Defined Benefit Versus Defined Contribution – Whats Next?

Defined Benefit pension plans have been a major headline in the last year and their future viability debated across the country.  Defined benefit pension plan contributions to the capital markets are key drivers of the economy, however, since the 2008 sub-prime crisis the general public has been made aware of the liability the average tax payer is incurring from these plans.  During strong economic growth, the defined benefit pension plans do not drive headlines and the general public supports  public employees’ opportunity to retire after their dedicated public service.  Strong economic growth has a way of hidiing certain liabilities and that is why the debate between the pros and cons of defined benefit (DB) versus defined contribution (DC) have been slow to materialize.  For the first time in our modern economy, the defined public benefit pension plans have been exposed for what they are – a major liability on the states’ balance sheets.  The private sector caught onto this liability decades ago and almost every private corporation has moved to defined contribution plans in order to maintain competitive in the fast growing global economy.

The United States is now facing the issue of what to do with the public defined benefit pension plans in our country and the battle is getting heated.  A great example is the current debate in Wisconsin regarding collective bargaining and unions’ ability to negotiate wages, benefits and retirement plans.  Furthermore, individual states are being down rated by rating agencies due to major liabilities and budget shortfalls that are predominately caused by under funded defined benefit pension plans.  This down rating is making it harder to obtain short term financing to cover budget gaps.  For example, Illinois has been down rated and recently had a difficult time raising the financing to cover pension beneficiary payments (WSJ Article).

The current economic downturn has made the tax payer aware that they are liable for making up the shortfalls of public defined benefit pensions plan.  The worst part is that the average tax payer does not have a seat at the table; most pension plans are run by boards that are made up of union representatives and political appointees.  Even with great investment minds and professionals managing the pension assets, they were still unable to fully fund the obligations to the beneficiaries in a growth market.  The California Public Employees’ Retirement System has to make 75 cents on every dollar in investment returns in order to fully fund all the promises to beneficiaries.  This is completely unsustainable and proven by the fact that most defined benefit pension funds were underfunded during a healthy economy and strong stock market.

The private sector made the jump from defined benefit to defined contribution in order to remain competitive and now the public sector is in the same position.  States must redefine their pension system in order to remain competitive in the global economy.  However, this will not be an easy transition due to the strong labor unions that are adamantly against a change from defined benefit to defined contribution.  The unfolding of this debate may make for the most monumental in our Country’s history.  If states do not address their current liabilities through changing the defined benefit pension plans or drastically reducing other state programs, we will eventually face potential state bankruptcies, leading to other unique issues.

Optimum specializes in researching the private capital markets, thus, we are mainly concerned with the impacts of eliminating defined benefit plans.  This could potentially eliminate a high percentage of the largest institutional investors in the world that make large allocations to alternative asset classes.  Even though the defined benefit pension plan is a major liability to the health of our country, the defined contribution plans are not any better for the overall financial health of the country.  The 401K retirement plan (defined contribution pension plan) is a relatively new financial instrument that was created as a solution for companies moving away from defined benefit plans.  Most individuals that are vested in 401Ks as their main source of retirement income have not been able to retire based on their portfolio returns and contributions.  The major factor contributing to under-performance is the lack of investment choices and over-allocation to the public capital markets.  Primarily, defined contribution plans invest in retail investment products, in effect restricting access to the private capital markets and alternative asset classes which produce the highest returns in the capital markets.  This brings a major issue to the forefront with defined contribution plans.  If every state pension transitioned to defined contribution this would definitely improve the states’ balance sheets, but the problem would only shift to the individuals.  Further, it would eliminate a large pool of capital currently invested in various alternative assets.

The positive aspect of defined benefit plans is their ability to build very large and sophisticated portfolios with allocations to a broad array of asset classes.  For example, most defined benefit plans invest into alternative investments like venture capital and infrastructure which ultimately benefit society through development of new technologies and infrastructure projects.  If defined benefit plans were eliminated, then most of the capital going into alternative assets would also be eliminated.  This would cause a lower  return profile for investors and lack of capital into new projects and technologies.  Therefore, the defined benefit versus the defined contribution discussion is the wrong discussion.

How do we solve the problem of reducing state liabilities but also making sure investors have exposure to multiple capital market investments?  Since we have defined why America is having the wrong discussion,  we must review what the rest of the world is doing and I will turn to the best example of pension systems in the world – the Australian Superannuation Funds.  The continent of Australia is made up of approximately 25 million people but their pension system is valued at over $1 trillion dollars.  The United States has plenty to learn from this system and how it operates.  Every citizen in Australia has to contribute nine percent of their earnings to the Superannuation system each year and by every citizen that is the public and private sector.  Furthermore, Superannuation funds were created by industry and not geographic location, thus, if you are a construction worker your contributions would go to the construction Superannuation fund.

Australia has built a culture of savings for their citizens across the board so there is no arguments between public sector and private sector or union versus non-union.  This debate is taken off the table because everyone is contributing the same.  This system also takes the liability off the individual to increase investment returns and allows large institutional investors to do what they do best – build sophisticated portfolios.  This model also allows for allocations to alternative assets to remain in tact, thus driving forward new technology and innovative projects.  Australia also recently took their system one step further by allowing citizens to choose which Superannuation fund to invest their retirement capital.  As a result, this created competition amongst the Superannuation funds to drive the best investment returns or commit to certain portfolio strategies to attract investors.  The Superannuation pension model is quite unique from the United States pension system and the results in the above graph illustrate the major differences in funding levels and truly proves the inadequacy of the United States pension system.  Debate for change in the pension system has begun in the United States, but we are having the wrong debate.  Rather than focus on defined benefit vs. defined contribution, the debate needs to focus on how to solve the whole problem, and the Australian Superannuation Fund is an exemplary model.

Optimum truly hope the leadership of this country has the courage to move forward on the issues of our pension systems and look to our global neighbors to gain wisdom.  The capital markets are an integral aspect of our livelihood and Optimum will continue to fight for what  is best for our local, national and global economy.  If you find the current system as troubling as we do then we encourage you to speak with your local, state and federal political leaders and voice your opinion.