STUMP » Articles » Happy Idea: Moving from Defined Benefit to "Defined Ambition" » 9 May 2018, 06:36

Look, it’s going to be difficult to find truly happy pension stories.

So I take what is a bit of marketing, of something not entirely new, and see what happy stuff we can get out of it.

A SWITCH TO DEFINED AMBITION

Moving Pensions From Defined Benefit to ‘Defined Ambition’ – Bloomberg

The British, Canadians and Dutch explore a way to keep what’s good about pensions while avoiding the crises.

Let’s run through some fun retirement-savings jargon: DB, for defined benefit, means a traditional pension plan. The monthly payout is defined from the start and guaranteed by the plan sponsor. DC, for defined contribution, is an individual retirement account such as a 401(k). The amount of money you put in is defined by you, and maybe your employer chips in a match. After that, good luck!

A lot has been written in recent years about the drawbacks of both systems. DB plans require providers to take on big, long-term risks, which private employers in the U.S. have generally decided they don’t want to do anymore and some state and local governments have done an awful job of managing. DC plans put all those risks on the shoulders of individual workers and retirees, with predictably mixed results.

It sounds like there ought to be a middle way, right? There is, and it’s being developed mainly outside the U.S.

A name I had previously heard for these middle-way schemes is collective defined contribution, which doesn’t exactly roll off the tongue and has an acronym that in the U.S. has already been claimed by the Centers for Disease Control. The Financial Times called them “target benefit” plans in an article this week on their possible rise in the U.K., but “TB” is already taken, too. So my new favorite term for these plans, which I learned Tuesday from John Kiff of the International Monetary Fund, is “defined ambition.” As Niels Kortleve, innovation manager with the Dutch pension fund manager PGGM, put it in a 2013 article in the now-defunct Rotman International Journal of Pension Management, DA plans usually start out looking a lot like DB plans, with a target benefit based on salary and years of service. Then comes the twist:

The main difference for DA contracts is that when asset value and longevity change, the benefits are adjusted downward in poor times and upward in good times. This should happen through well-communicated preset rules, such that all stakeholders know beforehand what will happen in each situation and how it will affect their contributions and benefits.

I agree that “defined ambition” is a bit better phrase than “collective defined contribution”, at least from a marketing point of view. But it’s pretty amorphous.

I don’t know what already has taken the “target benefit” slot.

By the way, a defined contribution level during working years and some sort of lifetime income that adjusts with the group’s changing longevity & investment performance during retirement… that product/process already exists. It’s TIAA’s core retirement annuities product.

THE STORY OF TIAA-CREF

Note: I worked at TIAA-CREF from 2003-2008, in the actuarial department. I am not going to give extreme details here, but a simplification. Partly because not all of the info is public, a lot of it is boring except to actuaries… and it’s been ten years. I don’t remember it all. I’m using Wikipedia to help my memory a little.

Back in the 1910s, Andrew Carnegie had been going around, endowing this and that. He established many public libraries and funded a lot of universities (so, universities… maybe be a bit more circumspect about bashing the sorts who shovel you a lot of money, hmm?)

The story goes that he met some antiquated professor, still hobbling to the classroom, and wondered why the man hadn’t retired at such an advanced age.

The obvious answer: (other than run-of-the-mill professors are notoriously bad with money) he had no pension.

So Carnegie founded Teachers Insurance and Annuity Association, a mutual insurance company, in 1918.

The core product was a “fixed” annuity, which meant that you were guaranteed a few things: minimum crediting rate on your deposits, and a minimum lifetime income upon retirement (at certain eligible ages). Of course, the company could (and did) pay dividends to the annuitants above these low guarantees — it is a mutual company, so all “extra” which would be profits to a non-mutual company eventually go back to the owners of the company… that is, the annuitants and policyholders (that’s how mutual insurers work.)

That initial product did well for decades, until inflation started to bite. The fixed annuity really couldn’t keep up, so the College Retirement Equities Fund was born — essentially, a variable annuity (with none of the fancy guarantees you see on variable annuities now). The concept is that it was one big pile of equities, and all those with money in the CREF annuity would participate in the investment returns and longevity of the whole pool.

That’s when the company became TIAA-CREF, though the TIAA and CREF parts were kept separate. My understanding was that, at the time CREF came into being (1952 — when my parents were born), the most your were allowed to put in the CREF portion was 50% of your contributions.

So here is how the system worked. Contributions would be made during the working period of the professor (and then, later, other university employees) – it usually was some fixed percentage of the salary… just like today’s defined contribution plans. Indeed, this was well before 401(k)s, but one’s TIAA-CREF accounts belonged to the individual, and professors could (and did) move between universities, but still had their retirement savings building up, no matter who their employers were.

This was one of the reasons professors didn’t have pensions, by the way – defined benefit pensions tended to be attached to working at one employer for decades (and then there are the union pensions – again, it assumes you’re going to be doing that specific union work throughout your working years.) Defined contribution plans have always been portable – attached to the worker, not the specific work or employer.

