Original Research for Inquisitive Investors

The Future of Retirement Plans October 2013

WWW.BRANDES.COM/INSTITUTE [email protected] Executive Summary

Collectively, Americans are woefully unprepared their retirement accounts. But how? We suggest financially for retirement. This retirement automatic enrollment and greater education on problem actually reflects a collection of diverse how critical contributions are. Limiting choices in issues. This paper identifies the most important DC plans to assets that better mirror professionally ones: longevity; access; contributions; portability; managed DB plans would help. Guiding workers behavioral mistakes; funded status; expenses; and to retire later also would have significant benefits. regulation. Our research focuses on solutions for Concerns over securing retirement assets are both plan sponsors and participants. not unique to the United States. We investigated The Retirement Rule, Benefits = (Contributions retirement structures in select developed countries + Investment Earnings) – Expenses, provides a and share approaches that may have relevance for good framework to evaluate the problems and the American pension community, including: less assess potential solutions to the pensions crisis. stringent mark-to-market rules to foster a longer- It also clearly identifies where the move from term investment perspective; the introduction defined benefit (DB) to defined contribution (DC) of variable benefit plans; approaches that result plans alters the balance of risk and cost from plan in higher contributions; greater education and sponsor to participant. access to annuities as a distribution option for retirement plans; “official” retirement age that Three generations of American workers have is indexed to life expectancy; and automatic experienced an amazing transformation of enrollment for plan participants. the employee benefit landscape with changes that initially provided greater wealth, but Two proposals at the national level aim to fill the subsequently led to capped or reclaimed benefit gap for workers who do not have access to an promises. With relatively little public awareness, existing DC or DB plan: NCPERS’ Secure Choice but with significant consequences, within the last and Senator Harkin’s USA Retirement Plan. Both few years DC plans have been transformed for use the cash balance plan concept and both aim many from supplemental savings to the primary to solve the issues of investment risk, longevity source of retirement income. Plan sponsors have risk and the need for professional management. experimented with “hybrid” DB plans (such as There are significant differences between these cash balance plans and adjustable benefit plans), proposals, but they could co-exist. The NCPERS but today’s landscape remains dominated by a proposal uses a state-by-state approach, while shift away from DB to DC with significant impact the USA Retirement Plan proposes a federal for participant benefits. framework. We believe both are sound, and as long as contribution rates are adequate, these Various factors are likely to hurt DC participants plans can play an important role in the industry. financially, including lower contributions, lower investment returns and potentially their own Hybrid plans may emerge as viable, long-term poor investment decisions. In the meantime, DB solutions. In theory, DB and DC plans that are plan sponsors are still dealing with underfunding well designed, well-funded and properly invested problems. The “simple” (but not necessarily easy) can deliver adequate retirement benefits. In reality, solutions include: increase contributions; retire some DB plans and most DC plans do not meet later; and increase investment returns. The real these objectives. We believe adaptations of hybrid solution for the pension community is to find plans will emerge as competitors to existing DC ways to enable participants to build adequate plans and alternatives to DB plans if the latter retirement income and to do so in a structure continue to be phased out by plan sponsors. The that works effectively for cost- and risk-conscious newer hybrid plans require various legislative plan sponsors. changes and regulatory approvals. We support moves that make these plans easier to implement as To help get to and through retirement workers they offer features that address current challenges must participate in and make contributions to for participants and plan sponsors, alike.

PAGE 2 To achieve success, in our view the retirement plan of the future needs these features: • Contribution levels should be high, in the range of 15% of salary each year. • The plan design should use behavioral techniques to encourage participation and raise contribution rates. • Assets should be professionally managed.

Collectively, • Plan assets should be portable across employers. Americans are • Longevity risk should be minimized by pooling individual participants’ assets with others. woefully unprepared • Retirement age should be deferred where feasible, increasing both savings and benefits. financially for retirement. This • Participants should be able to understand in simple terms how well prepared they are for retirement “problem” eventual retirement. actually reflects a The retirement train is pulling into the station; it is our collective responsibility to get passengers off the collection of diverse tracks and onto the platform. issues. 1. The Problems for Retirement Planning1 Section 1 Summary: Collectively, Americans are woefully unprepared financially for retirement. This retirement “problem” actually reflects a collection of diverse issues. This paper identifies the most important ones: longevity; access; contributions; portability; behavioral mistakes; funded status; expenses; and regulation. Our research focuses on solutions that can work for both plan sponsors and participants. Simply put, the biggest problem facing the workforce today is that collectively Americans are woefully unprepared financially for retirement. “Woefully” is the right word: there are potentially a lot of financial and social woes waiting for future generations of U.S. retirees. But retirement planning is a highly complex issue. Many factors impact the ability to provide adequate pensions: economic, political, actuarial and even psychological. “The U.S. pension industry is in crisis,” has become a widespread lament among plan sponsors, plan participants, taxpayers and politicians. Given the potential impact on society as a whole, there’s a growing understanding that there’s a big problem that needs to be fixed. This paper aims to cut through the complexity and identify the most important issues, evaluate some suggested solutions and make recommendations. In the late twentieth century over half of American workers were covered by DB pension plans.2 Most didn’t have to worry about saving for retirement. But now fewer than one in six private sector employees have access to a DB plan that’s open to new contributions, according to the Urban Institute Retirement Security Data Brief, April 2013. And as we’ll demonstrate, the DC plans that are replacing them as the main retirement saving vehicle are not filling the gap. This is a well-covered story, usually presented as a looming problem for workers, retirees and for society as a whole, with employers and plan sponsors portrayed as part of the problem, not the solution. But as we describe later, we see a flurry of innovation from plan sponsors aiming to provide adequate pension benefits at a reasonable cost. The motivation may include fiduciary responsibility but in practice stems from the need to provide competitive compensation in an open marketplace for employees. If successful, these innovations may change not only today’s apparent trend toward DC, but also reinforce the importance of the skillsets developed over the years by the DB plan sponsor community.

1 We note the difference between “pensions” and “retirement.” A pension, according to the Merriam-Webster dictionary, is a fixed sum paid regularly to a person following retirement from service. While “pension plan” and “retirement plan” are often used interchangeably, there is an important distinction. As the dictionary notes, “pension” implies a regular payment during retirement. In theory, while a retirement plan could be as simple as a decision to “go live with the kids when I retire!” More realistically, retirement plans would include investment accounts such as 401(k) or IRA defined contribution plans, which may have no pension element. So we’ve broadened the scope of this research deliberately to encompass retirement planning, not just pensions. 2 Seburn, Patrick W. “Evolution of Employer-Provided Defined Benefit Pensions.” Monthly Labor Review. Dec. 1991. PAGE 3 Can the solution be as simple as just setting aside more for retirement savings? Unfortunately not. But contribution rates are a good place to start in understanding the scope of the problem. To accumulate enough money to replace their salary at retirement, people need savings (including any company match) equivalent to 15% to 20% of their salary every year over their entire career while averaging investment returns of around 4% annually above inflation on these investments, according to Bob Maynard, CIO of the Idaho Public Employees Retirement System. And these numbers assume at least 20% of that retirement income target comes from Social Security payments. Can the solution be as simple as just The National Conference on Public Employee Retirement Systems (NCPERS) is in the same camp. In its setting aside more for report, “The Secure Choice Pension,” it estimates that a worker 35 years from retirement needs to save retirement savings? around 12% of salary to replace 80% of income in retirement. This is consistent with Brandes Institute Unfortunately not. models that estimate that 15% annual contributions may come close to replacing final salary. But contribution rates Stacking these objectives against the reality of many workers’ savings and investments, especially those are a good place to reliant on DC plans, reveals a wide gap. Government estimates from the Social Security Bulletin (volume start in understanding 71, no. 2, 2011) measured the median annual contribution by participants in DC plans in 2006 at around the scope of the 5.5%. Wealthier savers tended to save more, but not nearly enough. For the highest decile of earners, problem. the median annual contribution rate was 7%, dropping to a meager 3% for the lowest decile of earners. Either out of necessity or choice, participants struggle to set aside enough to help their future selves a couple of decades down the road. Exhibit 1: The Savings Shortfall: Around 10% a Year in Contribution Levels, as of 2006

Median annual contribution rate for DC plans Estimated annual contribution to replace final salary 16%

14%

12%

10%

8%

6%

4%

2%

0%

Source: Social Security Bulletin as of 2011, EBRI, NCPERS Secure Choice Pension, Brandes Institute estimates

At the contribution rates in Exhibit 1, a participant might achieve 30% replacement of final salary, instead of 82% if contributions had been made at the recommended rate. According to the Employee Benefit Research Institute (EBRI), the average U.S. worker likely will need $900,000 upon retirement to maintain his or her lifestyle, but, “The average balance in all 50 million U.S. 401(k) accounts is just over $60,000. Even people within 10 years of retirement have saved an average of only $78,000, and more than a third of them have less than $25,000.”3 In addition, “43% of workers between the ages of 45 and 54 said they weren’t currently saving for retirement at all.” Collectively, the difference between what U.S. workers have saved for retirement vs. what they should have at this point in their lives is $6.6 trillion.4

3 The EBRI 2012 Retirement Confidence Survey, March 2012.

PAGE 4 Exhibit 2: The Income Shortfall: Over 50% of Final Salary, as of 2006

At median annual contribution rate for DC (5.5%) At recommended annual contribution rate of 15% 90%

80%

70% “43% of workers between the ages of 60% 45 and 54 said they 50% weren’t currently 40% saving for retirement 30% at all.” Collectively, the difference between 20% what U.S. workers have 10% saved for retirement vs. 0% what they should have at this point in their Source: Social Security Bulletin as of 2011, NCPERS Secure Choice Pension, Brandes Institute estimates. Illustration of percentage of final salary replaced assumes real investment returns of 4% over a working lifetime. It also assumes a 25-year old retiring at 65, inflation and contribution increasing at 3% lives is $6.6 trillion.4 annually, costs at 1% annually. This hypothetical example is for illustrative purposes only. It does not represent the performance of any specific product. Actual results will vary.

