employer, a state or city, to recognize an unfunded pension liability on its balance sheet. Rather, the investment risk associated with the plan would be managed by the trustees of the collective retirement plan based on a contingent reserve and other measures. In specific, the trustees would establish a “probable” benefit schedule for retirees based on the amount and timing of their contributions, plus the contributions of their employer.  That schedule would assume a 5 percent annual return on plan investments and a cost-of-living adjustment based on the consumer price index.

How would the collective retirement plan mitigate the risk that it could not deliver the “probable” benefit schedule? To begin with, the assumed Investment return of 5 percent  is below the 6+ percent historical return of the balanced portfolio described above, and much below the 7+ percent assumed return of most defined benefit plans in the public sector. At the same time, the collective retirement plan would have much lower costs than a traditional defined contribution plan.

As a result, the trustees of the collective retirement plan could gradually establish a reserve of 3 percent to 7 percent  of the plan’s asset as a contingent reserve. That reserve, invested in U.S. Treasuries, could be drawn down as needed to meet the “probable” benefit schedule if there were a shortfall in the returns of the balanced portfolio over successive periods. If the portfolio’s return plus the reserve were still insufficient to meet the “probable” benefit schedule, the trustees could waive the cost of living adjustment for a few years.

If the collective pool underperformed for many years, there might have to be a modest reduction in the benefit schedule. On the other hand, if the portfolio outperformed for an extended period, those reductions could be restored and/or the reserve could be expanded.

In short, most defined benefit plans in the public sectors are going down an unsustainable path. However, if we want to avoid pension crises like the ones in Detroit and Illinois, we cannot expect public sector unions to accept the investment risks and high costs of the typical defined contribution plan.  Instead, we need to create a new type of pension plan, which can be gradually implemented with due regard for grandfathered benefits.

Although a collective retirement plan is not perfect, it is much less risky and much less costly than the typical defined contribution plan. While a collective retirement plan cannot provide “guaranteed” benefits at retirement, it can offer reasonable assurances that the benefit schedule would be met in most instances. And the promised benefits of many public sector plans are not actually “guaranteed” by anyone.

Pozen has been a nonresident senior fellow at Brookings since 2010. In 2015, he generously committed to endow the Director’s Chair for the Urban-Brookings Tax Policy Center. Until 2010, Pozen was executive chairman of MFS Investment Management and, before 2002, served in various positions at Fidelity Investments. He did not receive financial support from any firm or person for this article or from any firm or person with a financial or political interest in this article. He is currently not an officer, director, or board member of any organization with an interest in this article.