December 13, 2015

The third way: A hybrid model for pensions

By David Villa

Conventional wisdom focuses on two structures for accumulating wealth to provide income for retirement: defined benefit and defined contribution pension schemes. In each case, ownership of both upside and downside risk sits firmly on one side of the table. There is little talk of alternative structures.

In fact, there is a third, more balanced way – a hybrid model where the risk is more equitably shared between the employer and employee for the benefit of all. This structure may be less well known, but it has been tried and tested over the last 30 years in the state of Wisconsin.

By better aligning the interests of the employer and employee, the Wisconsin model creates a virtuous cycle of good governance that leads to better outcomes for both employer and employee as well as society at large.

Pensions – who carries the risk?

Today, the two dominant models for pension schemes, those of defined benefit (DB) and defined contribution (DC), share a common thread: Employees defer wages that are invested to provide a future stream of income in retirement.

In both structures, the desired outcome is to have the present value of those deferred wages equal the present value of the income in retirement. In a perfect world there is no excess value creation or destruction, one simply equals the other. But that is a highly unlikely scenario. Almost all of the outcomes will involve value creation or value destruction. In the defined contribution structure, the risk of excess value creation or destruction is owned by the employee. In the defined benefit structure, that risk belongs to the employer or sponsor of the scheme.

Those risks comprise two key areas: investment risk and governance risk. The investment risk is the difference in the present value of the contributions and the present value of the benefits that results when the realised investment returns deviate from the target return.

Governance risk relates to the chance that the management and oversight functions of the structure allow it to break down. This is a complex area of risk involving many different factors such as investment assumptions, wage growth assumptions, funding decisions, cost management and execution risk.

Download the full whitepaper (pdf , 74.45 KB)


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