Defined Contribution Schemes Should Employers or Countries be Permitted to Sponsor Them?

1. Defined Contribution SchemesShould Employers or Countries be Permitted to Sponsor Them? This article shows that the goals of DC plans can be achieved by permitting participants full access and control over their accumulations. It suggests that to do otherwise subjects the accumulations to unreasonable risks of loss. We believe that actuaries fulfill their obligation to participants by supporting separation from employer control upon vesting New Zealand Society of Actuaries Conference, 14 November 2002, P12

2. Introduction • Les Lohmann • Defined Benefit (DB) actuary • Cultural issues New Zealand Society of Actuaries Conference, 14 November 2002, P12

3. Introduction • Thrift • Saving money for a later need • Defined Contribution (DC) • DB Retirement • Cannot pay before actual departure • Life annuities also depend on age of vesting New Zealand Society of Actuaries Conference, 14 November 2002, P12

4. Introduction • Importance of Culture • Canada • Japan • Importance of history • Merrick, Aberdeen and Grennock • Importance of the numbers • Expose and explain New Zealand Society of Actuaries Conference, 14 November 2002, P12

5. Introduction • Goals • Startling • Unbalanced • Stimulating New Zealand Society of Actuaries Conference, 14 November 2002, P12

6. Introduction • Who controls the disposition of the money? • Participant • Employer • Government (investment quality requirements excepted) • "Holding the money" refers to where the center of gravity of control lies. New Zealand Society of Actuaries Conference, 14 November 2002, P12

7. Important definitions • Sponsor The sponsor of a scheme maintains a significant relationship with the accumulating contributions of the participant, even after the participant is "fully vested" in any contributions made by the sponsor. New Zealand Society of Actuaries Conference, 14 November 2002, P12

8. Important definitions • Participant • "Someone with rights, vested or not, in a scheme” • Employees not yet eligible count • Portable • Saturated with savings • Retirement scheme • Age retirement New Zealand Society of Actuaries Conference, 14 November 2002, P12

9. Important definitions • Pension scheme • When a "pension scheme" provides severance benefits, it is in the form of or equivalent to the value of a deferred annuity payable at normal retirement age • Severance scheme • Termination • Like "pension scheme," the formal name of the arrangement does not change the fact of the benefits provided. New Zealand Society of Actuaries Conference, 14 November 2002, P12

10. Assumptions • Retirement schemes provide the money in one or a mix of two forms • annuity • lump sum • A retirement scheme can provide severance benefits. New Zealand Society of Actuaries Conference, 14 November 2002, P12

11. Assumptions • Lump sum • When a scheme determines benefits as a lump sum, the fact that a beneficiary has opportunities to purchase, with the scheme lump sum disbursement, an annuity does not change a scheme into a pension scheme, even when that annuity is an alternative form available from the scheme New Zealand Society of Actuaries Conference, 14 November 2002, P12

12. Assumptions • This article does not apply to schemes that are merely tax deferral schemes or severance schemes • The scheme sponsor has decided to implement a retirement scheme as opposed to a severance scheme. New Zealand Society of Actuaries Conference, 14 November 2002, P12

13. Assumptions • Capital efficiency Always plays a role • the sponsor has developed some ideas of how much money should be provided at age retirement and that this concept is being applied in the development of the sponsored scheme New Zealand Society of Actuaries Conference, 14 November 2002, P12

14. Assumptions • Capital efficiency Always plays a role • Employees have an idea of how much money they will need at retirement and will try to save this amount in a cost-effective way. For an employee, "cost-effective" means achieving a reasonable balance between satisfying immediate needs and thrift. New Zealand Society of Actuaries Conference, 14 November 2002, P12

15. Characteristics of DC Schemes • Not pension schemes • Often require participant contributions in order to attract employer contributions. • Benefits • Taxable • Portable • DC schemes shift risk from the employer to the participant when compared with defined benefit (DB) schemes. New Zealand Society of Actuaries Conference, 14 November 2002, P12

16. Characteristics of DC Schemes • Employer costs are more certain than DB schemes. • Are career-average • No participant ever gets the retirement/severance benefits designed or expected • DC schemes encourage saving over consumption, often with a tax subsidy New Zealand Society of Actuaries Conference, 14 November 2002, P12

