defined contribution schemes should employers or countries be permitted to sponsor them?

2002 年 11 月 9 日 RotoruaNew Zealand Society of Actuaries Conference, 14 November 2002, P12

Lohmann International Associates ©2002, slide 1/50

Defined Contribution SchemesShould Employers or Countries be

Permitted to Sponsor Them?

This article shows that the goals of DC plans can be achieved by permitting participants full access and control over their accumulations. It suggests that

to do otherwise subjects the accumulations to unreasonable risks of loss. We believe that

actuaries fulfill their obligation to participants by supporting separation from employer control upon

vesting



Introduction

• Les Lohmann– Defined Benefit (DB) actuary– Cultural issues



Introduction

• Thrift– Saving money for a later need– Defined Contribution (DC)

• DB Retirement– Cannot pay before actual departure– Life annuities also depend on age of vesting



Introduction

• Importance of Culture– Canada– Japan

• Importance of history– Merrick, Aberdeen and Grennock

• Importance of the numbers– Expose and explain



Introduction

• Goals– Startling– Unbalanced– Stimulating



Introduction

• Who controls the disposition of the money?– Participant– Employer– Government (investment quality requirements

excepted)

• "Holding the money" refers to where the center of gravity of control lies.



Important definitions

• Sponsor

The sponsor of a scheme maintains a significant relationship with the accumulating contributions of the participant, even after the participant is "fully vested" in any contributions made by the sponsor.




• Participant– "Someone with rights, vested or not, in a

scheme”– Employees not yet eligible count

• Portable• Saturated with savings• Retirement scheme

– Age retirement




• Pension scheme– When a "pension scheme" provides severance

benefits, it is in the form of or equivalent to the value of a deferred annuity payable at normal retirement age

• Severance scheme– Termination– Like "pension scheme," the formal name of the

arrangement does not change the fact of the benefits provided.



Assumptions

• Retirement schemes provide the money in one or a mix of two forms– annuity– lump sum

• A retirement scheme can provide severance benefits.



Assumptions

• Lump sum– When a scheme determines benefits as a lump

sum, the fact that a beneficiary has opportunities to purchase, with the scheme lump sum disbursement, an annuity does not change a scheme into a pension scheme, even when that annuity is an alternative form available from the scheme



Assumptions

• This article does not apply to schemes that are merely tax deferral schemes or severance schemes

• The scheme sponsor has decided to implement a retirement scheme as opposed to a severance scheme.



Assumptions

• Capital efficiency Always plays a role– the sponsor has developed some ideas of how

much money should be provided at age retirement and that this concept is being applied in the development of the sponsored scheme



Assumptions

• Capital efficiency Always plays a role– Employees have an idea of how much money

they will need at retirement and will try to save this amount in a cost-effective way. For an employee, "cost-effective" means achieving a reasonable balance between satisfying immediate needs and thrift.



Characteristics of DC Schemes

• Not pension schemes• Often require participant contributions in or

der to attract employer contributions.• Benefits

– Taxable– Portable

• DC schemes shift risk from the employer to the participant when compared with defined benefit (DB) schemes.



Characteristics of DC Schemes

• Employer costs are more certain than DB schemes.

• Are career-average• No participant ever gets the retirement/seve

rance benefits designed or expected• DC schemes encourage saving over consum

ption, often with a tax subsidy



DC schemes are not pension schemes

• DC schemes are either severance schemes and/or tax deferral schemes.

• DC schemes recharacterize current pay. They are perceived as retirement vehicles only because employee participants are not permitted access to their accumulated money until they quit.– Japan actually denies access until age 60



DC schemes often require participant contributions

• In the absence of enabling legislation, participant contributions are fully taxable as ordinary income before being saved.



DC schemes often require participant contributions

• American enabling legislation recharacterize participant contributions as employer– Vesting rules recognize these funds as truly bel

onging to the participant - requiring immediate vesting and participant control.

– Even without enabling legislation, amounts paid by the employer sponsor to a DC scheme are tax-deductible as a reasonable employment expense.



DC Scheme Benefits

• Taxable to the beneficiary upon receipt.

• Portable. There is no reduction for– early retirement– survivorship



DC schemes shift risk from the employer to the participant



DC Scheme Costs are certain

• Equal to the contribution

• Over the long term, costs are higher than DB schemes for the same planned age retirement benefits.

• Employers have more flexibility



DC Schemes are Career-average

• Can't provide benefits related to the participant's final standard of living

• Penalize better than average performance near the end of a career

• Do little to reward better than average performance occurring early or mid-career

• Tend to reward savings made during the years of career development and family formation



DC Schemes Cannot Deliver

• No participant ever gets the retirement/severance benefits designed or expected from a DC scheme– If investments have done well, (s)he will get

more than planned– If investments have soured, (s)he will get less

than planned.



