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Pension Management

Pensions Making Ambitious Plans

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May 07, 2018

Public and private pensions are changing to a less costly hybrid approach for their pensions; going to "defined ambition."

Game planA recent increase in treasury rates has given a boost to both corporate and public sector pension plans in the last month or so. Still, many US pensions continue to struggle and will face shortfalls in a few years. This is why some countries are adopting hybrid pension plans that are more sustainable and often offer better returns.

Currently companies and governments have either defined benefits (DB), like a traditional pension, or defined contribution (DC), which are 401(k)s. But the new pension route, called “collective defined contribution” (CDC), also known as “defined ambition,” keeps the attractive parts of a pension but avoids the steep drops that can suddenly put a town or company in a hole.

CDCs are already offered in the UK, Canada, Denmark and the Netherlands. The good news, according to Fitch Ratings, is that many pension plans will likely convert to the new hybrid plans. The bad news is that if a company already has made the switch to a 401(k), it’s unlikely it will move back to a pension, whatever the structure. “Voluntary switching to these schemes by corporates and institutions that have already successfully adopted defined-contribution schemes is less likely,” Fitch said in a note.

Fitch said that like DC plans, “the employer’s and the employee’s contributions are largely fixed. However, all funds are pooled and there are no individual employee pots and no individual investment decisions.” But also like DB plans, a CDC “offers a ‘target’ or ‘ambition’ amount of pension to be paid, indexed in line with inflation.” CDC plans can make long-term illiquid investments that are not available in most 401(k) plans. In addition, all investment decisions in CDCs are centralized “and the schemes have the flexibility to smooth the pension outcomes by investing in a wider range of return-seeking assets,” Fitch said.

But CDCs are not for everyone, Fitch noted. In order for it to be viable, “its member pool needs to be large enough, or a multi-employer setting needs to be available, so that it can benefit from effective risk-sharing and economies of scale.” It also needs “robust governance and risk management structures” in place, something usually only larger MNCs would have.

“Due to these requirements, we believe that CDC schemes are more likely to be adopted by larger corporates and the public-sector institutions that currently run DB schemes, but are seeking ways to switch to less costly solutions,” Fitch said. Meanwhile, according to Legal & General Investment Management America (LGIMA), the funding ratios for "typical" corporate pension plans increased 2 percentage points to 89.2% in April, primarily driven by the increase in Treasury rates and positive equity returns.

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