Over the 40 years to yearend 2012, U.S. stocks had gained 9.8% annualized and long-term government bonds gained 8.9% annualized. But since the start of 2000, U.S. stocks gained less than 2.0% annualized through yearend 2012, as measured by Ibbotson data. The continuation of the bond bull market has

Exhibit 3: The Assets Shortfall

What the average “near-retirement worker*” has saved What the average worker may need for retirement $1,000,000

$900,000

$800,000

$700,000

$600,000

$500,000

$400,000

$300,000

$200,000

$100,000

$0

Source: EBRI, Social Security Bulletin, NCPERS Secure Choice Pension, Brandes Institute estimates. *“near-retirement” defined as within 10 years of retirement age.

led to 10-year U.S. Government bonds yielding less than 3.0% (both at yearend 2012 and into the third quarter of 2013). As a result, many workers (and many plan sponsors) may have turned sour on equities due to poor returns, while bond yields are still close to historic lows.5

4 The Retirement Crisis and a Plan to Solve it, a proposal by Senator Tom Harkin, July 2012

PAGE 5 With the combination of low savings rates and key investment decisions (allocation low investment returns, the retirement train and selection) onto workers and is pulling into the station. And far too many retirees who (despite increased availability of basic investment potential passengers are waiting on the tracks, not education) may be inexperienced and the platform. vulnerable to behavioral mistakes that can cost them dearly in long- In order to fix the “problem with pensions,” we term returns. Many DB pension must first figure out what actually is the problem. plans, especially in the Like much in life, it depends who you ask! A 6. Funded Status. Some state or public sector, use long- review of media, practitioner and academic municipal DB pension funds are so underfunded, according to a term investment return opinions quickly reveals a multitude of “pension Moody’s Investors Service Report on assumptions that problems.” Every one of them has potentially a June 27, 2013, that they are (or may appear high compared major impact on benefits, funding and/or society soon be) unable to pay promised to current market (read “taxpayers”). None of them has an easy fix future benefits. conditions so if those or it wouldn’t be on this list. 7. Expenses. Administrative and fund assumptions are not Aggregating these opinions, we come up with a expense costs of many DC retirement met over time, the savings plans appear high, especially broadly defined list of eight factors that encompass in a current environment of low plans may prove the United States’ “pension crisis.” bond yields and historically low to be significantly equity returns. underfunded. THE WORKFORCE, EMPLOYERS and 8. Regulation. Regulatory policies RETIREES intended to make DB plan assets 1. Longevity. Retirees whose tax- “safer” could have a contrary effect deferred savings are in investment by (a) shortening the time horizon accounts providing capital for plan sponsors and reducing their accumulation but no lifetime income ability to deliver adequate investment option face a risk of running out of returns in the long term and (b) money if they live “too long.” removing incentives to fund benefits, leading to freezing or closure of many 2. Access. Many workers who don’t have DB plans, as well as reduced matching access to any employer-sponsored money for DC plans. retirement plans for tax-deferred saving may be left totally unprepared Many DB pension plans, especially in the public for retirement. sector, use long-term investment return assumptions 3. Contributions. Workers or retirees who that appear high compared to current market do have access to tax-deferred plans but conditions so if those assumptions are not met fail to make suitable contributions could over time, the plans may prove to be significantly fall short of an adequate standard of underfunded. living in retirement. And even if those long-term return assumptions 4. Portability. Workers who move more frequently may not be well served by are met, a few of these DB pension funds may traditional employer defined benefit still be dangerously underfunded relative to their pension plans whose benefits are in long-term benefit obligations, based on their some cases not portable. existing actuarial assumptions. With people living longer most DB pension funds THE RETIREMENT FUNDS that pay lifetime benefits may have underestimated 5. Behavioral Mistakes. Some the additional cost of this longevity, and so may retirement plans increasingly push be even more underfunded than they appear.

5 U.S. stock returns represented by data from Ibbotson Associates via Morningstar. Long-term U.S. Government bonds represented by data from Ibbotson Associates via FactSet through yearend 2005 and the Barclays U.S. Treasury 20+ Year Index from 2006 to yearend 2012. Historical 10-year U.S. Government bonds yields were drawn from Prof. Robert Shiller’s website: http://www.econ.yale. edu/~shiller/data.htm. According to the Shiller data, the 10-year U.S. Government bond yield reached its all-time low (based on monthly data back to January 1871) in July 2012 when it fell to 1.53%. Outside of this decade, the last time U.S. Government bonds were at a comparable level was January 1941 when they fell to 1.95%. The yield in August 2013 was 2.57%. The 40-year returns for stocks and bonds referenced above are for Jan. 1973 to Dec. 2012. Past performance is not a guarantee of future results. One cannot PAGE 6 invest directly in an index. All of the above factors contribute to the problem. Every topic on this list has generated articles and arguments regarding dangers and the implications for individuals, employers and even society as a whole. The problem is complex, and there is no easy solution. In this paper, we touch on all of these, but our focus is on finding the solutions that have the broadest impact on the primary goal: ensuring that adequate retirement benefits are at least within reach for most workers and retirees. This includes finding approaches that work effectively for both plan sponsors The retirement and participants. problems in the United States must 2. A Framework for a Solution include solutions for both DB and DC plans Section 2 Summary: The Retirement Rule, Benefits = (Contributions + Investment Earnings) – Expenses, and for any other plan provides a good framework to evaluate the problems and assess potential solutions to the pensions crisis. design variations It also clearly identifies how the move from DB to DC plans alters the balance of risk and cost from plan that evolve. sponsor to participant. Retirement Rule: Benefits = (Contributions + Investment Earnings) – Expenses B=(C+I)-E This simple rule provides a framework for evaluating almost all of the problems identified in section 1, as most of these are directly related to failings in one or more of C, I or E in that equation. Two other factors must be added to the roster of issues: longevity and portability. These will be considered later in this research. The retirement problems in the United States must include solutions for both DB and DC plans and for any other plan design variations that evolve. As noted earlier, “solving” means that B (benefits) must be adequate for the participant to retire. While the Retirement Rule is a finance equation that can be addressed mathematically, in practice the design and implementation of realistic solutions involves a complex web of political, economic and investment issues. For context, we first look at the U.S. retirement system past and present, and then analyze the current situation in the framework of the Retirement Rule and the finance/political/behavioral impacts. Over time, American workers have become increasingly dependent on DC plans as traditional DB plans are closed or limited. The Retirement Rule is valid for both, but the definitions of each term may differ and some specific risks are passed to the DC participant that would have been accepted by the sponsor in a DB plan. While these are well known, it may be helpful to set them down in a Retirement Rule format as we will follow this method in our analysis throughout this article. Exhibit 4 summarizes the key differences in traditional DB and DC plans.

Exhibit 4: Plan Definitions Benefits Contribution Investment Earnings Expenses

Typically, DB plan Primarily sponsor6 Plan return Sponsor control Annual pension

Sponsor oversight but Usually sponsor and DC plan Lump sum Participant return influenced by participant7 participant asset mix

6 In some cases, participant contributions also may be significant. 7 Sponsor contributions may be suspended or eliminated during difficult times. For example, in the wake of the Financial Crisis in 2008/2009, 53 Fortune 1000 companies in the United States changed their matching contribution to their employees' savings plans, PAGE 7 as of May 2009, according to Towers Watson. Exhibit 5: Which structure poses higher risks or costs: DB or DC? The answer is different for Plan Sponsors and Participants Higher risks or costs for PLAN SPONSORS Investment Benefits Contribution Earnings Expenses Financial Risk DB DB DB DB Over time, American Longevity Risk DB n/a n/a n/a workers have become Behavioral Risk n/a n/a DB n/a increasingly dependent on DC plans as Higher risks or costs for PARTICIPANTS traditional DB plans Investment are closed or limited. Benefits Contribution Earnings Expenses The Retirement Rule Financial Risk DC n/a DC DC is valid for both, but Longevity Risk DC n/a n/a n/a the definitions of each term may differ and Behavioral Risk DC DC DC n/a some specific risks Source: Brandes Institute are passed to the DC The bottom section of Exhibit 5 demonstrates disadvantage to professional plan sponsors. participant that would the risk comparison for plan participants, tilted Lastly, Expenses of DB plans are generally lower have been accepted firmly toward DC plan participants. The financial than those of DC plans, although the difference by the sponsor in a risks impact DC plan participants in three ways should narrow in the United States given that the DB plan. (B, I and E). First, in low yield markets, it may recent move to make DC expenses transparent be difficult to annuitize a lump sum at retirement to participants will bring market competitive to provide a meaningful lifetime Benefit. For pressures to bear. example, a 65-year old man seeking to replace a The transfer of longevity risk to DC participants proportion of his final salary would have to spend impacts benefits (B), allowing the possibility that a lump sum of around 16 times every dollar of assets will run out during retirement. lifetime income he needs. (To replace $10,000 of income a year for the rest of his life, he would This is exacerbated by the behavioral risks in have to spend $160,000. Replacing $20,000 of DC plans. In fact, there are severe participant income would require spending $320,000.) In behavioral risks in every aspect where the addition, there may be regulatory issues and participant has a direct decision-making role: B, C tax consequences that make it difficult for many and I. Behavioral risk to Benefits can be aggravated DC plan participants to convert some or all of by not annuitizing any of the lump sum proceeds, their accumulated assets into annuities. The or even worse, by spending a material amount Department of Labor and IRS are both moving of the proceeds early in retirement (similar to to make this easier, but there is still work to be the lottery effect: when individuals have a much done, especially for deferred income annuities.8 bigger lump sum than they’ve ever seen before, the temptation may be to spend a chunk of it on Secondly, even before behavioral errors, the “the good life”). The behavioral effects are well- playing field is not level for DC participants documented regarding investors’ insufficient level relative to their professional DB counterparts in of Contributions, but adding an extra layer of respect of limited menu choices and lack of scale complication is that most participants suffer from economies. Add that to behavioral issues and DC behavioral issues that may cause them to fall way participants are at a material Investment earnings short of success.

