What can defined benefit and defined contribution plans learn from one another?

Older man looking at a newspaper sitting next to a younger man looking at a tablet

I’m always trying to teach my children skills to prepare them for life. I’ve been around a while, and hope I can use my experience to help them on their journey. However, there are lots of occasions when it’s the other way around. Thanks to my kids, I know what a meme is and I can do the Floss dance. Well, almost.

The point is, despite our age differences, we can learn from one another. And I think we can apply that takeaway in other areas as well. Take, for instance, defined benefit (DB) plans, which have been around for some time, and the newer kid on the retirement block, defined contribution (DC) plans.

At Willis Towers Watson, I work with both, and while it’s tempting to think of them as being quite different in terms of their set-up, objectives and investment needs, they also have a lot in common: They’re both long-term savings plans and need to cater to diverse needs. And while each has its own merits, there are lessons the more mature DB plans could learn from the younger, more innovative DC plans, and vice versa.

3 lessons defined contribution plans could learn from defined benefit plans:

1. Go big, or go home

Defined benefit plans have learned to use their scale advantages to lower costs to employers, whereas many defined contribution plans are small and struggle with high costs. Among those costs, manager fees are an easy one to measure. We recently studied fees paid by DC pensions and found there’s been a material divergence, with fees for large and medium plans going down, while small plan fees have stayed static and are now around double those of larger plans.

What’s a small plan to do? The simple answer is become big. One way is to use intermediaries to help you join forces with other plans and create purchasing power. Alternatively, you can join a MasterTrust, such as Nest, or Willis Towers Watson’s LifeSight.

2. Maximize your opportunity set

Both DB and DC plans employ diversified growth-style investment approaches. But the DC version isn’t always as diversified as it appears in terms of asset class or risk premia. DC investments tend to be skewed toward the equity risk premia for a large proportion of their returns, while DB plans tend to have more evenly distributed risk premia, with more returns coming from credit, manager skill and illiquidity, among others. If you accept that an even distribution of risk is a better way to achieve long-term returns, why won’t DC funds embrace it? Well, DC-friendly, truly diversified growth funds are still few and far between, but that can change if the market demands it.

3. Dynamic de-risking

Many Defined benefit plans track their assets and liability daily, looking for opportune times to move between asset classes and/or de-risk the scheme. Most investment consultants will be able to provide a DB plan with a snazzy tool to help. No such technology is used by DC plans. Why? It could be just as useful. DC calls its journey the lifecycle whereas the DB plan is on a journey, but they’re both looking to reshape the portfolio over time. Referring back to lesson one: DC needs to bulk up and use its new-found bulk to demand this kind of tool from providers.

3 lessons defined benefit plans learn from defined contribution plans:

1. Streamline the supply chain

Defined contribution plans can’t charge members more than 0.75% in manager fees for their default investment option. While this has caused angst among some trustees, advisors and fund managers, there have been some positive consequences. DC fund managers have focused efforts on smart beta implementation routes. We’ve seen an increase in demand for fundamental indexation from DC plans, demand for passive versions of infrastructure strategies and even plans looking at passive versions of multi-factor strategies. Active management is used only where there’s high confidence in manager skill.

Would a cost constraint on DB have benefits, too? Defined benefit plan could consider a self-imposed charge cap, at least for some parts of the portfolio, and a commitment to spending money only where it can really make a difference to the portfolio and where the scheme can’t compete effectively. There’s no place for mediocre and expensive investment solutions.

2. The importance of customer focus

If you’re a DB person, you’re very familiar with charts showing the liabilities of your scheme. It’s a top down thinking process. In DC, the assessment of the liability profile is bottom up: Each individual member has a very different profile. There’s no corporation focused on ensuring future spending needs are met. That’s a big risk, but also presents an opportunity: flexibility.

With DC plans, we have more opportunity to tailor outcomes to what individuals want. Why is that an important lesson for DB? Well, some would argue the volume of transfers out of DB plans tells us something about the value members place on their DB providers. Not everyone wants a steady pension: Some want to pay their mortgages off and buy a Lamborghini. Defined benefit sponsors should care about this and react because pension provision must, above all, respond to members’ needs.

3. Look beyond traditional financial factors

Defined contribution members are increasingly proactive in demanding the inclusion of environmental, social and governance (ESG) investments and many trustee boards have responded. Remember, many defined contribution plans have substantial populations of millennials focused on a very long time-horizon and the future. We pension scheme investment consultants and trustees also care deeply about the sustainability of our investments, but we tend to be more focused on the financial impact they have on members’ benefits.

Quite a few DB plans are now taking ESG seriously and integrating it into their investment approaches, but DC is still ahead. Whatever the motivation behind it, financial or social, in DC, it’s more likely to be a core topic at trustee meetings and a key consideration for default strategies. DB could learn a thing or two from this integrated way of thinking if they believe a sustainable portfolio will add value.

Final thoughts

The lessons we learn from experience will always be worth passing on, but the insights we draw from youthful innovation can be just as valuable and useful. So when it comes to thinking about pension plans, consider what defined benefit plans do well and see if those will also apply to defined contribution plans and vice versa. In most cases, I think you’ll find what works well for one type of plan will work well for the other.

Julie D. Alexander, Senior Consultant at Willis Towers WatsonJulie D. Alexander is a senior investment consultant at Willis Towers Watson.

Categories: Employee benefits, Investment, Retirement | Tags: , , , ,

Leave a Reply

Your email address will not be published. Required fields are marked *