DC Schemes Encourage Thrift over Consumption

• Often with a tax subsidy– Taxes are deferred to a later date, then taxed as

ordinary income (U.S. approach).– Taxes are reduced regardless of payment timing

or other income (Japan approach).



Characteristics of employer-sponsored DC schemes

• Employees must pay to participate.

• Employer contributions must be "invested" in company shares.

• Employer contributions vest only on service - not by reason for termination.

• The employer sponsor has no liability once the contribution is made.



Characteristics of employer-sponsored DC schemes

• The employer has the use of both the participant and employer money for a period before being invested. During that period, the participant is a general creditor.

• "Investment options" are totally controlled by the employer sponsor.

• Scheme costs are borne by participants usually through a reduction in investment earnings.



Common Misconceptions of DC Schemes

• Investment returns are higher than for funds invested for DB schemes.

• DC schemes cost less for employers.

• Higher benefit security

• DC schemes benefit the economy.



DC Schemes have Higher Returns

• Current return vs assumed discount rate

• Shorter horizons

• Lower risk tolerance

• Diversification (efficient frontier)



DC schemes cost less

• Administration

• Cost shifting

• Lower overall benefits– Less than 100% participation– Matching



DC Schemes Provide Higher Benefit Security

• Principal protection/Risk

• Employer shares



DC Schemes Benefit the Economy

• Japan– Investment losses– Participant ignorance

• Economic consequences– Savings vs consumption– Supply vs demand

• Economic activity• New capital



Recent "discoveries" about DC Performance and Weaknesses

• Average people/lottery

• Market volatility

• Employer flexibility

• Investment fees vs fund performance

• Investment choice cycles vs capitalizing losses



The Average Investor is Below Average

• Buys and sells on emotions.

• Does not have prompt access to the information that drives markets.

• Bets the farm on a "sure thing."

• Believes that his/her own account will outperform the illustrated investment returns.



How to Make Money with a DC Scheme

• Percentage of gross assets under management

• Per transaction




• Corporate insiders– Personal trading– Using participant equity assisting or opposing t

akeover efforts– Less than arms length loans

• Penalties vs profits– How to become president!




• Can employees be sufficiently educated?– Gambling?

• Market volatility/Ruin theory



Recent cases

• Tyco, GE and Intel illustrate the ease with which management can transfer all corporate earnings into their own pockets

• Enron and Worldcom tell us something about the ways management can unload shares on insider knowledge without notice and engage in cross transactions that benefit a few at the expense of the owners, transferring sums wildly exceeding earnings into their own pockets



Recent cases

• AOL taught us that actuarial probabilities can apply to allocating an income stream to CDs that are passed out for free.

• Bell Labs, owned by Lucent, reported scientific discoveries of Nobel prize stature. They were faked.

• Several companies taught us how to borrow money and report it as income.



Pro-Forma Sins

• Double/Triple/Infinite counting

• Misallocation of expenses

• Funny income

• Swaps

• "Round trips"

• Buying political advantage with someone else's money



Investment Rules

• Wrong sets of investment rules– DB– Full funding vs employer liability– Payment of contribution



Control

• Participants investment discretion

• Employer shares vs full vesting

• Investment option control– Perception of value versus risk– Unilateral rights of the sponsor vs abuse

• Privacy

• Universe of investment options



Conflicts of Interest

• Why would your employer set up a bank account for you?

• Smoke and mirrors

• Scheme expenses

• American unions

• "Total pay systems"




• Choosing investment vehicles– Employer liability– Expense levels– Investment performance– Existing business relationships– Who pays for the analyses?




• Risks of fiduciaries and sponsor– Completed transaction– Insurance– Insolvency law– Cost of legal actions



Participant interest

• Low expenses

• High Return



Government-sponsored schemes

• Governments are subject to the same temptations, perhaps more so, as private industry

• Japan EPF

• Japan "401K"



Benefits to Society

• Pressure on Social Security vs DC Schemes

• Tax-deferred savings vehicles

• Loans

• Turnover

• Payroll deduction

• Broader economic issues (Japan)



The Bottom Line

• The basic question is, why should fully vested participant money require termination of employment to become completely controlled by the participant and independent of the employer?



The Bottom Line

• Employers and governments that wish to provide retirement security to their people should be required to do so with the technique that is not readily available to individuals - DB retirement schemes.

• DC scheme funds should be placed outside the reach of the employer or the government as soon as practicable.

defined contribution schemes should employers or countries be permitted to sponsor them?

Documents

severance benefits

participant contributions

employer contributions

employer control

assumptionsretirement

rolethe sponsor

defined benefit db schemes

accumulating contributions