Is Risk-Based Supervision Right for DC Plans?

World Bank paper says it's time to think about DC risk in a different way.

April 15, 2014

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story_images_dice-rolling-riskFor the past decade, defined benefit (DB) plans have been working to shift how they think about investing. These days it’s all about risk and liabilities, particularly for those plans that don’t want to revisit the deep, dark days of the Tech Wreck or the 2008 Financial Crisis. As DB plans focus more closely on the pension promise (their raison d’être), the big question remains: what about defined contribution plans? DC plans have raised questions about  their ability to deliver adequate income in retirement to plan members. And yet they are growing in popularity as more plan sponsors seek to shed the balance sheet risk inherent in DB plans.

Perhaps it’s time to rethink how DC plans are supervised altogether according to a new paper just released today which asks whether or not risk-based oversight would be appropriate in the DC space. The paper, “Pension Risk and Risk-Based Supervision in Defined Contribution Pension Funds,” is the product of a working group at the World Bank. Its authors, Tony Randle and Heinz P. Rudolph provide a useful examination of the costs and benefits of applying best practices  from the DB pension and insurance supervisory space to DC plans. Could a risk-based framework for oversight provide better outcomes to plan members in the long run? The authors run into a few problems, including capital requirements which aren’t a good fit, however they do explore the idea of reference portfolios as benchmarks to adequately gauge risk across plans – a possible takeaway for regulators.

The authors also raise important questions about the value of DC plans. If the role of a pension system is to ensure that individuals have enough to live on in retirement, then what is the role of a DC plan within that framework? Ultimately, say Randle and Rudolph, the supervision of DC pensions must take a more proactive role in minimizing pension risk. Read and download the paper here.

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MARK.YAMADA.1

The obvious problem comparing DC plans with DB plans is that their objectives are different. Align their objectives then compare. We measured how successfully popular DC investment choices (60:40 balanced and target date funds) would have been at delivering a DB like 70% replacement income. 60:40 balanced replaced 70% of income 37% of the time and target date funds did so 52% of the time. (Rotman International Journal of Pension Management, 2011). If comparing retirement benefits, one must equate the DB plan's annuity-like income stream to a DC investment. We did this in a follow-up paper (RIJPM, 2013) and explored a dynamic investment strategy that would provide for a steady income stream post-work while trying not to run out of money. Bottom line: DC plans don't care about post-work income. With few exceptions, most money is withdrawn soon after retirement.

Transcontinental Media G.P.