How to Structure a Good Defined Contribution Plan

A good public pension plan should balance the interests of three major stakeholder groups: taxpayers, employers and employees. Corresponding to these interests are three criteria: fiscal sustainability, workforce productivity and retirement security. In other words, a good pension plan should not impose excessive burden on taxpayers (fiscal sustainability), should improve worker retention and recruitment (workforce productivity), and should provide some reasonable level of retirement income (retirement security).

Defined contribution (DC) plans, by definition, are fiscally sustainable because they do not create or perpetuate unfunded liabilities for government pension plans and they have predictable contribution levels. Unlike defined benefit (DB) plans, DC plans do not shift investment risks to taxpayers and produce no lag between benefit promises and payments. In terms of workforce productivity, DC plans are an attractive retirement vehicle for the modern mobile labor force due to their portability, transparency and freedom of choice. Having a three- or five-year vesting requirement for the eligibility for employer contributions may further improve the retention of quality employees.

Retirement security may not be a strong aspect of traditional DC plans, not because of any inherent feature of the DC structure, but because of workers’ financial choices. Many individuals who are offered 401(k) plans fail to save early in their career, or simply do not know how much to save and/or how to invest. Many also fail to properly diversify their investments, exposing their retirement funds to excessive market risk. A number of modifications can significantly improve a DC plan’s performance in this area:

– Automatic enrollment: Workers, by default, would automatically be enrolled in the pension plan and have the option to opt out. This would prevent procrastination in investments, while still allowing for flexibility.

– Index funds: While the majority of ordinary workers do not possess advanced financial knowledge, and thus may not know how to optimally allocate their investment portfolios, these skills aren’t necessary for a successful retirement. Most professional investors (even “superstar” investors and mutual funds) do not beat the market. This means that non-expert individuals could outperform most active fund managers by simply putting their pensions in passive index funds. Having index funds as default investment options is a good way to make sure that workers’ pension funds not only are well diversified but also generate greater returns than what an average professional investor could deliver. These investment vehicles are also low-cost, and thus would not chip away too much at the pension savings. A simple 60-40 stock-bond index portfolio composed of domestic stocks, foreign equity and municipal bonds could be set as the default asset allocation, which workers would be able to modify as they wish.

– Target-date funds: While younger individuals can pursue more aggressive investment strategies, those approaching retirement should have more conservative portfolios. A target-date fund does exactly that, by automatically adjusting the pension asset mix according to a selected time frame. This should be a default feature offered to workers, as many neglect to alter their pension portfolios over time. Again, workers should be allowed to opt out of this arrangement.

– Collective DC plans: By pooling individual accounts together and having them managed collectively by professional money managers, a collective DC plan would reduce administrative costs, improve investment decisions, and enable “intergenerational risk sharing,” allowing different age groups of employees to share risk and returns over time. While this DC design has certain advantages over traditional DC plans, it strips individual workers of the control of investment strategies and may allow for the politicized management and policies that have plagued some traditional defined benefit systems. These downsides should be considered if the plan is to be adopted.

– Annuity: DC plans should provide individuals with an option to convert their account balances into an annuity when they retire.

When looking for public pension reform, properly structured DC plans can balance the interests of taxpayers, employers and employees while being fiscally sustainable, increasing workforce productivity and providing retirement security.