Comparing Costs and Risks of Retirement Plans for Sponsors

• Published date: 01 September 2013
• DOI: http://doi.org/10.1111/rmir.12010
• Date: 01 September 2013
• Author: Mark Warshawsky,Gaobo Pang

Risk Management and Insurance Review

C

Risk Management and Insurance Review, 2013, Vol.16, No. 2, 195-217

DOI: 10.1111/rmir.12010

COMPARING COSTS AND RISKS OF RETIREMENT PLANS

FOR SPONSORS

Gaobo Pang

Mark Warshawsky

ABSTRACT

This stochastic simulation analysis compares funding costs and volatilities for

private sponsors of traditional defined benefit (DB), pension equity (PE), cash

balance (CB), and defined contribution (DC) retirement plans. Plan provisions

of equivalent benefit generosity in the different plan types are determined. The

modeling includes current funding requirementsand practices as well as a com-

prehensive set of uncertainties in asset and labor markets. The results show that

costs and risks for sponsors vary significantly with plan types, investment and

funding strategies, and participant demographics. The hybrid PE and CB plans

exhibit characteristics of cost efficiency, as in the DB plan, and risk reduction,

as in the DC plan, for plan sponsors under conventional investment strategies.

These features are more saliently observed in the CB plan, but it is also more

difficult to implement effective asset–liability management strategies for it.

INTRODUCTION

Employer-sponsored retirement plans are important for workers, because the plans

provide income resources for retirement, and for employers, because the plans can help

attract and retain talented workers and support more orderly labor force exit at older

ages when worker productivity starts to wane. The landscape for plan sponsorship is

evolving with the confluence of changes in demographics, worker preferences, economic

and financial events, public opinion, and laws and regulations. For plan sponsors, it is

essential to have a good assessment of the cash costs and risks that are associated

with retirement plans. Different plan types and designs have varying and sometimes

Gaobo Pang is a Senior Economist at Towers Watson; telephone: (703)258-7401; fax: (703)258-

7492; e-mail: gaobo.pang@towerswatson.com. Mark Warshawsky is the Director of Retire-

ment Research at Towers Watson; telephone: (703)258-7636; fax: (703)258-7492; e-mail: mark.

warshawsky@towerswatson.com. The authors thank Ronald Evans, Tomeka Hill, PierreJraiche,

Michael Orszag, Michael Pollack, Mark Ruloff, Richard Shea, Aaron Weindling, Noriyoshi

Yanase, two anonymous reviewers, and participants in the Quantitative Society for Pensions

and Savings (QSPS) 2010 workshop, a 2010 Covington and Burling lunch seminar, and the

American Risk and Insurance Association (ARIA) 2011 annual meeting for helpful comments

and suggestions. Opinions expressed here are the authors’ alone, not necessarily those of their

affiliation, and do not constitute investment advice. This article was subject to double-blind peer

review.

195

196 RISK MANAGEMENT AND INSURANCE REVIEW

competing efficacy in serving various corporate goals and the welfare of participants.

This article, through stochastic simulations, intends to providea quantitative comparison

of the prevailing retirement plans and discuss the implications of plan offerings in the

context of corporate cash flows.

A traditional defined benefit plan (hereafter DB, denoting traditional) automatically pro-

vides retired workers with guaranteed lifetime benefits based on the level and duration

of earnings with the employer. The sponsor makes contributions to fund the accrued

benefits and makes up any funding deficits that may develop. Plan assets are pooled and

the sponsor is responsible for investment losses but does not have access to surpluses

for general corporate purposes. A defined contribution plan (DC), such as a 401(k) ac-

count plan, usually has some contributions by the employer, often matching employee

contributions, and plan participants bear all the investment and retirement income risks.

Hybrid pension equity (PE) and cash balance (CB) plans combine elements of DB and

DC plans. They are designed as individual account plans paying a lump sum benefit

but feature principal and return guarantees from the sponsor on the pay credits accrued

to the account.

Our analysis focuses on the levels and volatilities of funding costs from the plan spon-

sor’s perspective, given that the benefit generosity to participants is set to be roughly

equivalent across the plans. We examine how the plans fare with the most salient plan

provisions, operating under the main legal and regulatory requirements and common

workforce circumstances. Stochastic simulations of asset returns and interest rates re-

flect standard market shocks in normal times and low-probability large-magnitude(rare)

economic disasters. Simulations of labor earnings for each worker capture the life-cycle

age-earnings profile, idiosyncratic (random) individual income variations, and broad

correlations of general wage levels with macroeconomic shocks.

The simulation results show that costs and risks vary significantly with plan types,

demographics, and investment and funding strategies. The most important results

are the higher cost volatility of the DB plan, the higher cost level of the DC plan,

and the lower volatility (compared to the DB plan) and the lower cost (compared

to the DC plan) of the hybrid plans. Liability-driven investment (LDI) strategies,

which are increasingly used to manage and hedge risks in DB plans, however, are

difficult to implement in hybrid CB plans. The results highlight the advantages

and disadvantages of the different retirement plan types as currently designed and

regulated.1

The remainder of this article is structured as follows. The following section reviews the

literature, especially related to plan funding. The “Assumptions and Simulations” sec-

tion contains the assumptions of the stochastic simulation analysis, as well as explains the

funding rules and how benefit equivalence across plan types is assured. The “Findings

from Simulations” section provides the baseline results and alternative specifications.

The final section concludes.

1Innovations, including legislative reforms, may provide a better alignment of retirement plan

design with corporate and workforce goals and preferences. Warshawsky (2010), for example,

proposes a flexible structured plan that would share investment risk and returns between

employees and employers.