Advantages of Pooling are Too Great to Ignore

By Charles E.F. Millard

Charles E.F. Millard

More than 50 million working Americans have no workplace retirement plan, and many states are developing “Secure Choice” legislation, creating publicly run defined contribution systems to address this problem. Similarly, many states are moving from defined benefit plans for public employees to create another form of publicly run DC plans. The creation of Secure Choice systems helps solve a pressing problem, and moving toward DC plans from DB plans may help alleviate liability pressure on states.

But these systems are failing to take advantage of pooling to create safer and sounder retirement systems. Pooling is the great benefit of defined benefit pension plans. It is even more important than the plan sponsor guaranty. If states can use the benefits of pooling in collective defined contribution plans, they will leave employers less exposed to long-term liabilities, and they will leave employees with more security in retirement.

Collective DC systems pool assets and investments; they pool longevity risk; they pool sequence of payments risk (the risk that the markets will be terrible when an individual retires); and they pool the benefits of a long-term investment policy even after the participant turns 65. These plans already exist in the Netherlands and elsewhere — and they work.

The many benefits of pooling 

In a DB plan, the CIO and investment team pool assets and investment policy. They invest with an outcome in mind: not a pot of money, but the ability to pay each retiree a pre-determined pension, usually something like 60% of average pay over a period of years.

In a 401(k), however, participants are on their own, deciding asset allocation and rebalancing time frames. Managers must be selected from the platform the employer has selected. And when participants reach a certain age, they must begin depleting the savings whether or not it’s needed.

The power of pooling longevity risk is simple: Those who die early subsidize those who live long.

When a chief investment officer invests the assets of a DB plan, she is using actuarial formulas to target a final payout. She can confidently estimate, through actuarial large numbers analysis, how long individuals in her plan will live.

This allows her to plan properly what her needs will be for liquid assets when payments are due, and for less liquid riskier assets that can be used to meet liabilities that are further away.

An individual in a DC plan is alone. If she takes time to look up actuarial tables and sees that the average age of death is 85, she might make a rational plan to spend down her funds until she dies at 85. But what if she gets to 85 and is in good health. She took the time to plan actuarially but she wasn’t in an actuarial situation. She was in an individual situation. She has to plan to live to be 100! And if she does get to 100 she’ll have to plan for 110!

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