Saving for retirement is a risky endeavor. A key factor driving the shift over the past four decades from defined benefit (DB) pension plans to defined contribution plans (mainly 401(k) plans) and individual retirement accounts (IRAs) is employers’ desire to avoid the risks associated with providing guaranteed pension benefits to their employees. This guarantee—a defining feature of DB plans—can entail large and unpredictable changes in funding obligations, which can wreak havoc on corporate balance sheets and budgets. But the flight from DB plans to 401(k)s and IRAs did not make financial risks disappear; instead, it transferred the risks to individual workers, many of whom are ill-equipped to respond to market fluctuations, changes in economic conditions, and other unanticipated contingencies.
In a new paper, we explore the potential for collective defined contribution (CDC) plans to help rethink risk sharing between employers and individuals and among savers and retirees. CDCs and other hybrids combine DB and DC elements in different ways. CDC plans generally let employers avoid the funding volatility and investment risk of DB plans while reducing the financial risks individuals face in many DC plans. Although CDCs are technically DC plans, they look largely like DB plans to savers and retirees. Compared to 401(k) plans, which feature individual accounts, participant-directed investing, and typically lump-sum payouts, CDCs share investment and longevity risk among employees and retirees, providing DB-style pooling of investments, professional investment management, and lifetime retirement income. They do not, however, provide guaranteed benefits. Instead, benefits can be adjusted or required contributions increased if necessary to reflect plan funding and investment performance.
Similar plans already exist in the Netherlands (where they are called “defined ambition” plans) and Canada, are receiving serious consideration in the United Kingdom, and have counterparts and close parallels (such as money purchase plans) in the United States.
In the paper, we examine the opportunities and challenges associated with implementing CDCs in the United States. We highlight several issues that CDC plans must confront, regarding expectations, equity, transition, and trust. We conclude that, under appropriate circumstances and contingent on addressing those issues, adding particular CDC features to either a conventional DB plan or a 401(k) has the potential to improve outcomes for workers, retirees, and employers. More generally, we emphasize that evaluations of CDCs depend greatly on the answers to two questions: “Compared to what?” (e.g., traditional DB plans or 401(k) plans) and “From whose point of view?” (e.g., employees, retirees, or employers).
While they face significant issues, CDCs and similar approaches that transcend a strict adherence to traditional DB or 401(k) plan designs can help improve retirement security. Looking beyond the conventional plans to explore a more nuanced array of risk-sharing and pooling strategies is a welcome development that will help identify more optimal allocations of financial risks and retirement benefits.