8 DC plan participants are typically required to make an annual minimum withdrawal, called a Required Minimum Distribution (RMD), soon after reaching age 70½. The RMD is calculated based on the participant’s age and the account value. But participants who purchase a deferred income annuity (sometimes called longevity insurance) with a lump-sum premium and hold the contract within their DC plan (to preserve the tax-deferred status of the premium paid) could still be subject to RMDs even though the contract may not begin to pay income until they reach age 80 or 85. Participants who do not have additional resources within the DC plan to make the annual minimum withdrawals would be subject to surrender charges for withdrawing money prematurely from the annuity contract to satisfy the RMD. The Department of Labor has proposed modifications to required minimum distributions with regard to deferred income annuities but no changes have taken effect. PAGE 8 Annual studies by Dalbar show consistently that the average mutual fund investor achieves results well below the overall market, largely because of following the crowd—buying high and selling low. Their most recent study, for the 20 years through 2012, shows a shortfall of 4% annually over the past two decades. That’s actually on the low end of the range seen historically in the Dalbar studies. To be fair, DB plan sponsors are not exempt from the behavioral errors of chasing short-term performance. Research by Goyal and Wahil in 2008 covering a 10-year period to 2003, showed that plan In 1940, private sponsors tended to fire managers after they underperformed, and subsequently those fired managers pensions covered 4 tended to outperform their successors. Nevertheless, the impact of this factor appears modest compared million people or about to the potential damage individual investors can inflict upon themselves when making their own DC 15% of the active U.S. investment decisions if the Dalbar study is representative of their results. workforce. By 1960, So there is fairly significant evidence that DC plans fall short of DB plans from a participant perspective. those numbers had But this is not “new news.” Our focus is on evaluating DC, DB and other competing plans to see which, grown to 23 million or if any, can provide a solution to the various issues outlined earlier. about half of all private sector employees.9 In order to provide the right context, we need to start with the past: how did the American retirement industry get to this state of affairs?

3. A History of DB and DC Plans in the United States Section 3 Summary: Three generations of American workers have experienced an amazing transformation of the employee benefit landscape with changes that initially provided greater wealth, but subsequently led to capped or reclaimed benefit promises. With relatively little public awareness, but with significant consequences, within the last few years DC plans have been transformed for many from supplemental savings to the primary source of retirement income. Plan sponsors have experimented with “hybrid” DB plans (such as cash balance plans and adjustable benefit plans), but today’s landscape remains dominated by a shift away from DB to DC plans – with significant impact for participant benefits. As the United States economy entered the post-World War II era, robust private sector growth fostered the development and expansion of employee benefit programs to attract and retain skilled workers. For working-age survivors of the Great Depression and WWII, this meant fresh opportunity to pursue much-improved lifestyles based on current “real” income growth and enhanced retirement benefits. Demographic realities supported this expansion of income and health-related benefit programs—more active workers in proportion to inactive or retired workers. In 1940, private pensions covered 4 million people or about 15% of the active U.S. workforce. By 1960, those numbers had grown to 23 million or about half of all private sector employees.9 As the number of active workers continued to exceed the number of actual retirees, growth in employer-provided medical care and retirement medical care also grew substantially. By 1980, defined benefit (salary replacement) retirement plans had grown further to cover 60% of private sector employees, and an even higher proportion of the public sector. In return for these tax benefits, the corporate sponsors of these plans assumed both investment risk and longevity risk for the benefits that were “defined” in the plan formulas. Regardless of capital market returns (which were also strong during this period and fostered a sense of complacency among plan sponsors with regard to advance funding of these benefits), most workers did not have to worry about the security of their promised benefits. Even though many would also participate as private investors in U.S. equity and debt markets, most workers could ignore capital market valuations and volatility—and spend more of their current income in support of a fulfilling lifestyle. When a few plans did fail (e.g., Studebaker), Congress stepped in to provide protection via ERISA and creation of the Pension Benefit Guaranty Corporation (PBGC).

9 Seburn, Patrick W. “Evolution of Employer-Provided Defined Benefit Pensions.” Monthly Labor Review. Dec. 1991 PAGE 9 This corporate-centered paternalism continued With Investment earnings low given the lack of unabated for 50 years. Government entities at exposure to equities and Contributions limited, the local, state, and national level developed Benefits = (C+I)-E could hardly be other than similar retirement income and medical coverage supplementary. But that was not seen to be a programs (albeit on a smaller scale) to attract and problem as workers would not be relying on retain workers. In the context of the Retirement these DC plans as their primary means of support Rule, Investment earnings were relatively high, in retirement. And by the late 1990s, the equity In 1985, the Expenses were controlled, and the aggregate euphoria gave many participants the idea that Department of Labor Contributions made by the plan sponsors were their DC savings could comfortably fund their reported there were manageable as the participants were fewer and retirement on their own if need be. 114,000 DB plans in younger (and hence lower paid) when compared But beginning in the late 1990s, even before the the United States. to the demographics of plans in the more recent tech bubble, corporate plan sponsors (well ahead decades. As a result, the economic impact of the of their public plan peers) began to realize that the Benefits paid was acceptable; certainly not at the economics and demographics of DB plans were top of the agenda for corporate management. moving against them, even with the associated B=(C+I)-E was solvable for many decades. tax benefits. Accounting rules made fluctuations In the 1980s a new form of retirement income in DB plan values increasingly apparent to readers savings was introduced broadly in the U.S. of the income and balance sheet disclosures of markets, based on the Revenue Act of 1978 which corporate performance. This was only a “potential created 401(k) plans. Instead of a defined benefit, for disaster” while asset prices were rising. But if these plans relied on “defined contributions” from they should ever fall (and post 1999 they certainly participants and their employers. Companies did) corporate plan sponsors took the brunt. promoting these plans to their workers stressed At the same time, actuaries were pushing plan the supplemental nature of the new benefit and sponsors to recognize the economic reality of promoted participation by offering matching longer expected lifetimes for both men and grants (essentially free money) to those who women. This combination of rising portfolio signed up. The primary goal was attracting and volatility and increasing longevity risk would retaining skilled workers in the face of steady prove toxic to the now broadly available DB economic growth. plan benefits for American workers. In 1985, the Investment menus for these defined contribution Department of Labor reported there were 114,000 plans initially were limited and largely focused on DB plans in the United States. By 2012 this had capital preservation. However during the 1990s fallen to 38,000. The Bureau of Labor Statistics average exposure to equities grew, fueled by the noted in 2012 that only 15% of private sector bull market euphoria. By 1999 when the internet employees were covered by an open DB plan bubble was well underway, EBRI statistics put the where they could accrue benefits, and in most of average 401(k) exposure to equities at 55%, with these cases, many of the ancillary medical and life another 19% in company stock. These levels fell insurance plans have also disappeared. For the during the 2000s and by 2011 equities represented public sector the number remains high, at 85%, at only 39% of 401(k) allocations, with company least for now. Nominal asset growth of DB plans stock down to just 4%. continued to build, but corporate management began to curtail worker eligibility, beginning While these plans exposed participants to with non-union salaried employees and gradually investment risk, and raised awareness of the extending to union workers. variability of capital market yields and total returns, in the early years workers took comfort A key strength of the DB plan from the participant from the fact that their portfolios were tax- perspective has always been the sponsor deferred and that the resulting benefit was truly contribution. While employees can and often just a supplement to their promised DB payout. do make voluntary contributions, these sponsor

PAGE 10 contributions generally have been sufficient to compared to the few who stay put throughout support actuarially the level of benefits. Closing their career (assuming that plan also stays put). A a DB plan and offering a DC plan instead does greater number of plans to manage may enhance not have to reduce the sponsor contribution, the likelihood of behavioral mistakes. More but in practice, this is often the case. The plans may mean greater costs and many plans employer contribution in a DC plan is frequently go unclaimed as participants lose track of them wholly or partly dependent on the participant’s over time. A key strength of the contribution, via matching. And employees DB plan from the The portability that is built into DC plan structures generally “undercontribute.” Leading Canadian participant perspective has been a clear advantage for that structure and in actuary Malcolm Hamilton notes another reason has always been the the list of pros and cons of DB versus DC plans, it for employers to reduce contributions: many ranks near the top of the “pro-DC” list. Separately sponsor contribution. participants tend to undervalue their pension from job moves, in recent years DB plan sponsors While employees can benefits in his view, so it is logical for sponsors have however supported portability when it and often do make to find more cost-effective ways of compensating can be used as an incentive for participants to voluntary contributions, them. Brandes Institute Advisory Board member move from their DB plan to a newly introduced these sponsor and former pension fund executive Bill Raver DC plan. contributions generally notes that pressure remains on plan sponsors have been sufficient to to reduce headcount in their plans (and hence Late in the 20th century, some large corporations support actuarially the cost). This can be done by buy-outs or by offering experimented with DB designs that increased level of benefits. portability as a proactive move by the sponsor. portability but importantly from the sponsor perspective reduced the sponsor’s investment risk. In fact a weakness of the traditional U.S. DB plan The first of these designs was the cash balance from the participant perspective has been the lack plan. Other plan designs have been introduced at of portability. While this is theoretically permitted an increasing pace. Generically they are usually in DB plan design, most sponsors did not include referred to as “hybrid” plans, as they combine this feature except for a small number of multi- features of both DB and DC plans, although most employer plans. So any employee changing jobs are legally structured as DB plans. would typically leave their “old” benefit frozen and start again in a new plan with the new Cash balance plans were first introduced in employer. In an era of lifetime employment and the mid-1980s. As sponsor concerns over DB few job changes this was not a critical weakness plans grew during the 1990s, they appeared to as employees might still accumulate substantial address the main sponsor concern of funding benefits in perhaps two or three DB plans. an increasingly large and volatile liability. While However, the increased voluntary and involuntary legally defined as DB plans, they had a key feature job mobility that has become the workplace norm of a DC plan: a reported account balance for each in recent decades has made this weakness much participant. These plans had the desired effect for more damaging. sponsors of curtailing the growing uncertainty in future dollar benefits due to investment risk. The lack of DB portability has two elements to However, unless participants took their benefits it. First, can the accrued benefit (or equivalent as a lump sum on retirement, the plan had to assets) be moved to a new plan? Second, if not, provide an annuity and so was still exposed to assuming identical contributions and results, longevity risk. Furthermore, the new cash balance does the participant suffer financially from plans did little or nothing to relieve corporations accumulating pension benefits under several of the increasing burdens of accounting and plans rather than consolidating into one? The first government regulation surrounding DB plans. question is one of convenience and practicality. It’s a lot easier to manage one pension “pot” than So the early versions of cash balance weren’t a several. The second question has more financial full solution for sponsors. They certainly weren’t impact. By moving jobs periodically, participants accepted as a solution by DB plan participants who in traditional final salary DB plans may lose out were being “switched” into cash balance plans.