Over the decades, these core products – on both TIAA and CREF – continue. I’ve got quite a bit of my retirement savings in my old TIAA-CREF employee benefits (non-contributory, which means all the money came from the employer, not from me — yes, it all comes from the employer, but there are tax implications yadda yadda). I also had a 401(k), which was in their mutual funds, not the annuities. But I can still roll that over into a lifetime income annuity when I retire.

There have been a lot of risks impinging on the TIAA-CREF products over time — the same ones impinging on all pensions: investment risk, interest rate risk, longevity risk. The risk is spread throughout the annuitants, and TIAA is one of the highest-rated insurers in the U.S., along with a few other mutual insurers. (TIAA-CREF changed its name back to TIAA after I left… I guess it was getting too cumbersome for a cool logo or something.)

The guarantees on the annuities are (relatively speaking) very low. Should longevity get to the point that everybody is living a thousand years… yeah, TIAA would be in trouble then.

But so would everybody else — and it would have hit everybody. Not all risks can be managed away.

RISKS CAN’T ALL BE MANAGED AWAY

Look, employees can’t be fully shielded from the risks borne in a pension plan. It’s not feasible.

When I say “can’t” I don’t mean “shouldn’t” — I mean pension plans are not able to prevent risks hitting participants.

There are certain diversifiable risks – such as the very specific aspects of when an individual will die. Some die young, some die around the expected value, some live well beyond that. That can be diversified.

There’s a certain amount of investment diversification that can also go on.

But the pension plan cannot fully shield participants from generally increasing longevity, macroeconomic environment, and so forth.

That’s for any pension.

But for public pensions, one of the things that the plan can’t do much about is the particular number of taxpayers who can actually provide a backstop to the plan.

It has been assumed “governments don’t go out of business”, but because it’s been known that insurers definitely can flop, there have been regulations to try to prevent this (while keeping insurance affordable — there’s a balance to be had.)

Obviously, insurers have flopped, sometimes in a big way, many times because they promised too much. The most infamous version of this was Equitable Life UK, which promised a way too high “guaranteed” rate on annuities. Turns out you can’t guarantee 6% interest for life, in a low interest rate environment.

Just like governments can’t guarantee 8% returns on their pensions.

UNHAPPY: BACK TO REALITY OF OVERPROMISING

One of the biggest “duh” headlines comes courtesy of the Wall Street Journal:

Pension Funds Still Making Promises They Probably Can’t Keep.

But the subhed is an even bigger “duh”:

Public pension fund projections don’t always match actual experience

The value of investments by public pension funds declined last quarter, widening the gap between what these funds say they will earn and what they actually earn.

Pension funds across the U.S. must each year estimate how much they expect to earn on investments—a projection that determines the amount the government that is affiliated with the pension fund must pay into it. Robust returns reduce the need for government support.

But forecasts don’t always square with funds’ actual experience. Retirement plans across the country still project their investments will grow at a median rate of 7.25%, according to Wilshire Consulting, an adviser to pension funds. Yearly returns on public pension plans have returned a median 6.79% over the past decade and 6.49% over the past 20 years, according to Wilshire Trust Universe Comparison Service, a database.

The investment return assumption is the easiest assumption to understand.

The problem are a whole bunch more assumptions that also lowball the amount of money needed: payroll growth, longevity not increasing, etc.

These pension funds have also steadily narrowed this gap on their own. Three quarters of the 129 state pension plans monitored by the National Association of State Retirement Administrators have reduced their investment return assumption since fiscal year 2014.

But government officials seeking to make their investment targets more conservative have a powerful disincentive: High returns assumptions appeal to elected leaders because they reduce the amount governments need to set aside to cover pension promises. For some, pensions have already caused budget pressure.

Yes, but most are dropping their assumptions only 25 basis points or so – rather than the whole percentage points these things need to be dropped.

Birmingham, Alabama, even raised its target rate on one of its pension funds to 7.5% from 7% in 2016 after moving some of the money out of fixed-income investments and into equities. The move made the city’s annual contribution to the Retirement and Relief System less costly than it otherwise would have been.

“Why Birmingham changed the investment rate return…is a bit questionable,” said Richard Ciccarone, president and chief executive of Merritt Research Services LLC, a research firm.

I love all these weasel words.

Birmingham’s investment assumption increase is questionable, and not just a bit. The reasoning is that they put more into equities, thus: ta da! We assume higher returns!

But Tom Aaron, senior analyst, Moody’s Investors Service said the temporary budget relief comes at a price.

“You’re supplanting a budgetary contribution with increased risk taking. If those (investment) assumptions don’t pan out that’s going to result in higher than expected budgetary contributions down the road.”

And “down the road” could be during this very decade.

But enough unhappy for now.

This is supposed to be happy.

So here’s the happy news: there are choices other than what public pensions are doing, and could still provide good retirement benefits. TIAA has been doing this for decades… and many employees of public universities have accounts there, even.

It’s better to have very low guarantees, with participation in upside results. That way, people can plan appropriately and not be fooled into believing overly sunny promises, which, when they fail, fail catastrophically.