DC Better Than DB? Who’s Kidding Whom?
By: Michael Beswick
Since DC pension plans first made an appearance, the debate has raged over which is better – Defined Contribution or Defined Benefit? For Michael Beswick, senior vice-president of the pension division at OMERS, the decision is clear-cut. He has five good reasons why, from the employee’s point of view, DB is the better alterna-
Now that the equity markets have ‘mean reverted’ and our expectations of fabulous wealth for all have been dashed, it is good to revisit the debate of the ’90s, DB vs DC.
I have worked for a Defined Benefit pension plan for many years. In the late 1990s, and for a couple of years after that, I found increasingly that people were extolling the advantages of a Defined Contribution approach. ‘Employees can control their own destiny;’ ‘There is a new world for investors;’ ‘It’s more portable;’ and ‘We can all get rich’ were among the many reasons given for why the DC approach was better. And what surprised me was that these reasons were often offered by otherwise rational people. Indeed, there are many who wish to convert social security, both in Canada and the U.S., to a DC plan.
I didn’t buy it then (when I was accused of being a dinosaur) and I don’t buy it now. Simply put, from a broad employee point of view, DB is always the better approach.
Why DC Won’t Work
In general, DC is a flawed concept, if DB can be an alternative. DC may be better than nothing, but DB is better. In my view there are five basic reasons that weaken the DC approach.
1. Half win; half lose.
In DB plans, the risks and rewards are shared across the group of members. That is their main strength. Results are predictable and secure. In DC plans, results (investment returns) are distributed over the individuals who comprise the group. Some have good returns; some have average returns; and some have poor returns. Half win and half lose when compared to the median return.
Further, it is likely the distribution will be skewed to sub-par returns because people are naturally risk averse, and, as individuals, cannot assume as much risk as is possible for a risk-shared group.
I guess if you are in the high end of the win side, you will like the DC approach. But, more will lose than will win.
2. Rational Behaviour
As Professor Daniel Kahneman, the Nobel laureate from Princeton, has pointed out, when it comes to investing, people do not behave rationally, contrary to long-held economic theory.
The recent market bubble has shown that investment professionals do not behave rationally, so how can we expect simple individuals to do so en masse?
People tend to be risk averse and tend to hold on to losers, in the misguided hope that they will recover. Both of these tendencies push returns lower. This is true both for mutual funds and for individual stocks.
The flip side of this is that many investors have an exaggerated sense of their own abilities, for no reason whatsoever – another tendency which pushes returns lower.
3. Access to Information
Another problem for the individual investor is that good information is hard to come by. It is hard enough for professionals, let alone individuals. Investors need information which is relevant, reliable, sufficient, and timely. Most of us read the newspaper or those relatively useless pontifications put out by managers or brokers – hardly good sources of information.
Even if we could get good information, most of us would not know how to use it. We have neither the education nor experience to do so.
The last major impediment to effective personal investing is time.
To do a good job investing for the future requires real work and effort, and most of us are very busy. That is a fact of modern life. With demanding jobs, two jobs per household, scrambling to be good parents and citizens, who has time to become an investor?
All of these reasons argue against the DC approach to retirement saving. Indeed, given a choice, the only ones who would rationally choose the DC approach are the managers, advisors, and brokers, who all profit from more money being available to individuals who have less bargaining power.
DB Is Better
Of course, there are situations where a DC plan is appropriate or good. However, it is my observation that, given a choice, DB is better, and much better since the pension reform of the late 1980s. Give me the predictable, riskshared DB anytime.
As a result, we should be doing all we can to encourage the formation and expansion of DB plans. Governments need to clarify and simplify the rules for pension plans and to stop running scared every time a vested interest group or union makes a lot of noise.
Unions, especially those in the public and broader public sectors, need to stop their expedient and cynical behaviour and accept fair play rules, especially around surplus ownership. For example, it is not fair that plan sponsors are denied surplus because the tax authorities forced certain plan wording 40 years ago. Surplus ownership should reflect the risk deal of the plan.
And, finally, all pension plans, especially those in the public sector, should be governed by sound funding principles. Contributions should reflect benefits being earned and deficiencies should be retired over reasonable periods. Otherwise, public perception of the plans becomes negative and benefit demands become unrealistic because the true cost is deferred.
From an employee’s point of view, Defined Benefit plans are clearly superior. If they have shortcomings, then we can work to improve them. We need to promote them and do everything we can to facilitate their formation.
Michael Beswick is senior vice-president, pension division, at OMERS.
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