What comes out of a pension system is the same as what goes in. And only two things go in: contributions and investment returns.
Investment returns, of course, are uncertain. That’s why the basic division in pension plan design is between defined contribution (DC) and defined benefit (DB): DC fixes the contributions – so the benefits that come out are subject to all the uncertainty created by the investments; DB fixes the benefits that will be paid – so the uncertainty shows up in the contributions that must be made.
There is, however, another possibility. The uncertainty could be shared between the contributions and the benefits. The latest attempt to make this happens comes out of the UK, where legislation was recently proposed that would allow sponsors to create “defined ambition” plans. This is enabling legislation: that is to say, it removes barriers to the creation of risk-sharing plans, rather than actually creating them. It would enable the pooling of risk between plan members and across generations, and also allow self-annuitization.
The latest edition of Communiqué, Russell Investments’ quarterly institutional investor newsletter, includes a Q&A with Sorca Kelly-Scholte, who heads our client strategy and research team there. She says: “I like the defined ambition concept. It takes us back to where defined benefit started out.” As the burden of delivering on the aspirations of DB increased (including, in the UK, compulsory cost-of-living increases), employers looked for a way out. Defined ambition targets a DB-type benefit, but without the guarantees.
Sadly, it may have come too late in the UK. Sorca’s view is that: “The consensus, with which I agree, is that employers don’t have the appetite to get back into [the DB] game. It’s a shame, because the ideas really do represent a middle way between DB and DC, with a balance of risk between employers and employees. So I’d love to be proved wrong and see someone step into the breach.” However things turn out, this story will be worth tracking.
This is not, of course, the first attempt at finding a middle path between DB and DC. The Ontario Teachers’ Pension Plan in Canada has a risk-sharing formula, as does the Dutch collective DC system. In the U.S., both multi-employer (Taft-Hartley) plans and cash balance plans can be seen as forms of hybrid. But as the U.S. pension system moves through a state of uneasy transition, defined ambition is a useful reminder that DB and DC are not the only options.