Flexible framework needed for pension plans

The general framework for occupational pension plans can be described as intra and inter-generational hybrid, with risk-sharing mechanisms between members and with sponsors. The degree of hybridity of a pension plan can be defined as the extent of risk sharing with the sponsor. At one end of the spectrum lie traditional defined-benefit (DB) funds, where all the risk is with the sponsor and the pension benefit is independent of plan returns. In a DB scheme, the sponsor gives a guarantee to the fund in exchange for the possibility that its initial cash contribution is reduced so that the pension fund has an underfunded guarantee value.

As the degree of hybridity of funds is linked to the degree of risk sharing with the sponsor, collective defined-contribution (CDC) and DC funds, where risk is entirely borne by individuals, both lie at the other end of the spectrum.

However, as the market value of the pension rights in individual DC funds is always equal to the market value of the fund where all pension assets are invested and risk is individualised, they stand apart because they are not collective solutions.

They do it over there

Individual DC plans are dominant in Commonwealth countries and have replaced traditional DB funds in the UK and in the US. European countries have opted towards more risk-sharing in the form of hybrid funds – defined as collective pension plans that benefit from some risk sharing between participants and the sponsor, and usually offer guarantees and conditional indexation.

The demographics of developed countries have led the retirement system to rely less on sponsor guarantees. In fact, demographics imply that the unfunded part of the pension diminishes as a proportion of labour revenues. In the UK and the US, the rigidity of laws governing pension arrangements – conditional indexation is prohibited in the UK – has meant that the reduced aggregate reliance on sponsor guarantees has been obtained by a mix of DB and individual DC funds rather than by more hybrid funds. In hybrid systems, the system can only adapt through greater hybridity, which means lower sponsor guarantees and lower overall (nominal) guarantees.

The UK and the US rely mainly on individual DC funds and traditional DBs. Individual DC funds are usually sub-optimal since they are plagued by poor governance, inferior default options, are expensive and do not offer annuitised income. Traditional DB funds are often plagued by unhedged exposure to the risk of sponsor bankruptcy. The failure to transfer systematic longevity risk has been a major risk and has contributed to exhausting the sponsor guarantee. Given current practices, the sustainability of these funds is not guaranteed.

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