INTRO: The traditional defined benefit plan allocated most risks to the employer, who committed to a given pension and provided it regardless of the effect of investment fluctuation and changing economic conditions. A defined contribution plan is on the other end of the spectrum. The employer commitment is limited to making an annual contribution. This is an efficient way for employers to eliminate risk, but the risk of financing retirement is not reduced when benefits are provided in a defined contribution plan. All risks for managing the retirement proposition remain the same, but are merely shifted to the employee. Jim McHale, a principal with PricewaterhouseCoopers L.L.P.'s human resource services retirement practice, suggests a shared-risk approach may be a more sustainable alternative for some employers than either traditional defined benefit and defined contribution retirement plans.

Will defined benefit pension plans make a comeback? Why would chief financial officers ever consider taking back the risks that they have already shed? However, not everything that looks like a defined benefit plan quacks like a defined benefit plan. If employers tune in to what their employees are thinking and consider with an open mind some of the opportunities that are available, they may find themselves taking a hard second look. Rather than making either dismal or rose-colored predictions, it may be more valuable to consider what has happened to retirement plans in the United States, what the needs and gaps are, and how they might be addressed.

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The notion of having a retirement plan of any kind is, at its heart, a risk-allocation exercise. We take compensation earned today and save it for our elder years to avoid the risk that the ability to earn will be impaired at that time. But as we do that, we must contend with other risks. How much do we need to save? How long will we live? What will inflation be? How will we invest the money set aside and what is the chance it will yield the return we expect? How will all of these factors change between now and the time of retirement?

The traditional defined benefit plan allocated most of these risks to the employer, who committed to a given pension and provided it regardless of the effect of investment fluctuation, increasing longevity, and changing economic situations. In the past 10 to 20 years, the combination of ever-decreasing interest rates, volatile capital markets and increasingly prescriptive accounting and funding rules exposed employers to the risks of these plans in dramatic fashion. Chief financial officers saw significant volatility in contributions and financial statement results that often drew unwanted attention from analysts and shareholders.

In response to this, many employers have frozen or eliminated these plans and have limited their commitment to providing only a defined contribution plan. A defined contribution plan is on the other end of the spectrum. The employer commitment is limited to making an annual contribution. This is an efficient way for employers to eliminate risk, but the risk of financing retirement is not reduced when benefits are provided in a defined contribution plan.

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All risks for managing the retirement proposition remain the same, but are merely shifted to the employee. Risk is in fact increased in defined contribution plans, which are individual account plans that do not permit pooling of any risks across the population.

And, if employers can't handle the risks, why would individual employees have a better chance of being successful on their own? Most employees do not have the skills, time or leverage to manage their retirement nest egg effectively. This problem has surfaced again and again in data that shows employees earn inferior rates of return in defined contribution plans as compared to professionally managed retirement plans. Other sources have documented concerns with inadequate savings rates, and excessive use of borrowing and hardship provisions in 401(k) plans, as well as problems with retirees outliving their retirement savings. These issues underscore a growing consensus that defined contribution plans fail in managing the retirement problem on their own. They may be a necessary and important piece of the puzzle, but a defined contribution-only system may not be viable.

So, if traditional defined benefit plans are at one end and defined contribution plans are at the other end of the risk spectrum, what is in the middle? Is there a shared-risk approach that could be more sustainable than traditional defined benefit and defined contribution plans? If we think about the trend away from defined benefit plans, the motivation for employers to head for the exits has mostly come from the risks that most directly effect the financial statements, namely the investment and interest rate risks that cause volatility to the corporate bottom line. A shared-risk model could ask employees to take on most of this risk while working, perhaps with some minimum guarantee or a no-loss-of-capital rule.

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Many believe the most difficult risk for the employee to manage is longevity. With current longevity trends headed towards 25% of retirees living past age 90, it will be difficult for workers to plan for the unpredictability of their own life span. Employers can probably more effectively manage the longevity risk of a large group of retirees than they can investment risks. Note that when the market goes down, all retirement funds for all employees plummet at the same time, but variations in longevity affect each retiree differently and tend to offset each other. Long-term trends in lifespan improvement tend to happen slowly, and are somewhat predictable for large groups, allowing employers time to adjust. Moreover, employers can consider insuring themselves against longevity risk.