PAGE 11 Legal challenges were mounted by participants are still waiting for IRS approval, and if this is against the IBM and Xerox plans among others, not granted, the sponsors seeking to introduce in essence claiming that their benefits were being adjustable plans would likely revert to a DC format reduced illegally.10 From the sponsor perspective, instead. Separately, another concept that allows a reducing liabilities (i.e. future benefits) was a varying benefit within a final salary DB structure central element in the change, but the lawsuits is on the drawing board. This is the DoubleDB hinged on whether the changes contravened plan, patented by actuary Ed Friend, which locks According to the pension law: while cash balance plans acted like in the contribution rate by the sponsor but allows Federal Reserve’s Flow DC plans in some ways, they were legally defined the benefit (as a multiplier of final salary) to vary of Funds Accounts, as DB plans and regulated as such. depending on investment results. We are not there were assets of aware of any sponsors as yet who have adopted Court decisions in the early 2000s went against $4.3 trillion in DC plans Double DB. as of March 2013, with the plan sponsors, even though some were another $5.8 trillion in eventually overturned on appeal. While the In asset terms, so far cash balance and adjustable IRAs. This compares to suing participants won the battle (switches to plans have had only a small impact on the DB/DC $2.6 trillion in private cash balance plans were blocked as they were debate and the large-scale shift from DB to DC sector DB plans, and held to provide a less valuable benefit than DB plans has continued unabated. Companies have another $5.0 trillion in plans), participants in aggregate lost the war. encouraged this shift from DB plans by expanding public sector DB plans. The enthusiasm for cash balance plans among the investment menus of DC plans, increasing the large corporations was significantly dampened, So of the $17.6 trillion level of company match monies, and promoting and ironically led to more, rather than fewer, broader worker participation – in lockstep with total, DB plans are terminations of DB plans. the freezing or termination of the DB plans now the minority with a that previously supported these same workers. 43% share of the total. However, the passage of the Pensions Protection According to the Federal Reserve’s Flow of Funds Act in 2006 resolved some of the issues on legal Accounts, there were assets of $4.3 trillion in status of cash balance plans, and opened the door DC plans as of March 2013, with another $5.8 to a resurgence of interest, especially from the trillion in IRAs. This compares to $2.6 trillion in small-business segment. More on this later in the private sector DB plans, and another $5.0 trillion section The Retirement Gap: Proposed Solutions. in public sector DB plans. So of the $17.6 trillion Some sponsors of DB plans are now moving total, DB plans are now the minority with a 43% to other variations on the theme of sharing share of the total. investment risk with the participants. Pioneered The gradual nature of the shift and the complex by consulting actuarial firm Cheiron, adjustable nature of the debate mean that public awareness plans are DB plans where the participant’s benefit has lagged reality. A good example of this denial of varies directly with the actual performance of reality is contained in the EBRI Issue Brief (#369, the plan’s assets, typically on a yearly basis. As March 2012, p31): “As a cautionary note, although such some of the investment risk is moved to 57 percent of workers surveyed said they (or their the participant while maintaining the pooled spouse) expect to receive benefits from a defined longevity risk and professional investment benefit plan in retirement, only 32 percent report management advantages of a traditional DB plan. that they and/or their spouses currently have such Early adopters of the adjustable plan approach a benefit with current or previous employers.” We include corporate (e.g. the New York Times) can only wonder where the other 25% think their and multi-employer plans (e.g. Greater Boston benefits will come from! Hospitality Employers Local 26). Because the adjustable plan concept is new, early adopters

10 Walsh, Mary Williams. “Xerox Reaches Settlement With Retirees on Pension Suit.” The New York Times. Nov. 15, 2003. PAGE 12 4. Focus on the Problems Section 4 Summary: Various factors are likely to hurt DC participants financially, including lower contributions, lower investment returns and potentially their own poor investment decisions. In the meantime, DB plan sponsors are still dealing with underfunding problems. The “simple” (but not necessarily easy) solutions include: increase contributions; retire later; and increase investment returns. The real solution for the pension community is to find ways to enable participants to build adequate retirement income and to Even for those who do so in a structure that works effectively for cost- and risk-conscious plan sponsors. contribute actively This shift from DB to DC plans combined with the low-return market environment has a major impact to DC plans, the on Benefits, especially for DC participants. Contributions have gone down (as participants have generally longevity and not used even the modest maximum limits allowed). Investment earnings from equities have been poor behavioral risks in recent years and the record low level of bond yields pose the risk of negative future returns (both associated with nominal and real) from bonds. With C and I down, the money available for Benefits that are supported DC plans (see by C+I-E are likewise down. By getting out of the “DB Business,” plan sponsors no longer make up the Exhibit 2) potentially difference. Participants have taken on the responsibility of picking up this tab, even if many haven’t leave another gap realized it yet. between adequate replacement income Even for those who contribute actively to DC plans, the longevity and behavioral risks associated with levels and the likely DC plans (see Exhibit 2) potentially leave another gap between adequate replacement income levels and outcome for the likely outcome for most retirees. most retirees. The discussion on fixing the “pension crisis” appears ever more complex. But we believe the key drivers that can remedy many of the failings are quite simple. Using the Retirement Rule, we can move forward from the historical context and see that any serious solution must include two elements: • Save more: increase C • Earn better returns: increase I (While reducing Expenses would also help, its impact is likely to be small relative to the other two, so we have excluded it as a meaningful solution). Note that a solution for the participant is not the same as a solution for the plan sponsor. For a DB plan sponsor, the preferred solution for many is to close or terminate the plan, or to pay to transfer the liabilities to an insurance company. This may solve the problem for the sponsor. However, even if this solution preserves the already-earned benefits for the participant, it leaves a gap to be filled in respect of pension benefits based on future earnings. On the sponsor side of the equation, there is also the well-publicized and debated issue of underfunding. With stagnating asset values and low bond yields, funding gaps have increased in recent years. This is meaningfully impacting private sector DB plans which use a high quality corporate bond yield as the liability discount rate.11 Record low yields have reduced the level of funding, and contributed to the desire to get the pension liabilities off the balance sheet. Changes in bond yields, especially from recent low levels, can have a significant impact on private sector plan funding ratios. Estimates by consultants Mercer on the aggregate pension funding ratio of the companies in the S&P 1500 show the ratio climbed from 74% at the end of 2012 to 86% by May 2013. Public sector DB plans have more flexibility in selecting their liability discount rate, and tend to use less conservative assumptions than their private sector peers. Underfunding is a major problem for some, but not all, large public DB plans. For example, a June 2013 report from Moody’s estimated that while the fifty states are in aggregate 74% funded on published data, when adjusted to take into account market

11 According to guidance at the IFRS Foundation/IASB website (ifrs.org), the organizations’ Interpretation Committee did not specify a credit rating, noting that “…the discount rate should be determined by reference to market yields at the end of the reporting period on ‘high quality corporate bonds.’” While acknowledging that the general interpretation of this rule is understood not to be bonds with a credit rating below AA, “The Interpretations Committee discussed this issue in several meetings and noted that issuing additional guidance on or changing the requirements for the determination of the discount rate would be too broad for it to address in an ef- ficient manner.” For more information: http://www.ifrs.org/Current-Projects/IASB-Projects/Employee-Benefits-Discount-Rate/Pages/ Project-summary.aspx PAGE 13 risks (for example by changing the liability discount rate to that used by private sector plans), the funding ratio drops below 50%. Moody’s numbers show a wide range between best and worst states in terms of funding ratio and overall pension burden (Nebraska, Wisconsin and Idaho top the Moody’s rankings as having the lowest pension burden). There is debate in the industry over the validity of these assumptions and methodologies but this is beyond the scope of this paper. The take-away from our perspective is that both private and public sector DB plans will be dealing with The reality is that a underfunding issues for the foreseeable future, and this will continue to undermine the rationale for pension plan is sponsors to maintain their traditional DB plans. deferred compensation. For a DC plan sponsor, there is no problem as the whole premise of the DC industry is that the risks As part of the overall and consequences of inadequate contributions, poor investment earnings and longevity are all largely compensation package handed to the participants. for employees, it can be an important Can plan sponsors solve their own pension crisis simply by this financial “pass the parcel” technique of element in recruiting, dumping the problem into the laps of their employees (and ultimately on society as a whole which could retaining and need to support a growing number of destitute retirees)? We don’t think so. The reality is that a pension motivating employees. plan is deferred compensation. As part of the overall compensation package for employees, it can be Its financial impact is an important element in recruiting, retaining and motivating employees. Its financial impact is often often underestimated underestimated by workers. Employer-sponsored DC pension arrangements may be seen as increasingly by workers. unattractive in coming years as today’s retirees run out of assets. Then the competitive power of an effective pension plan may be an even more visible and valuable management tool for the plan sponsor. The real solution for the pension community is to find ways to enable participants to build adequate retirement income and to do so in a structure that works effectively for cost- and risk-conscious plan sponsors.

