The shift from defined benefit to defined contribution ...

1 The shift from defined benefit to defined contribution pension Plans - Implications for Asset Allocation and Risk Management John Broadbent Domestic Markets Department Reserve Bank of Australia Sydney, NSW 2000 Michael Palumbo Division of Research and Statistics Federal Reserve Board 20th and C Streets, NW Washington DC 20551 and Elizabeth Woodman Financial Markets Department Bank of Canada 234 Wellington, Ottawa Ontario K1A 0G9 December 2006 Prepared for a Working Group on Institutional Investors, Global Savings and Asset Allocation established by the Committee on the Global Financial System The analysis and conclusions set forth in this paper are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors or any other officials in the Federal Reserve System or at the Federal Reserve Bank of Australia or at the Bank of Canada.

2 I Contents Executive I. II. Main Features of defined benefit and defined contribution pension Plans and Distribution of A. defined benefit pension B. defined contribution pension C. Hybrid pension III. Extent of the shift Away From Traditional DB pension A. Within the B. Trends in Australia, Canada, the United Kingdom and the United IV. Factors Contributing to the shift to DC Plans in Private-Sector A. Regulatory and tax B. Increasing Costs of DB pension C. Changes in the Industry Composition of D. Increase in Labour E. Introduction of 401 (k) F. Increasing Familiarity with the Stock G. Actual or Proposed Changes to pension V. Implications of the shift from DB to DC Plans on Asset A. Aggregate Asset Allocation in DB and DC Plans in the United B.

3 Aggregate Asset Allocation in DB and DC pension Plans in C. Aggregate Asset Allocation in DB and DC pension Plans in VI. Issues for Retirement Security Posed by DC pension A. B. contribution C. Asset D. Withdrawal Patterns for DC pension E. How Might DC outcomes be improved along some key dimensions?.. 38 VI. Implications for Financial A. Financial Market B. Annuity VIII. Box Box ii Executive Summary Traditional DB pension plans are gradually losing their dominance in the occupational pension systems of many countries; over the past few decades there has been a gradual shift towards DC pensions and, in some countries, DC plans now account for the majority of invested assets in private sector occupational pension plans. It is widely anticipated that recent and prospective regulatory and accounting reforms in the pension sectors of a number of countries will accelerate the ongoing shift from DB to defined contribution (DC) plans.

4 In this note we have examined the shift from DB to DC plans with a view to assessing the implications for asset allocation and risk management. The transition from DB to DC plans in private sector pensions is shifting investment risk from the corporate sector to households. Households are therefore becoming increasingly exposed to financial markets, and retirement income may be subject to greater variability than before. This is not only the case in countries with a mature occupational pension system, but also interestingly in emerging markets, where pension reforms (aimed at either setting up private occupational pension schemes or funding pay-as-you-go systems) are adopting a structure predominantly based on that of DC or hybrid schemes. A number of explanations have been offered for the shift from DB to DC pension plans.

5 From a long-term perspective, factors such as increased workforce mobility associated with demographic and industrial change appear to have been important drivers of the shift away from DB pension plans, which has been particularly pronounced in the All else being equal, mobile workers have less of a preference for DB pensions because traditional benefit formulas are backloaded , favouring long-tenured employees, and because DB benefits are not portable from one employer to another. The recent acceleration of the trend towards DC plans appears to be linked to a confluence of factors ( , pension under- funding and its persistence due to a decline in long-term interest rates, the move to more market-based accounting, increasing regulatory burden and uncertainty and recognition of the effects of increased longevity on plan costs) that has prompted plan sponsors to improve their management of the financial risks in DB plans.

6 It is also linked to regulatory and accounting reform that is making these risks more transparent. Since DC contributions can be fixed as a predictable share of payroll, migrating to a DC plan offers employers a means of reducing balance sheet and earnings volatility at least over the long term. The shift towards DC pensions does have some positive aspects, both for employees and for sponsor companies. Among them, it favours labour market mobility because it decreases so-called accrual risk , ie the fact that pension benefits in DB plans tend to be iii backloaded, so that workers who change employers can lose a great portion of expected benefits if these are not transferable from one employer to another. However, such a shift also reallocates investment risk within the financial system from the corporate to the household sector, which may have implications for financial stability.

7 Aggregate pension sector data available for Australia, Canada and the , shows that asset allocations are quite similar for DB and DC plans, particularly in Australia where there are no differences of note. Both DB and DC plans hold most of their assets in equities and fixed income securities. One key difference noted in the asset allocations of and Canadian plans is that DC plans tend to hold a greater share of assets in mutual funds while DB plans tend to have higher weightings in directly held securities. In the US this applies to holdings of fixed income and equity. In Canada, the fixed income weightings for DB and DC plans are similar for both direct holdings and mutual funds. In both countries DC plans tend to hold a smaller share of equities in international stocks. DC plans also tend to have a larger share of assets in guaranteed insurance company contracts and other stable value instruments, although, aggregate sector weightings in money market and stable value funds are not that high.

8 Despite the similarities in aggregate asset allocations, households do not necessarily manage risks in the most appropriate way. There is a large body of evidence to suggest that there is considerable inertia and myopia regarding retirement decisions, which may ultimately threaten the capacity of DC plans to provide retirement security. For example, research has shown that in some DC plans employees are generally investing too heavily in their own company s stock. Furthermore, employees tend to remain in a plan s default option even if it does not provide sufficient portfolio diversification. Finally, employees in DC plans may not have a sufficient number of investment options to create a portfolio suited for their investment objectives, risk tolerance and constraints. Retirement security for some households is threatened by a lack of participation, low contribution rates, suboptimal asset allocation, early withdrawals and a failure or inability to annuitise plan assets at retirement that may reflect well documented behavioural biases and a lack of basic financial literacy.

9 Thus it is important for policymakers to address these issues. The experience of some institutional investors in emerging markets that created mandatory private pension funds some time ago may also be relevant for other countries moving from DB to DC schemes. Introduction In a number of countries the pension sector is in the midst of regulatory and accounting reform1. The reforms are largely a response to the deterioration in the funding of defined benefit (DB) pension plans from about 20012 and longstanding concerns regarding the effect of complex, opaque pension accounting methods on the valuation of the DB pension plan and the sponsoring firm. Recent and prospective reforms, in particular those aimed at introducing fair-value measurement and improved transparency in pension accounting, are expected to introduce greater volatility in the financial statements of sponsors.

10 This is likely to provide more of an incentive for sponsors to adopt investment strategies such as asset-liability management, that are aimed at reducing wide fluctuations in the value of the DB plan surplus (the plan assets-the plan liabilities). Most expect that the reforms will also accelerate the ongoing shift from DB to defined contribution (DC) plans. This note addresses the latter, examining the shift from DB to DC plans with a view to assessing the implications for asset allocation and risk management. Traditionally, funded occupational pension systems were designed around DB pensions; DC plans accounted for a small fraction of employer-sponsored pensions and were typically offered by smaller firms or as supplementary plans for high income earners. Over the past three decades there has been a gradual shift , predominantly in the private sector, towards employee-directed DC plans and hybrid arrangements that combine features of both DB and DC plans.