After years of inaction, it looks like both parties and both Houses in Congress may come together this year to pass important legislation to improve retirement security. The bills under consideration in Washington make good progress, but they fall short of the real innovation needed. The best pension systems in the world, those in the Netherlands and Denmark, offer examples that Congress can follow. Since retirement legislation passes about once a decade, Congress should take this opportunity to enact the best reforms possible.
Over 50 million working Americans lack access to a work-based retirement savings option. No pension plan, no employer-matching 401(k), no 401(k) at all. For smaller employers, the administrative cost, the regulatory burden and the fiduciary responsibility are just too much.
{mosads}To help address this problem, the last two presidential administrations have supported the idea of open Multiple Employer Plans (MEPs). Currently, Congress is seriously considering open MEPs. This reform is supported by House Ways and Means Committee Chairman Richard Neal (D-Mass.) and Ranking Member Kevin Brady (R-Texas). And in the Senate, Finance Chairman Charles Grassley (R-Iowa) and Ranking Member Ron Wyden (D-Ore.) are preparing to introduce similar legislation which they have supported in the past. This is very good policy, but Congress can do more.
Today, if small employers have an “employment based common nexus or other genuine organizational relationship … unrelated to the provision of benefits,” they may share costs and pool assets. But under current law, if they do not have that connection, then they cannot do so.
The various proposed bills would allow for open MEPs, without a common industry nexus. These would be pooled DC plans run by a common administrator. This creates efficiencies and liability protection for employers, and lower fees for employees. These are powerful benefits, and there seems to be a consensus among policymakers that creating open MEPs is a good idea. We agree.
However, open MEPs should go further. The open MEP proposals should create a category of DC plan known as collective DC. A collective DC plan allows participants to take advantage of pooling. Pooling is what makes insurance work; it is what makes defined benefit pensions work; and it makes collective DCs work.
A DB plan leaves the employer with all the risk and all the liability. A typical DC plan leaves the individual employee with all the risk and all the liability. A CDC lets the employee share the risk and the liability – not with the employer, but with thousands of other employees. That is the power of pooling.
{mossecondads}Collective DC plans are run just like DB plans, but without the employer guaranty. The employer and employee both contribute to the plan, and the administrator and investment team run the plan with the intention of achieving a specified return: say, 50 percent of final pay as a lifetime income. After the employer has made its contribution, it has no further liability.
One of the perceived drawbacks of a collective DC plan is that the outcome is not guaranteed. That argument would make sense if the comparison for a CDC plan were a DB plan. The real comparison for a collective DC plan, however, is a regular DC plan — which of course carries no guaranty whatsoever. Worse: in a DC plan, you are the chief investment officer, whether you know anything about investing or not; and you cannot share longevity risk with anyone else.
In a collective DC plan, a participant receives regular notices regarding the investment performance of the plan and the likelihood, based on certain assumptions, that the plan will be able to pay the target lifetime amount. This likelihood may shift from year to year and individuals can always put more into the plan if they wish to strengthen the likelihood of a positive outcome.
The amount of variability in the likely outcome diminishes as the participant ages, and becomes very narrow at the time of retirement, so that the annual payout varies as little as possible, though it could vary a percentage point or two in times of stress or strength.
Collective DC plans take advantage of four kinds of pooling without adding additional liability for plan sponsors. They pool investment management for professionalism and scale. They pool longevity risk: those who die early subsidize those who live long. They pool sequence of payments risk: those who retire when markets happen to be higher subsidize those who retire when markets happen to be lower. And they pool long-term investment policy risk: keeping the plan’s overall portfolio invested in somewhat higher percentages of return-seeking investments, rather than going to “all bonds” when the participant may have another 30 years to live.
The pooling of longevity risk is particularly powerful. The National Institute for Retirement Security has estimated that the benefits of longevity pooling alone should result in a 20 percent higher income in retirement. Adding investment expertise and lower fees, the difference can be even higher. That is a huge difference in likely outcomes for retirees.
Collective defined contribution plans already exist in other parts of the world, particularly in Denmark and the Netherlands, which are the global gold standard of pension and retirement policy. And the government in the UK has just recently thrown its support behind a plan to implement them there.
This is an exciting time for labor and business; many needed retirement reforms may have real chance of passing this year. In a time of such tremendous political partisanship in Washington, it will be wonderful if both parties can come together around this topic. But it would be a shame if, in doing so, we miss the opportunity to give retirees this opportunity for superior retirement security.
Charles E.F. Millard was Director of the U.S. Pension Benefit Guaranty Corp. under President George W. Bush.