5. The Elements of a Solution Section 5 Summary: To help get to—and through retirement—workers must participate in and make contributions to their retirement accounts. Automatic enrollment would help, along with improved participant education on how critical contributions are. DC participants can help themselves by retiring later, and would be helped further if they could be moved away from a broad and confusing menu of investment choices, and towards collective investment pools that mirror professionally managed DB plans. Of the three elements discussed in the previous section, better return (increased I) is only partly under the control of the sponsor or participant. With the risk-free bond rate still near historical lows, high future returns may be difficult to attain, certainly for the industry in aggregate. This means the solution for Investment returns has to be in one of two places. One is to increase the skill level of investors, which realistically is only possible by moving a higher proportion of assets to professional management. The other is to reduce the behavioral mistakes made in investment selection, timing and management. Training participants in this area is not an industry-wide solution. While some individuals may benefit, the impact on the broad mass of participants is essentially a zero-sum game. We believe the only feasible approach to solving the behavioral issues is to structure the rules and constraints in such a way to minimize the ability of participants to harm their long-term financial future even if this flies directly in the face of the DC industry trend toward more choice. In short, professionally managed DB plans are already focused on the Investment return; all that can be done for DC participants in aggregate is to constrain choices towards an appropriate DB-style portfolio. Remember that the returns target needs to be achieved over very extended periods. (Recalling from earlier in this paper, Bob Maynard suggested a target of 4.0% annually above inflation.) For a typical worker, his/her retirement planning horizon is multiple decades, spanning both career and retirement. History is reassuring

PAGE 14 over such extended timeframes. As shown in 4.0%, with the lowest (1940 to 1979) at 3.8%, just Exhibit 6, since 1926, the annualized real return short of that 4.0% goal. over rolling 40-year periods has averaged 5.1% for We also looked at average annualized real returns a simple 65/35 equity/bond portfolio, rebalanced for this 65/35 portfolio over rolling 10-year annually. In only four of the 48 rolling, 40-year periods; the worst 10-year period return was periods since 1926 were returns less than the target -2.3% and returns failed to reach that 4.0% target Retiring later is the most effective way of Exhibit 6: 40-Year Real Returns for 65% Equity, 35% Bond Portfolio (1926-2012) coping with reduced benefits in the DC 8% s n r

construct. This implies u 7% t e R

deferring the pension 6% a l or portfolio drawdown, e R

g 5% but most importantly, n i l l implies that the o R

4% a r

individual continues e to work. 3% 4 0 Y

d 2% z e i a l u

n 1% n A 0%

Dec-65 Oct-73 Aug-81 Jun-89 Apr-97 Feb-05 Dec-12

Source: U.S. stock returns represented by data from Ibbotson Associates via Morningstar. Long-term U.S. Government bonds represented by data from Ibbotson Associates via FactSet through yearend 2005 and the Barclays U.S. Treasury 20+ Year Index from 2006 to yearend 2012. Performance is for the period Jan. 1926 to Dec. 2012. Past performance is not a guarantee of future results. One cannot invest directly in an index. Rolling periods represent a series of overlapping, smaller time periods within a single, longer-term time period. For example, over the illustrated 87-year period, there are 48, 40-year rolling periods, with the first one running from 1926 through 1965, the next from 1927 through 1966, and so on. There are 78, 10-year rolling periods with the first one running from 1926 through 1935, the next running from 1927 through 1936, and so on.

in 22 of the 78 periods studied (28.2%). Thus, Retiring later is the most effective way of coping taking a much longer-term perspective has helped with reduced benefits in the DC construct. investors achieve targeted real returns. Maynard This implies deferring the pension or portfolio looked back even further and found that the drawdown, but most importantly, implies that 65/35 portfolio delivered an average annualized the individual continues to work. Every year of real return of 4.2% over rolling 55-year periods retirement deferral then has a double impact: no between 1865 and 2010. drawdown on assets combined with additional job income. This is more feasible for some than others, Reducing Benefits should not be seen as a depending on type of work, health and willingness solution for DC participants, although for many to continue in the workforce. Currently this is this will be the reality of retired life. In the DB primarily an individual decision. To make this world, promised pensions are unlikely to be part of an industry-wide solution, the national reduced although in some instances this is being retirement age must rise along with longevity. challenged in the courts. For example, recent Chapter 9 municipal bankruptcies in California Retiring later can have a powerful effect on (Stockton and San Bernardino) and Rhode Island retirement income. It provides more years of (Central Falls) have raised the question of the legal contributions, allows the assets additional years standing of DB plans relative to other municipal to grow and a higher annuity rate applies to the creditors. The bankruptcy of the City of Detroit in older age when retirement eventually occurs. July 2013 may prove to be the landmark test case Take our hypothetical 25-year old from Exhibit 2, in terms of size. contributing at the median 5.5% over a working lifetime. Even with a respectable 4% real return

PAGE 15 before costs, the lifetime savings resulted in toward solving the problem for the younger only 30% of final salary at age 65 using current generations of workers. annuity rates. By delaying retirement to age 70, The questions for plan participants hoping to boost his retirement assets would have grown enough to retirement income with higher contributions are: provide 42% of his final salary at that age. To get 42% of final salary at the original retirement age • Can they afford to sacrifice any of 65 only by adjusting the lifetime contribution current income for a potential The United States is deferred benefit? rate, then that contribution would need to have among those countries been over 8.5%, up from the original 5.5%. • Should society motivate them to do so effectively reducing with high tax exemptions benefits by pushing the But empirical evidence is clear that workers are on contributions? retirement age higher. reluctant to take later retirement even when • And even with tax breaks and The Social Security there is a clear economic advantage to doing so. affordability, will they in reality make full-benefit retirement Behavioral scientist Professor Richard Thaler those contributions? age is rising from 65 noted in The New York Times (July 16, 2011) that The power of increased contributions is high, towards 67 for those at least 95% of those eligible for Social Security especially at younger ages. The Retirement Plan born in 1960 or later. start claiming benefits by age 66 (and about half of those claim reduced benefits when first eligible Solution (Ezra, Collie and Smith, published by at age 62) when many people could realize a Wiley Finance) shows that over a typical 40-year substantially higher monthly benefit amount career, each dollar of contributions on average by delaying claiming age until 70, even without generates nine dollars of eventual spending power. assuming any additional contributions. Even However, as shown in Section 1 of this paper, the though some of this preference for immediate shortfall between today’s median contribution cash is likely a result of economic necessity, there and the likely amount needed is so great that a is still a clear preference by retirees to take less significant behavioral shift will be needed to have today rather than much more tomorrow. any impact. The United States is among those countries Changing behavior in this context is a effectively reducing benefits by pushing the challenge, but may not be impossible. Voluntary retirement age higher. The Social Security full- contributions to DC plans have been framed in benefit retirement age is rising from 65 towards participants’ minds in the era when these plans 67 for those born in 1960 or later. It is always were supplemental top-ups, not the primary source difficult politically to increase retirement ages on of retirement benefits. Annual contributions of a national basis. In the United States, this has been 4-6% have become accepted norms, consistent achieved by “dodging” the baby-boomer voting with the median DC plan contribution of 5.5% demographic and phasing in a higher retirement cited in Section 1. age only for those young enough not to feel any The goal must be to change the mindset so that immediate impact. In the United Kingdom a accepted norms move towards 15-20%. The two more durable solution may have been found as most effective ways of achieving this goal are the retirement age is being indexed to longevity likely to be: improvement in the population. France is moving the other way. Citing “social justice,” the Socialist 1. increase participation through wider use of automatic enrollment government has reduced the retirement age back to 60 from age 62 where the prior administration 2. increase contribution rates by had raised it! “anchoring” participant decisions on a higher number as the norm So now we’re back to a focus on Contributions. for contributions This element has the most direct impact of the Professors Richard Thaler and Shlomo Benartzi three, and is the one that is most under the control authored the 2004 paper “Save More Tomorrow” of participants and sponsors. A sufficient increase suggesting how to increase contributions using in contributions could in theory go a long way behavioral techniques. “The essence of the program

PAGE 16 is straightforward: people commit in advance to allocating a portion of their future salary increases toward retirement savings.” The authors essentially enabled apathy as a positive force by automatically increasing contributions faster than pay rises unless an enrolled participant opts out of the “Save More Tomorrow” arrangement. Behavioral methods have also proved successful in raising overall contribution rates elsewhere. We look at lessons from some other countries in the next section. In sum, given that Investment returns are substantially tied to the fate of the markets, the only major variable in the Retirement Rule that is under ...The Canadian our control is Contributions. For any long-term solution, for Benefits to be adequate, Contributions industry has pioneered must rise. the path towards variable benefits in 6. Lessons from Outside the United States North America, moving away from the “pure” Section 6 Summary: Concerns over securing retirement assets are not unique to the United States. defined benefit model, We investigated retirement structures in select developed countries and share approaches that may have and sharing some of relevance for the American pension community, including: less stringent mark-to-market rules to foster a longer-term investment perspective; the introduction of variable benefit plans; approaches that result in higher the pre-retirement contributions; greater education and access to annuities as a distribution option for retirement plans; “official” investment risk with retirement age that is indexed to life expectancy; and automatic enrollment for plan participants. the participant. While the post-World War II baby boom generation is a common factor across many developed nations, its retirement problems and those of succeeding generations are by no means identical. It is outside the scope of the paper to review the worldwide pensions industry, but we can learn from the experiences and solutions applied elsewhere. We have described the U.S. pension system as being in crisis. While it’s hard to find a developed country that has no problems at all with its pensions system, there are countries that provide good examples of how to avoid problems escalating to a crisis level. We look at Canada, Australia, and the United Kingdom. Sharing a common language, and some common background in culture and pensions approach, these three countries have developed differences in their pension systems that appear to have avoided the crisis potential of a systematic breakdown.

Canada: A Stronger Benefits Safety Net Canada’s basic old age pension is complemented by the Old Age Security (OAS), which is paid out to low-income retirees. With the social safety net, the need for replacement income in retirement is materially lower than in the United States. Canadian pension expert Zev Frishman (member of the Brandes Institute Advisory Board and EVP of Open Access Ltd.) estimates – based on statements made by leading Canadian actuaries – that the replacement need for final salary for many if not most Canadians may be around 50% compared to the 80% typically assumed in the United States. Effectively, this reduces the strain on the Benefits element of our Retirement Rule, Benefits = (Contributions + Investment Earnings) – Expenses, B=(C+I)-E. The need for high Contributions is therefore less than for the United States. In fact, because of the means tested component of government pensions, those who contribute higher amounts towards their retirement may actually be worse off, with claw-backs in benefits that offset the additional savings. As a result, some of the pension failings that are common to both Canada and the United States are less impactful in Canada. This includes the fall in funded status of DB plans and the problems for those employees who don’t have access to an adequate DB or DC plan.