The Pension Protection Act of 2006 provided a framework for hybrid pension plans, which can be designed to have some of the attributes above. For instance, a market cash balance plan (at least under proposed regulations) could have a cash balance account that is indexed to a real market asset, such as a mutual fund, or the actual return on fund assets. If the interest crediting to accounts is driven by the same investments that are in the trust, the investment risk would be borne by the employee while he or she is working (although with professional investment management and a capital preservation requirement). If the employee elects an annuity on retirement, the longevity and investment risk in the “draw-down” phase would be shifted to the employer. In addition, cash balance plans cannot allow loans or hardship withdrawals and are generally funded by employer contributions only, so the possibility of employees tampering with retirement savings is prevented. Although cash balance plans typically provide lump sums, they are not required to, so employers could add some security for employees by prohibiting or limiting lump sums.

Market cash balance plans, based on a technical definition, are defined benefit plans, but they have a very different risk profile. These plans would be much easier for employers to manage than more conventional defined benefit plans — funded status volatility would be substantially dampened because liabilities (the employees' accounts) would move in tandem with assets, at least for active employee accounts. This dynamic results in substantially less fluctuation of assets vs. liabilities on the balance sheet and more predictable cash requirements than traditional defined benefit plans.

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Market cash balance plans are one example, but other approaches that allocate risk more sensibly are being considered. Multiemployer plans are experimenting with defined benefit plan designs that protect funded status by adjusting prospective benefit accruals downward when investment experience suffers. Variable annuity plans, which vary the annual benefit with ups and downs in the plan assets, have been around for decades, and may have the potential to be used in a shared risk approach if pressed into wider use.

While a shared-risk pension arrangement can address many of the problems of the current retirement system, such plans cannot thrive unless the stakeholders buy in to them. How might the various stakeholders and other onlookers view them?

Employees. As employees become more aware that their 401(k) alone will not provide sufficient retirement security, a shared-risk arrangement will clearly benefit them in comparison. Employees value the flexibility they have with defined contribution plans, but should be willing to give that up, at least with respect to a portion of their retirement savings, in exchange for more security.

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Employers. It may be hard to imagine that employers who have already moved from defined benefit to defined contribution plans will readily wade back into taking back some of the risk. They have been in many ways penalized by the capital markets for carrying defined benefit pension liabilities. Even if the system is broken, why should employers again step in to shoulder risks that have already been deemed unsustainable? However, in a broken retirement system, employees have real needs with respect to retirement financing. An employer that can meet those needs will be able to compete for talent more effectively. Moreover, if employees are able to retire when it makes sense for them to do so, that will allow more orderly workforce management. Defined contribution plans tend to provide better retirement security when times are good and markets are up and disincent retirement in tougher times when more careful workforce management is needed. This counter-cyclical property of defined contribution plans surfaced in the last economic downturn; one of the factors that hampered job creation was the fact that many workers who wanted to retire could not afford to do so. It is possible that employers in industries where defined benefit plans are still prevalent will see a shared risk approach as a way to move out of their traditional defined benefit plans in a more balanced way.

Legislators and regulators. New types of retirement plans will not flourish without clear rules that do not present administrative and technical roadblocks and avoid litigation. There is growing consensus in Washington that better retirement solutions are needed, and lawmakers may agree that retirement plans that provide more security to workers will ease pressure on Social Security and other government programs.

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Pension Benefit Guaranty Corporation. The PBGC has been reporting deficits of late, and these deficits are likely to increase as the pension risk-reduction trend increases among employers. Here's why: employers are seeking to exit the defined benefit system by paying insurance companies to take on their liabilities. This process is likely to accelerate as high-profile companies have moved forward even when economic conditions are not ideal. Since healthy companies may be the only sponsors who can afford to do this, their exit will reduce PBGC premium revenue, leaving less healthy companies in the system. New shared risk plans in the system with plans that are less likely to become underfunded should be a boon to the PBGC.

While it is not a lock that defined benefit plans will make a roaring comeback, the magnitude of the potential problems calls for innovative approaches. Conditions may be right for at least some employers and other stakeholders to take a look at retirement plan variations that can address many of the problems that more and more onlookers agree exist.

Jim McHale is a New York-based principal with PricewaterhouseCoopers L.L.P.'s human resource services retirement practice. He can be contacted at 646-471-1520 and jim.mchale@us.pwc.com.