In both defined benefit (DB) and defined contribution (DC) models ownership of upside and downside risk sits firmly on one side of the table. However, a hybrid model that has been tried and tested in the state of Wisconsin for three decades creates a better balance of risk between the employer and the employee. The result is an improved governance model that is less susceptible to assumption errors and large, destabilising shocks, which lowers the volatility of outcomes for savers.
David Villa, the 300 Club, said: “Governance risk plays a critical role in pension outcomes and is a very important consideration in the discussion of structure. Governance decisions are ultimately equivalent to a change in return and can contribute significantly to volatility of outcomes.
“If the governance structure is not balanced, one interest group can influence decisions at the expense of the other group. Both the DB and DC models lack the countervailing force provided by risk sharing,” Villa continued.
In his paper, Villa outlines the basics of the easily-replicable Wisconsin model whereby a minimum level of benefit is guaranteed by the sponsor and any value creation above that rate at the point of retirement is split between the sponsor and employee.
Villa said: “The risk sharing aspects of this design have profound implications for the governance of the system. Interests are not aligned in DB or DC structures. In the hybrid structure, risk is shared and the alignment of interest that results, contributes to a virtuous cycle of governance.”
Villa argues that risk sharing creates a win for employees, employers and society alike. The hybrid model is preferable to employees because it reduces the amount of risk they must assume versus DC models and also reduces the volatility in their pension provision versus DB schemes in exchange for assuming some of the risk.
While DC looks like the obvious choice for employers, evidence shows they are able to make adjustments to wages where they are able to offer lower-risk retirement benefits.
According to Villa: “There is evidence to suggest the labour market does make adjustments to wages to offset net benefits. The split in the value creation through the hybrid structure also compensates the employer for moving away from the DC model and assuming a greater degree of risk.”
Society is also a winner under the hybrid model, Villa argues. “Society would also be better off if we can avoid going off the defined contribution cliff, wherein financially unsophisticated individuals take on large risks that significantly change their wealth in retirement if they get it wrong,” he said.
“If a participant in a defined contribution plan experiences extreme value destruction, society bears the cost by providing a social safety net. Similarly, when a defined benefit is reduced by a large enough percentage due to poor governance, society pays the cost. This is especially the case for workers with low wages,” Villa continued.