PAGE 17 Portability of accrued benefits in DB plans has been already in existence in New Brunswick which has noted as a major issue in the United States but is passed enabling legislation. Saskatchewan, British less of a problem in Canada. Many Canadian DB Columbia and Quebec are also working through plans allow a commuted benefit to be transferred the enabling process. to a qualified DC plan when an employee leaves The SRPPs have some similarities to new plan (and this is more commonly done than in the structures proposed in the United States (see United States). Commuted values are based on Many Canadian Section 3 and Section 7), but are primarily Actuarial Standards Board formulas. Portability DB plans allow a appropriate for larger plan sponsors due to the may come at a price, but at least the employee has commuted benefit to high fixed cost that makes them (like a traditional the choice of deciding whether to accept this price be transferred to a DB plan) rather expensive for small businesses to of transfer. qualified DC plan when set up. So they don’t provide a solution for those an employee leaves. In the Investment element of the equation, small businesses or for workers not covered by Canada has both pluses and minuses. On the other pension arrangements. This segment of positive side, the large Canadian public sector the market may be helped by the introduction DB plans include some of the world leaders in of Pooled Registered Pension Plans (PRPP) investment technique, plan management, and which apply a variable benefits concept similar to governance. Ironically, the Canadian penchant those proposed in the United States. But as with for increased pensions “safety” tends to constrain SRPPs, the pace of progress depends on enabling these funds into meeting short-term mark-to- legislation at the provincial level. market accounting targets in direct opposition to their long-term real return strategies. At the Australia: Pushing Contributions Higher other end of the spectrum, individuals’ DC plans The Australian approach has focused on the not only suffer from the same behavioral choice Contribution element. In 1992, the Super- failings as their U.S. counterparts, but labor under annuation Guarantee (SG) was introduced, a much heavier expense burden for those forced with a modest mandated minimum employer to use retail mutual funds. contribution of 3% of salary, applicable to all In terms of plan structure, the Canadian industry employees. SG was designed to supplement the has pioneered the path towards variable benefits government-funded old-age pension system. in North America, moving away from the “pure” By 2009, this minimum contribution had been defined benefit model, and sharing some of the pre- increased to 9%, and is scheduled to reach 12% retirement investment risk with the participant. by 2019. The Australian government and pension The Ontario Teachers’ Pension Plan was a leader industry have very publicly placed emphasis on in Canada in making “one-off” adjustments the need for high contribution levels, and that in this way, with benefits adjusted for example has helped influence individual contributions. through deferred indexation or a later retirement Typically around half of all contributions are age, or contributions increased. The goal was to voluntarily made by participants. share the impact of any underfunding between Australian research firm Rainmaker notes that sponsor and participant, while preserving the twenty years ago when SG was introduced, longevity pooling, investment management and pension assets were $150bn. Now they have grown low-expense advantages of a DB plan. ten-fold, to around $1.5 trillion, and Rainmaker DB pension plans that use specific formulas to projects this total of pension assets (known as tie changes in contributions and benefits to levels “super”, the abbreviation of superannuation) to be of underfunding are being considered in several closing in on $8 trillion in another twenty years. Canadian provinces (pension plan supervision As well as a focus on contributions, there’s also and regulation is handled at the provincial, not a strong emphasis on the Investment return federal level). These are known as Shared Risk element. Employer and participant contributions Pension Plans (SRPPs) as they share the investment are generally directed into professionally managed risk between sponsor and participants. These are funds, which compete on returns and expenses.

PAGE 18 While Australia is among the world leaders in major step in taking the periodic political debate funding and managing the accumulation phase over funding the state system off the public stage. of retirement planning, less emphasis has been Mandatory auto-enrollment in a pension plan was placed on the decumulation phase. If participants introduced in the United Kingdom in 2012, and is use a managed drawdown strategy in retirement, being rolled out gradually toward full coverage by then there is a real risk of money death (running 2018. All employees earning above a minimum out of assets during the retiree’s lifetime). For tax level who have no other pension coverage must reasons, Australia has a very undeveloped market ... a 2013 mid-year be enrolled and those who do have coverage in annuities for private individuals. So there is less survey by the U.K.’s elsewhere can opt-in. Mandatory minimum public consciousness of the need for annuities, yet Department of Works contribution levels started at 2% of salary in 2012 a greater need for the “super” industry to focus and Pensions looked (of which 1% is from the employer), and will on provision of income rather than lump sums at actual experience gradually rise to 8% by 2018 (at least 3% from the in retirement. This is particularly true for those across nearly 2 million employer). The contribution levels are modest at or approaching retirement age now. They have workers and found an in comparison to the Australian SG pension, had fewer years to accumulate the mandatory SG opt-out rate of only for example, but the concept of auto-enrollment contributions, which were set at a much lower rate puts the behavioral pressure on the participant to 9%, a rather more in the early years of the 1990s. Australian workers decide deliberately not to save. encouraging response. now under 50 will typically be well-funded when they reach retirement age, but that’s less true for A research survey of close to 5,000 private and the Baby Boom generation. public sector workers by U.K. insurer Aviva in early 2013 indicated that even with very low minimum United Kingdom: A Behavioral Approach to contribution levels, the reaction is mixed. Benefits and Contributions Of those not yet auto-enrolled, just over a third claim they will opt-out, with the most common The U.K. pension system shares some of reason being they can’t afford to contribute. On the problems that afflict the U.S. system: an the other hand, around the same proportion say underfunded DB plan sector, low voluntary they will stay “opted-in.” But a 2013 mid-year contributions, job-hopping and lack of survey by the U.K.’s Department of Works and portability for DB accounts. As in the United Pensions looked at actual experience across nearly States, many corporate DB plans are being closed 2 million workers and found an opt-out rate of to new entrants. The United Kingdom has led only 9%, a rather more encouraging response. the United States in pension buy-ins and buy- To reinforce the power of auto-enrollment, the outs, where the liabilities are moved off the plan U.K. system provides that those who opt-out sponsor’s balance sheet and taken over typically can only do so for three years. After that, the by insurance companies. system automatically opts them back in, unless Two interesting developments are worth attention: they again make a decision to opt out. Only the indexing of retirement age, and auto-enrollment most determined or the most cash-strapped will as the mandatory default position. resolutely fail to save! Similar to the situation in the United States, Much advanced work on pension plan design increased longevity puts financial pressure on (in the United Kingdom and elsewhere) is being the government to raise the national “standard” coordinated or produced by the Pension Institute, retirement age. In the past decade, several Pension affiliated with the Cass Business School at City Acts have been passed that (among many other University in London www.pensions-institute. provisions) set out a gradual rise over coming org. We close this section with a quote from the decades in retirement age in line with improved conclusion of their 2013 paper “Good Practice mortality, for example lifting the male retirement Principles in Modeling Defined Contribution age from 65 (currently) to age 68 by 2044. Pension Plans,” by David Blake and Kevin Dowd, as Currently under consideration are proposals it summarizes well the reality facing the industry, to index the retirement age to improvements in not only in the United Kingdom, but in the United mortality. If these are successful, this could be a States and much of the rest of the world.

PAGE 19 “Applying these principles will often have uncomfortable implications for plan members. They will often show that if members want to have a particular standard of living in retirement, then they will be making insufficient contributions to their pension plan, following a recklessly conservative investment strategy, planning to retire too early, or some combination of these. Practitioners have told us that revealing this reality to members might put them off contributing to a pension in the first place. We would argue that it is much better to be realistic about the future than to hide your head in the sand.”

The NCPERS Secure 7. The Retirement Gap: Proposed Solutions at the National Level Choice Plan explicitly uses the cash balance Section 7 Summary: Two proposals at the national level aim to fill the gap for workers who do not have plan as its model, access to an existing DC or DB plan: NCPERS’ Secure Choice and Senator Harkin’s USA Retirement Plan. but given the legislative Both use the cash balance plan concept and both aim to solve the issues of investment risk, longevity risk negotiations of and the need for professional management. There are significant differences between these proposals, but state-by-state they could co-exist. The NCPERS proposal uses a state-by-state approach, while the USA Retirement Plan implementation, the proposes a federal framework. We believe both are sound, and as long as contribution rates are adequate, final versions may vary these plans can play an important role in the industry. in some respects. Since the 2008-9 financial crisis, proposals to solve the pensions crisis have been suggested by a number The Harkin Plan sets of sources, both from within the pension industry and from the political area. Some have been focused out a legislative outline on specific local problems, for example where municipal or state funds have fallen to such low levels of on broad principles, underfunding that benefits are threatened. But two proposals have focused on a national scale, aiming to remedy the shortfall in eventual pension benefits as workers are moved from defined benefit plans to leaving the private defined contribution plans as we have discussed. They also aim to provide pension benefits for employees sector to implement who are not covered by either DB or DC plans. within that outline. Note that neither of these proposals addresses the problems within existing DB or DC plans. They focus on adding a broad-based pension solution that will sit “on top of” those existing DB and/or DC plans with the goal of bringing eventual retirement income closer to an adequate replacement rate to maintain retirees’ living standards as they age. In September 2011, the National Conference on Public Employee Retirement Systems (NCPERS) proposed Secure Choice Pensions in a detailed white paper. (www.retirementsecurityforall.org/ document.php?f=plan) In July 2012, the U.S. Senate Committee on Health, Education, Labor & Pensions under the Chairmanship of Senator Tom Harkin (D-Iowa) proposed Universal, Secure and Adaptable Retirement Funds (USA Retirement Funds) www.harkin.senate.gov/documents/pdf/5011b69191eb4.pdf The NCPERS proposal is in the process of being adopted by a number of states. California has enacted enabling legislation (SB-1234, the California Secure Choice Savings Trust) but additional steps are needed for implementation. According to Hank Kim, Executive Director of NCPERS, Oregon has also taken initial steps, while Vermont, Ohio and Maryland are in the early stages of a similar process. Senator Harkin has stated his intention to move forward with the USA Retirement Funds proposal (the “Harkin plan”) during 2013. He has also announced he will retire from politics at the end of 2014; this would presumably be his main agenda until then. There are strong similarities between the two proposals: they both aim to provide a solution to fill the same perceived gap in pension coverage. Importantly, these proposals are not for additional DB or DC plans. They both borrow concepts from the cash balance plan concept that ran into practical difficulties when introduced by corporate plan sponsors in the private sector (see Section 3). The cash balance concept and other hybrids between DB and DC plans fit well with today’s pension needs. Despite the rocky start from a legal perspective, the Pension Protection Act of 2006 clarified the legal status of these plans and now, cash balance plans have become the fastest growing segment of the pension market,

