Risk Shifting

Defined-contribution pension plans increase labor mobility and facilitate the revival of old businesses in the face of massive industrial restructuring and longer life expectancy.

In early January 2006, IBM froze contribution to its defined-benefit pension plan and switched over to a defined-contribution plan. Motorola, Verizon, Hewlett-Packard, and Sears have made similar decisions. IBM’s move simply put the last nail on the defined-benefit-plan coffin. Already by 2005, 78 of the country’s largest 100 public companies offered defined-contribution plans (Economist 1/14/2006).

By moving from defined-benefit plans to defined-contribution plans, companies can look forward to big saving. For example, IBM would save an estimated $2.5 - $3 billion over 5 years (WSJ. 1/12/2006). What is more significant than the cost saving is the wholesale shift of risk to future retirees.

The benefit in a defined-benefit pension plan is determined by a formula, which can incorporate the employee's pay, years of employment, age at retirement, and other factors. Defined-benefit plans typically pay their benefits as an annuity, so retirees do not bear the investment risk of low returns on contributions or of outliving their retirement income (Wikipedia: “pension”)

In a defined-contribution plan, money contributed can either be from employee salary deferral and/or from employer contributions or matching. Examples of defined- contribution plans in the United States include Individual Retirement Accounts (IRAs) and 401(k) plans. In such plans, the employee is responsible, to one degree or another, for selecting the types of investments toward which the funds in the retirement plan are allocated (Wikipedia: “pension”)

Are employers or employees better able to shoulder the risk of low investment returns?

• With more competent fund managers, employers are likely to get higher returns on their pension fund than self-directed individual retirement accounts. But even competent pension funds are not immune to stock market downturns.

• Employers may under-fund their defined-benefit plans. Because of the J-shaped accrual rate, the cost of a defined-benefit plan is very low for a young workforce, but extremely high for an older workforce (Wikipedia: “pension”). That means older companies with older workforce may be increasingly unable to fully fund their plans.

• Attempts to honor defined benefits may make older companies cost uncompetitive against upstart rivals with younger workforce. These legacy cost may drive old companies into Chapter 11 bankruptcy in order to have a fresh start.

• Even in bankruptcy, the employees can still look forward to uninterrupted payment of pension benefits from the Pension Benefit Guaranty Corporation to which private employers in the United States have been paying insurance-type premium. But the premiums are not high enough to guarantee full benefits.

Shifting risk from employers to employees may be cold-hearted. But it is the only way to facilitate resource re-allocation in the face of massive industrial restructuring and longer life expectancy. Because of its portability, defined-contribution pensions encourage labor mobility from declining to growing industries. And because of more predictable financial commitment, older companies and industries are given a second chance to regain their competitive foothold. When the risk is systemically high, no risk-pooling is going to be completely solvent. Decentralizing risk to the individual may be the only way to spread the pain.