17. DC schemes are not pension schemes • DC schemes are either severance schemes and/or tax deferral schemes. • DC schemes recharacterize current pay. They are perceived as retirement vehicles only because employee participants are not permitted access to their accumulated money until they quit. • Japan actually denies access until age 60 New Zealand Society of Actuaries Conference, 14 November 2002, P12

18. DC schemes often require participant contributions • In the absence of enabling legislation, participant contributions are fully taxable as ordinary income before being saved. New Zealand Society of Actuaries Conference, 14 November 2002, P12

19. DC schemes often require participant contributions • American enabling legislation recharacterize participant contributions as employer • Vesting rules recognize these funds as truly belonging to the participant - requiring immediate vesting and participant control. • Even without enabling legislation, amounts paid by the employer sponsor to a DC scheme are tax-deductible as a reasonable employment expense. New Zealand Society of Actuaries Conference, 14 November 2002, P12

20. DC Scheme Benefits • Taxable to the beneficiary upon receipt. • Portable. There is no reduction for • early retirement • survivorship New Zealand Society of Actuaries Conference, 14 November 2002, P12

21. DC schemes shift risk from the employer to the participant New Zealand Society of Actuaries Conference, 14 November 2002, P12

22. DC Scheme Costs are certain • Equal to the contribution • Over the long term, costs are higher than DB schemes for the same planned age retirement benefits. • Employers have more flexibility New Zealand Society of Actuaries Conference, 14 November 2002, P12

23. DC Schemes are Career-average • Can't provide benefits related to the participant's final standard of living • Penalize better than average performance near the end of a career • Do little to reward better than average performance occurring early or mid-career • Tend to reward savings made during the years of career development and family formation New Zealand Society of Actuaries Conference, 14 November 2002, P12

24. DC Schemes Cannot Deliver • No participant ever gets the retirement/severance benefits designed or expected from a DC scheme • If investments have done well, (s)he will get more than planned • If investments have soured, (s)he will get less than planned. New Zealand Society of Actuaries Conference, 14 November 2002, P12

25. DC Schemes Encourage Thrift over Consumption • Often with a tax subsidy • Taxes are deferred to a later date, then taxed as ordinary income (U.S. approach). • Taxes are reduced regardless of payment timing or other income (Japan approach). New Zealand Society of Actuaries Conference, 14 November 2002, P12

26. Characteristics of employer-sponsored DC schemes • Employees must pay to participate. • Employer contributions must be "invested" in company shares. • Employer contributions vest only on service - not by reason for termination. • The employer sponsor has no liability once the contribution is made. New Zealand Society of Actuaries Conference, 14 November 2002, P12

27. Characteristics of employer-sponsored DC schemes • The employer has the use of both the participant and employer money for a period before being invested. During that period, the participant is a general creditor. • "Investment options" are totally controlled by the employer sponsor. • Scheme costs are borne by participants usually through a reduction in investment earnings. New Zealand Society of Actuaries Conference, 14 November 2002, P12

28. Common Misconceptions of DC Schemes • Investment returns are higher than for funds invested for DB schemes. • DC schemes cost less for employers. • Higher benefit security • DC schemes benefit the economy. New Zealand Society of Actuaries Conference, 14 November 2002, P12

29. DC Schemes have Higher Returns • Current return vs assumed discount rate • Shorter horizons • Lower risk tolerance • Diversification (efficient frontier) New Zealand Society of Actuaries Conference, 14 November 2002, P12

30. DC schemes cost less • Administration • Cost shifting • Lower overall benefits • Less than 100% participation • Matching New Zealand Society of Actuaries Conference, 14 November 2002, P12

31. DC Schemes Provide Higher Benefit Security • Principal protection/Risk • Employer shares New Zealand Society of Actuaries Conference, 14 November 2002, P12

32. DC Schemes Benefit the Economy • Japan • Investment losses • Participant ignorance • Economic consequences • Savings vs consumption • Supply vs demand • Economic activity • New capital New Zealand Society of Actuaries Conference, 14 November 2002, P12