PAGE 20 doubling in assets in the decade to 2010, according balance plan, portability means ease of moving to Department of Labor statistics. However, while the account to a new pension plan when changing they are now close to $1.0 trillion in assets, these jobs, the Harkin and Secure Choice Plans go one plans are still small compared to the nearly $8.0 step further as multiple employer plans. They trillion in traditional private and public sector allow participants to stay in the same plan in many defined benefit plans. cases even if they do change jobs. While for a corporate The NCPERS Secure Choice Plan explicitly uses We focus now on the similarities and differences cash balance plan, the cash balance plan as its model, but given between the Harkin and Secure Choice proposals. portability means ease the legislative negotiations of state-by-state of moving the account implementation, the final versions may vary Common Factors: to a new pension plan in some respects. For example, one variation when changing jobs, on Secure Choice that could be implemented Design the Harkin and Secure immediately without needing legislative change • Primarily designed for the private Choice Plans go one would be a simplified version, limited to employers sector with an emphasis on small step further as multiple with fewer than 100 workers. and mid-sized employers who do not provide adequate pension plans employer plans. They The Harkin Plan sets out a legislative outline on allow participants to broad principles, leaving the private sector to • Complements existing DB and DC plans without the intention of stay in the same plan implement within that outline. So while these replacing or changing them in many cases even if two new proposals draw on elements of the cash they do change jobs. balance plan, the eventual results may not strictly • Multiple employer coverage (this is fit the cash balance plan definition. a pioneering concept and distinct from “multi-employer” plans such However, there are similarities at the heart of as Taft-Hartley plans that cover these plans, addressing investment risk, longevity union employees regardless of specific employer) risk and the need for professional management: • Portable on changing jobs • A reported account value that varies over time representing each • Transparent account values with participant’s share of the total assets immediate vesting of contributions of the plan • Requires legislative change, including • Assets are pooled and professionally amendments to ERISA managed by the plan, not the participant Management • The “default” benefit at retirement • Independent trustees, drawn from is a lifetime annuity (even if some public and private sectors (also part of the benefit may be taken as a including retirees for USA plan) lump sum) • Professionally managed investments But most cash balance plans protect participants from some investment risk by crediting a specified • Seeking economies of scale in fees and expenses relative to individual rate of return to participant accounts. And if the pensions (e.g., 401(k) or IRA) assets fall short over time, it’s up to the sponsor to make up the difference. Both these proposals Contributions build in flexibility to vary the benefits depending on actual performance of the plan and the Harkin • Employers must contribute at a minimum level, and can choose to go plan quite explicitly takes employers “off the higher hook” in terms of any fiduciary responsibility to make up funding shortfalls. • Employees are not mandated to contribute but can choose to do so Most hybrid plans offer superior portability over traditional DB plans. While for a corporate cash

PAGE 21 Benefits • Provides a lifetime pension as the default benefit • The eventual pension benefit may vary depending on investment returns and other factors While the broad concepts are similar, there are important differences in the proposals. The Harkin plan envisages a mandatory nationwide approach, covering all eligible workers (i.e. those offered inadequate or no pension plans). The NCPERS proposal aims to leverage the existing state-level public pension Both proposals fund infrastructure to offer similarly managed pension funds to employers and their workers. Exhibit allow employees to 7 illustrates some key differences between the two proposals. Note that the NCPERS Secure Choice make additional Pension is explained in detail in its proposal, while the Harkin/USA approach is only outlined in its contributions, but these proposal, with detail expected when Sen. Harkin introduces a legislative proposal later in 2013. will be subject to the same behavioral factors EXHIBIT 7: Comparison of Harkin Plan and NCPERS/Secure Choice that already impact 401(k) contributions. Harkin/USA NCPERS/Secure Choice Public sector Managed by Private sector (in parallel with existing funds)

Supervised by Federal State

Some (on withdrawing from a Employer fiduciary liability None fund when it is underfunded)

Once started, pension guaranteed No Yes at that level as minimum

Number of plans Set by market competition 50 (one per state)

Subsidizes low income workers Yes No

Employers not offering an adequate Mandatory, through Voluntary pension plan must participate payroll deduction

Source: Brandes Institute

Comment on the Proposals The concept of filling the retirement gap with this type of broadly available hybrid plan proposal is a sound one in our view. Given the early stage of these proposals, it is not clear which would be a better solution, and we would expect the proposals to be modified as the political process unfolds. The two approaches are not mutually exclusive, and could co-exist well in a competitive market. Tax policy will also be a major factor in determining eventual success, especially any decisions on the maximum level of deductible contributions. When we look through the prism of the Retirement Rule (B=(C+I)-E), the strengths and weaknesses of these proposals are much clearer. Both Harkin/USA and NCPERS/Secure Choice use the common attributes with a DB-type plan structure to provide improvements in Investment returns (through professional management) and Expenses (through economies of scale). Critically, both proposals include portability, which is a real weakness of traditional DB plans in today’s world of rapid job changes. The NCPERS/Secure Choice proposal provides for the professional investment management of assets alongside existing State pension systems. It is implied (but not explicit) that the asset allocation policies of

PAGE 22 the Secure Choice funds would be similarly long- NCPERS advocates that a total of at least 18% term focused as are those State funds. While Secure of salary be contributed toward any individual’s Choice is already moving toward implementation retirement from all sources, including Social in some states, the Harkin/USA proposal still has Security as well as pension plans. to go through the political process. While its goal is Both proposals allow employees to make bi-partisan approval, some aspects of the proposal additional contributions, but these will be subject may be contentious. In the NCPERS/Secure to the same behavioral factors that already Choice proposal, The Harkin/USA proposal would turn the asset impact 401(k) contributions. We believe that any expenses are expected management role over to private sector firms eventual successful solution will require a total to be kept in line under the guidance of independent trustees. contribution rate of at least 15% of salary through with the state plans These independent boards are central to long- employer and employee contributions (including with which they term success. If they function effectively, the USA any amounts contributed to 401(k), IRA or other combine investment funds would be run with the necessary long-term DC plans). and administrative investment goals and allocation policies that are expenses. For the required to meet adequate real return targets. If Comment on What’s Not in the Proposals the boards are ineffective or their independence is Harkin/USA proposal, It’s also important to understand what these two subsumed to the influence of the plan providers, the expense control proposals do not address. They are both quite then long-term success will be elusive. mechanism is market clear that they aim to complement existing DB and disclosure. In the NCPERS/Secure Choice proposal, DC programs. So any inherent problems inside expenses are expected to be kept in line with the those structures are unaffected. As we explained state plans with which they combine investment earlier, these problems are much more prevalent and administrative expenses. For the Harkin/ in DC plans, and are focused primarily on the USA proposal, the expense control mechanism is Contribution and Investment return elements. market disclosure. Competition between private The good news is that the Contribution shortfall sector plan managers should help keep expenses within a DC structure may be much less damaging if down, especially if as expected, transparency in either or both of these hybrid proposals eventually fee comparisons are mandated in the proposed become widely available. For a chronically under- legislation. However, the possibility of an contributing DC participant, inclusion in such a oligopoly of a few large and dominant investment plan may boost his/her total contribution level firms may offset this. materially. That of course assumes the new plan is But the bigger issue once again is Contributions. not used as an excuse by the participant to lower As we have seen, this is a key determinant of the or eliminate contributions to the DC plan. Apathy long-term success for any pension plan. While may then be the participant’s friend! the Harkin/USA proposal includes a mandatory For Investment returns though, the behavioral employer contribution, it does not specify the risks remain embedded within DC plans. Even rate. The NCPERS/Secure Choice proposal’s if contribution rates are maintained or increased, illustrations use contribution rates of 5% and 3%, it has been demonstrated that participants’ which may be realistic but even the 5% level does investment choices and timing are generally not “move the dial” enough to be the primary adversely impacted by behavioral factors with the source of pension benefits. That illustration result of reducing long-term investment values. suggests that a 25-year old working for forty years would be able to replace only 29% of final salary We propose a simple solution for this Investment with the Secure Choice benefit. Social Security return problem. If and when such a nationwide could provide a similar amount, but the balance system of hybrid plans is set up, any participant needs to be filled by additional personal savings. should be allowed to roll part or all of his/her assets

PAGE 23 in any DC plans into one of these plans. While the participant still has investment risk, the behavioral impact of investment choices could be removed, the expense level may be lower, and longevity risk for the participant (a big problem for DC plan participants) could be reduced or possibly eliminated.

8. Evaluating Hybrid Plan Solutions Summary of Section 8: Hybrid plans may emerge as viable, long-term solutions. To achieve success, these The newer hybrid plans must: plans require various legislative changes and • Structure management of investments and operational costs to provide adequate long-term regulatory approvals. returns, and contain expenses We support moves • Provide pooling of longevity risk that make these • Allow portability in an era when changing jobs is the norm plans easier to • Use behavioral techniques to encourage participation and raise contribution rates implement as they offer features that address • Enable participants to understand in simple terms how well prepared they are for eventual current challenges for retirement participants and plan The newer hybrid plans require various legislative changes and regulatory approvals. We support moves that sponsors, alike. make these plans easier to implement as they offer features that address current challenges for participants and plan sponsors, alike. We have argued that any solution must deal with the Retirement Rule elements: I, E and particularly C. But as a practical matter, the structure of any broad solution must be: • appropriate and practical for both public and private sectors • supported and encouraged by government (federal, state and local) • reinforced as opposed to hindered by behavioral biases (both of participants and sponsors) In general, recommendations by political and industry experts all aim to boost contributions and investment returns, while containing costs. But as the saying goes, “The devil is in the details.” Our assessment of the two national-level hybrid proposals in Section 7 is that they have a good chance of success as long as the contribution levels are high enough to allow the math of the Retirement Rule to work. But as explained in Section 3, these are not the only approaches that use hybrid structures. Cash balance and adjustable plans in the United States and Shared Risk plans in Canada all offer a route for plan sponsors to maintain key pooling elements of the traditional DB plan while shifting some or all of the investment risk to participants and hence reducing the risk to sponsors. It may be that the broadening category of hybrid approaches will provide an effective long-term solution for the industry. We suggest five criteria that need to be incorporated in such a solution. Specifically, how well do the plans: 1. Structure management of investments and operational costs to provide adequate long-term returns and contain expenses 2. Provide pooling of longevity risk 3. Allow portability in an era when changing jobs is the norm 4. Use behavioral techniques to encourage participation and raise contribution rates 5. Enable participants to understand in simple terms how well prepared they are for eventual retirement

