Some Risk Is Good For Defined Benefit Plans, Says Study

Safe investments are good. But investments that are too safe also carry potential risks for beneficiaries. A study by two Iowa University professors suggests that defined benefit plan sponsors should expand their investment choices to riskier assets and go beyond liability-driven strategies that rely on fixed-income assets.

“Employees have some desire to have a fair risk-return trade-off,” said Wei Li, one of the authors of the study. “They would prefer to have some risk exposure.”

Alicia McElhaney reported on the Iowa University study in this article printed in Institutional Investor:

The research contradicts the view held by some defined benefit plan sponsors that given their fixed-income-like payouts, they should engage in liability-driven investment strategies, which rely on fixed-income assets to secure returns.

According to the research, this isn’t exactly beneficial for employees. Here’s why: many employees rely on their pension funds completely for retirement savings, according to the research. Regardless of how their plan sponsors invest, these employees are taking on some risk because their pensions could be wiped out if their employers file for bankruptcy. And while the Pension Benefit Guaranty Corp. (PBGC) provides insurance for pension funds, retirees are only insured up to a ceiling, the paper noted. For higher-paid employees expecting to retire with large pensions, a bankruptcy could spell trouble.

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There is, perhaps, a better way to distribute the risk fairly according to the paper: defined contribution plans. These plans make up 48.6 percent of pension assets in the seven major pension fund markets, according to Willis Towers Watson, and are steadily increasing their market share. Assets under management at these defined contribution plans increased by 5.6 percent over the past 10 years, while they grew by 3.1 percent at defined benefit plans during the same time frame, the report shows.

“A more efficient contract would let employees to shoulder all the pension investment risk while keeping them insulated from firm-specific risks,” according to the paper. “Interestingly, this arrangement resembles what a defined contribution plan offers. Our analysis shows that such an arrangement may substantially reduce firms’ pension funding costs.”