Public and private defined benefit (DB) pension plans are struggling with how to manage the mismatch between assets and liabilities. In order to control the mismatch risk, many plans have either begun to implement or are exploring implementation of liability driven investing (LDI). It is ironic, however, that the greatest opposition to increased risk management often can be found amongst the employees of these plans. I would like to explore why this may be the case.
Consider a DB pension plan with a financially sound plan sponsor. Since we assume that the plan sponsor will not have to file for bankruptcy, then we are left with two possible situations: the DB plan remains a going concern entity or the possibility exists that the plan sponsor may convert the plan to a defined contribution (DC) plan.
As a going concern, the employee is paid a pension based on the formula set out in the plan documents. In the event the plan is converted, however, the plan sponsor retains responsibility for any accumulated deficit in the plan whereas the courts have traditionally attributed surplus to plan members. Thus, employees generally find themselves in a “heads I win and tails you lose situation” and optimally should be encouraging the plan sponsor to take more risk with plan assets.
The plan sponsor, on the other hand, does benefit somewhat from accumulated surplus in the form of lower future contributions but cannot access surplus in the event of plan conversion. Therefore, there is little motivation for the sponsor to invest in risky assets when the assets of the plan equal or exceed the value of plan liabilities.
Hybrid plans are not uncommon as a plan design; they are also the source of the greatest misalignment of risk goals between member and plan sponsor. A member of a typical hybrid plan contributes to a designated account in his or her name and that account is invested with professional money managers until retirement. At retirement, the account value is converted to monthly income through the use of an annuity. That value is compared to the monthly entitlement of the member in a DB plan and the member receives the greater of the two calculations.
Let us consider two situations: in the first, the plan invests in risky assets and in the second the plan invests in low-risk assets. If we assume that the value of the DB calculation is equal to 100, then we can hypothetically assign potential terminal values as follows:
| Hypothetical terminal account value | ||
| High-Risk Assets | Low-Risk Assets | |
| Positive markets | 150 | 110 |
| Negative markets | 50 | 90 |
Now consider the outcome for both plan sponsor and for plan member. Recall that the plan sponsor will be required to fund any deficit below 100 (the defined benefit value at retirement) but does not participate in the surplus. Specifically, the result to the plan sponsor can be mathematically described as the minimum of (0, account value-100). The plan member will receive the greater of the account value and the defined benefit calculation, also denoted as the maximum of (100, account value).
The following tables illustrate terminal values to each party:
| Terminal value to plan sponsor | ||
| High-risk assets | Low-risk assets | |
| Positive markets | 0 | 0 |
| Negative markets | -50 | -10 |
| Terminal value to plan member | ||
| High-risk assets | Low-risk assets | |
| Positive markets | 150 | 110 |
| Negative markets | 100 | 100 |
The optimal risk preference for each party becomes obvious when considering the above tables. The plan sponsor wants to minimize risk since it minimizes the potential shortfall obligation if markets do not cooperate. The plan member prefers maximum risk, since it results in greater potential for outperforming the defined benefit minimum.
It is clear that in the world of pensions the interests of all parties are not typically aligned. We have demonstrated that even with respect to risk preference, a gap between plan sponsor and plan member exists. The important goal is to achieve a greater understanding of each party’s motivation, namely the desire to achieve an optimal outcome from his or her perspective.