33. Recent "discoveries" about DC Performance and Weaknesses • Average people/lottery • Market volatility • Employer flexibility • Investment fees vs fund performance • Investment choice cycles vs capitalizing losses New Zealand Society of Actuaries Conference, 14 November 2002, P12

34. The Average Investor is Below Average • Buys and sells on emotions. • Does not have prompt access to the information that drives markets. • Bets the farm on a "sure thing." • Believes that his/her own account will outperform the illustrated investment returns. New Zealand Society of Actuaries Conference, 14 November 2002, P12

35. How to Make Money with a DC Scheme • Percentage of gross assets under management • Per transaction New Zealand Society of Actuaries Conference, 14 November 2002, P12

36. How to Make Money with a DC Scheme • Corporate insiders • Personal trading • Using participant equity assisting or opposing takeover efforts • Less than arms length loans • Penalties vs profits • How to become president! New Zealand Society of Actuaries Conference, 14 November 2002, P12

37. How to Make Money with a DC Scheme • Can employees be sufficiently educated? • Gambling? • Market volatility/Ruin theory New Zealand Society of Actuaries Conference, 14 November 2002, P12

38. Recent cases • Tyco, GE and Intel illustrate the ease with which management can transfer all corporate earnings into their own pockets • Enron and Worldcom tell us something about the ways management can unload shares on insider knowledge without notice and engage in cross transactions that benefit a few at the expense of the owners, transferring sums wildly exceeding earnings into their own pockets New Zealand Society of Actuaries Conference, 14 November 2002, P12

39. Recent cases • AOL taught us that actuarial probabilities can apply to allocating an income stream to CDs that are passed out for free. • Bell Labs, owned by Lucent, reported scientific discoveries of Nobel prize stature. They were faked. • Several companies taught us how to borrow money and report it as income. New Zealand Society of Actuaries Conference, 14 November 2002, P12

40. Pro-Forma Sins • Double/Triple/Infinite counting • Misallocation of expenses • Funny income • Swaps • "Round trips" • Buying political advantage with someone else's money New Zealand Society of Actuaries Conference, 14 November 2002, P12

41. Investment Rules • Wrong sets of investment rules • DB • Full funding vs employer liability • Payment of contribution New Zealand Society of Actuaries Conference, 14 November 2002, P12

42. Control • Participants investment discretion • Employer shares vs full vesting • Investment option control • Perception of value versus risk • Unilateral rights of the sponsor vs abuse • Privacy • Universe of investment options New Zealand Society of Actuaries Conference, 14 November 2002, P12

43. Conflicts of Interest • Why would your employer set up a bank account for you? • Smoke and mirrors • Scheme expenses • American unions • "Total pay systems" New Zealand Society of Actuaries Conference, 14 November 2002, P12

44. Conflicts of Interest • Choosing investment vehicles • Employer liability • Expense levels • Investment performance • Existing business relationships • Who pays for the analyses? New Zealand Society of Actuaries Conference, 14 November 2002, P12

45. Conflicts of Interest • Risks of fiduciaries and sponsor • Completed transaction • Insurance • Insolvency law • Cost of legal actions New Zealand Society of Actuaries Conference, 14 November 2002, P12

46. Participant interest • Low expenses • High Return New Zealand Society of Actuaries Conference, 14 November 2002, P12

47. Government-sponsored schemes • Governments are subject to the same temptations, perhaps more so, as private industry • Japan EPF • Japan "401K" New Zealand Society of Actuaries Conference, 14 November 2002, P12

48. Benefits to Society • Pressure on Social Security vs DC Schemes • Tax-deferred savings vehicles • Loans • Turnover • Payroll deduction • Broader economic issues (Japan) New Zealand Society of Actuaries Conference, 14 November 2002, P12

49. The Bottom Line • The basic question is, why should fully vested participant money require termination of employment to become completely controlled by the participant and independent of the employer? New Zealand Society of Actuaries Conference, 14 November 2002, P12

50. The Bottom Line • Employers and governments that wish to provide retirement security to their people should be required to do so with the technique that is not readily available to individuals - DB retirement schemes. • DC scheme funds should be placed outside the reach of the employer or the government as soon as practicable. New Zealand Society of Actuaries Conference, 14 November 2002, P12