PAGE 24 Traditional DB plans didn’t meet all these criteria (for example #3), but as previously noted, traditional DB is increasingly unavailable as a retirement option. DC plans generally struggle with numbers 1 and 2, and need to do better with numbers 4 and 5. Hybrid plans, including the two national-level proposals, are structured to score well on the first three criteria. Depending on how they are implemented, they also have the potential to satisfy the last two criteria as well. It is likely that implementation will bring greater awareness of the hybrid concept, and It seems inevitable that may even redefine the DB vs. DC debate into a real three-way contest. over the long-term, The national-level proposals clearly state that they aim to supplement existing DB and DC plans, traditional DB plans not replace them. However cash balance plans are already rapidly stepping into the gaps vacated by will play a declining traditional DB plans, and adjustable plans also may gain popularity. It seems inevitable that over the role in retirement long-term, traditional DB plans will play a declining role in retirement planning at least for private sector planning at least employees. It is by no means inevitable in our view that DC plans will take over as the only or even the for private sector dominant alternative. employees. It is by no means inevitable in our But we are still at an early stage in this contest. Except for cash balance plans, the hybrid approaches view that DC plans will are still not widely used, and require more development work as well as various legislative changes and take over as the only regulatory approvals before they are cleared to be significant challengers to the dominance of traditional or even the dominant DB and DC. Exhibit 8 summarizes their status. alternative. In a free market (assuming no regulatory bias or impediments), long-term success should go to the structures that provide the best outcomes for both participants and plan sponsors. Hybrid plans appear to be well-designed in this context. As detailed earlier in this paper, most of today’s DC plans need significant improvement to meet the needs of participants for adequate retirement benefits. Design improvements are feasible: pooling longevity risk through annuity features, improved participation and contribution rates, and avoidance of behavioral investment errors. But they are not inevitable, nor is the dominance of DC in retirement saving.

EXHIBIT 8: Hybrid Plan Approaches in North America

Legal approval Investment risk borne Plan type Status Jurisdiction needed? by participant

Harkin/USA Outline proposal Federal Yes All

NCPERS, Secure Detailed proposal States Yes Partial Choice

Cash balance Established Federal Approved Partial

Canadian SRPP Newly introduced Canada provinces Yes Partial

Adjustable Newly introduced Federal Yes Partial

Double DB Detailed proposal Federal Yes Partial

Note: descriptions of these plans can be found in earlier sections as follows: Harkin/USA and NCPERS Secure Choice, Section 7; Cash Balance, Section 3; Canadian SRPP, Section 6; Adjustable and Double DB, Section 3. Source: Brandes Institute

PAGE 25 9. The Brandes Institute Advisory Board Perspective Summary of Section 9: In theory, DB and DC plans that are well designed, well-funded and properly invested can deliver adequate retirement benefits. In reality, some DB plans and most DC plans do not meet these objectives. We believe adaptations of hybrid plans will emerge as competitors to existing DC plans and alternatives to DB if the latter continue to be phased out by plan sponsors. Regardless of plan structure, we believe the following six recommendations are needed to give participants the opportunity to reach their We believe adaptations retirement goals: of hybrid plans will • Contribution levels should be higher, in the range of 15% of salary each year. emerge as competitors to existing DC plans • Assets should be professionally managed. and alternatives to DB • Plan assets should be portable across employers. if the latter continue • Longevity risk should be minimized by pooling individual participants’ assets with others. to be phased out by • Retirement age should be deferred where feasible, increasing both savings and benefits. plan sponsors. • Cost control and disclosure must be emphasized, not only for DC plans, but for any new hybrid design that aims to compete successfully for retirement savings. The retirement train is pulling into the station; it is our collective responsibility to get passengers off the tracks and onto the platform. The Brandes Institute Advisory Board includes nine external members with extensive experience in the retirement and fund management industry worldwide. All have been involved in this research and we are grateful for their input and opinions. A list of Board members is available at www.brandes.com/ Institute/Pages/BIBoardAndStaff.aspx and we thank all of them for their detailed and thorough work in providing guidance and reviews for this paper. However, the views expressed in this section are those of the Brandes Institute and should not be taken as personal or professional views of any specific Advisory Board member. In conclusion, we reiterate that regardless of plan structure, we believe that the most effective way to address the pension crisis must include a determined focus on the Retirement Rule (B=(C+I)-E). Here, we summarize our central arguments and offer recommendations related to: 1. Contribution Levels 4. Longevity Risk 2. Professional Management 5. Retirement Age 3. Portability 6. Expenses For existing DB and DC plans, neither rates a top grade in all six of these areas. DB plans fail on portability in the United States. With increasing numbers of DB plans closing, the DB plan structure is no longer widely available as a contribution mechanism. And while DC plans score well for portability, they generally fall short to some degree on most of the other criteria. Nevertheless, we believe that in theory, either DB or DC plans, IF well-designed, well-funded, and well- invested, can deliver adequate retirement benefits. In reality, some DB plans and most DC plans do not meet those conditions. So can hybrid plans fill the gap? At present the only approved and viable “contender” among hybrid plans is the cash balance structure, as other hybrids are still at a very early stage in the introduction/approval process. Nevertheless, we believe that adaptations on this theme may prove to be real competitors to DC plans, as traditional DB plans continue to decline in availability over the long term. The impact will likely be felt first in the private sector given the rapid erosion of traditional DB plans in that sector, but ultimately may gain wider acceptance with public plans as well.

PAGE 26 Regardless of which structure wins out, we variable benefit plans. We believe that portability believe contribution levels remain a key part of is a must for any future pension structures. a true solution. Even if hybrid plans can provide 4. Longevity Risk: The risk of running out of a workable replacement to today’s DB and DC assets during one’s lifetime is a growing concern. plans, unless participants and/or sponsors make It has not yet hit its stride in terms of financial adequate contributions, the effort is in vain. impact as the massive baby boom generation is We believe contribution still in its early retirement years. It will become levels remain a key Our 6-Point Recommendations a much bigger issue over the next two decades. part of a true solution. Hybrid plans, including the Harkin/USA and 1. Contribution Levels: Current levels are Even if hybrid plans NCPERS Secure Choice proposals, seek to inadequate, especially when they are voluntary on substantially reduce longevity risk, even though can provide a workable the part of the employee or employer. In addition, in some cases eventual lifetime income could be replacement to today’s many workers don’t even have access to employer- more variable than in a traditional DB plan. There DB and DC plans, sponsored tax-deferred retirement plans. We are other strategies that healthier and wealthier unless participants support any efforts to increase contributions. In individuals may choose to reduce longevity risk; and/or sponsors make particular we advocate behavioral solutions that for more information on these, please see the adequate contributions, use participant inertia to increase contributions Brandes Institute paper, Boomers Behaving Badly. the effort is in vain. rather than avoid them. That suggests a default option of enrolling employees where plans are 5. Retirement Age: Deferring retirement offered and requiring employees to “opt out” generally increases savings and potential benefits. (rather than requiring employees to opt in). As an For the average American worker, five years of example, we endorse “Save More Tomorrow” by additional work can raise a pension benefit by the Professors Richard Thaler and Shlomo Benartzi same amount as an additional 3% in contributions that increases saving by arranging for employee over a whole career (see Section 5). contribution rates to rise automatically over time. 6. Expenses: While not the most critical 2. Professional Management: Investment policy factor, expenses must be carefully considered and implementation should be managed by and incorporated into an effective solution. professionals wherever possible. While some Transparency of costs is helpful: what you can’t individuals may have the necessary expertise and measure, you can’t manage. temperament to manage their savings effectively, Recent advances in expense disclosures in DC the vast majority do not, leaving them vulnerable plan costs are a positive, and we would encourage to behavioral and other mistakes that can transparency of costs in hybrid plans as well. significantly reduce their long-term returns. We Economies of scale should also benefit cost believe a target of at least 4% real annual returns control, both in operational and investment is vital to helping investors toward a reasonably management expenses. secure retirement. And reaching that target is more likely by creating an avenue for most workers For those of us involved professionally in the to access professional management. If the Harkin/ retirement industry, whether plan sponsors, USA and/or NCPERS Secure Choice proposals trustees, legislators, investment advisers, become reality, we urge allowing transfers from consultants or other service providers, we have the existing DC plans into these hybrid plans. experience and training to see how this “pension crisis” is likely to develop over the coming 3. Portability: This feature is important, especially years. We have a duty to suggest and implement for younger generations in a world of frequent job practical solutions. As we said in the introduction changes. While DB plans could in theory offer to this paper, the retirement train is pulling into portability, in practice most do not, at least not the station. And it’s our collective responsibility in the United States. Transparent account values to get the passengers off the tracks and onto are a feature of DC plans and the different types of the platform.

PAGE 27 The Barclays U.S. Treasury 20+ Year Index is an unmanaged index consisting of U.S. dollar-denominated, U.S. Treasury-issued securities. The Index repre- sents public obligations of the U.S. Treasury with a remaining maturity of at least 20 years. The index is a total return index which reflects the price changes and interest of each bond in the index.

This material was prepared by the Brandes Institute, a division of Brandes Investment Partners®. It is intended for informational purposes only. It is not meant to be an offer, solicitation or recommendation for any products or services. The foregoing reflects the thoughts and opinions of the Brandes Institute.

The information provided in this material should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any security transactions, holdings or sector discussed were or will be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance discussed herein. Strategies discussed herein are subject to change at any time by the investment manager in its discretion due to market conditions or opportunities. Please note that all indices are unmanaged and are not available for direct investment.

All illustrations are hypothetical. Your actual results may vary. No investment strategy can assure a profit or protect against loss.

Withdrawals from tax-deferred retirement plans, such as traditional 401(k) plans and IRAs, are typically taxed as ordinary income and, if taken prior to age 59 ½, may be subject to an additional 10% federal tax penalty. Withdrawals must begin by April 1 of the year after the year in which you reach age 70 1/2.

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