This investment insight was produced as an experiment. Colleagues were told it had been produced very quickly, and were asked if it was of sufficiently high standard to publish. Their responses can be summarised as “not as out-of-the-box as your usual insights, but informative and good enough to publish”. The text below was produced by ChatGPT (artificial intelligence), and edited by me.
Defined benefit pensions, also known as traditional pensions, are retirement plans in which an employer promises to pay a certain level of benefits to employees upon retirement. In recent years, there has been a trend towards replacing defined benefit pensions with defined contribution plans, typically known in the USA as 401(k)s, which shift the investment risk from the employer to the employee.
Most defined benefit countries have an underpinning state pension system. In the USA, this is the Social Security program which includes retirement, survivor and disability benefits. The UK’s basic state pension, is considered to be relatively generous, as it provides a relatively high level of benefits to most retirees. In Canada, the Old Age Security (OAS) and the Canada Pension Plan (CPP) are the two main public pension programs. The CPP is a defined benefit plan that provides retirement, survivor, and disability benefits. The CPP is considered to be one of the most sustainable and well-funded pension plans in the world, and it covers nearly all working Canadians. The Netherlands have a similar reputation for sustainability and funding, and the pension system is based on a combination of defined benefit and defined contribution plans. The Dutch pension system has a coverage rate of nearly 100% and it also has a well-functioning system of governance and risk management.
Defined benefit pensions have been in relative decline for several decades, with a shift towards defined contribution plans. This shift has been driven by factors such as increased longevity, changes in accounting rules, and increased competition among employers.
In terms of risk and sustainability, defined benefit pension plans can be more predictable and provide a higher level of retirement income compared to defined contribution plans. However, they also carry more risk for employers as they are responsible for ensuring that there are sufficient funds to meet the promised benefits. This issue was recently highlighted by the liability-driven investment (LDI) crisis in the UK. While it is easy and convenient to point to Truss and Kwarteng’s mega budget as the cause, it could also be argued this was a systemic issue caused by a combination of low interest rates, increased longevity, and poor investment returns.
The issue here is the tension between security and affordability. The UK DB history is one of the UK government implementing a number of reforms in response to successive (smaller) crises. All of the reforms, such as the minimum funding requirement the pension protection fund, and new rules to measure funding levels, aimed at improving the security of defined benefit pension plans, perhaps believing this enhanced their sustainability. However, the associated de-risking of investment portfolios (we now know quite how much the liquidity risk increased) reduced investment returns and therefore affordability, which diminishes sustainability.
While the UK LDI crisis has highlighted the challenges facing defined benefit pension plans, it is important to note that these plans still play an important role in the global retirement landscape. Many experts argue that defined benefit pensions are more effective than defined contribution plans at providing retirement security, especially for lower-income workers. However, for their future, defined benefit pension funds need to be well-funded and well-managed, and employers and the government will have to continue to make changes to ensure their sustainability.
It is clearly difficult to predict the future of defined benefit pensions with any certainty, but we think they will continue their relative decline in the retirement landscape as defined contribution plans become more prevalent. However, to us this looks like the swing of pendulum to more affordable but less secure DC provision, and maybe that swing will go too far. Perhaps we should be more actively exploring the middle ground – a hybrid of DB and DC. The pension system in the Netherlands can be considered a good example of how a combination of defined benefit and defined contribution plans can be sustainable and provide a good coverage.
