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The Actuary The magazine of the Institute & Faculty of Actuaries

The best of both worlds?

IN THE LIGHT OF CONCERN FOR the amount of risk that
risk-averse workers bear when defined contribution
schemes provide an important part
of retirement income, this article explores the conceptual
basis for an employer-backed minimum rate of
return guarantee. Extending an earlier analysis (Turner
2000), the article presents a prototype model of a guaranteed
defined contribution scheme where the
employer match rate depends on the rate of return
earned on the scheme assets.
A minimum rate of return guarantee
A common feature in some types of defined contribution
schemes is an employer match for employee contributions.
With a match, the employer will contribute
an amount up to a maximum percentage of salary. The
guarantee proposed here uses an employer match,
where the match per £ of employee contribution varies
from zero to £1, depending on the rate of return on
the pension portfolio.
This guaranteed defined contribution scheme has
three design parameters. To illustrate how it works, a
prototype is presented. The prototype has individual
accounts in which the worker’s contribution equals
2% of the worker’s pay (parameter 1: the base contribution
rate). It guarantees a minimum annual nominal
rate of return of 6% (parameter 2: the guaranteed
rate of return). The scheme sponsor backs the guarantee
by a supplemental annual contribution of up to 2%
of the worker’s pay (parameter 3: the maximum supplementary
If the scheme earned a rate of return of 6% or more,
the rate of return that the participant received would
be the actual rate of return on the portfolio. If the
scheme in a year earned less than the 6% guaranteed
rate of return, the scheme sponsor would contribute a
supplementary matching amount, up to 2% of pay per
worker, to raise the worker’s account balance to where
it would have been had the scheme earned a 6% rate
of return that year. If the contribution of an additional
2% of pay were insufficient to raise the rate of return
to the guaranteed minimum rate, the guaranteed minimum
would not be met in that year, but no liability
to the scheme sponsor would be carried over to the following
scheme year. Thus, the scheme sponsor has a
limited liability and the guarantee is appropriately
thought of as a risk-sharing arrangement.
The scheme sponsor can vary the values of these
guaranteed rates of return higher or lower, and make
the guarantee more or less secure. Generally, forms of
investment protection cause the problem of moral
hazard (Whitehouse 2000). To avoid the problem of
moral hazard that would occur if participants were to
make the portfolio choice, the scheme sponsor would
need to choose the investment portfolio to control the
risk that the scheme sponsor is guaranteeing. The guarantee
would then not be subject to moral hazard problems,
since the employer would both manage the level
of risk and provide the guarantee.
While it may appear that the employer bears the cost
of providing the guarantee, the employee ultimately
bears that cost through two adjustments by the
employer. First, the employer will presumably invest in
a more conservative portfolio, so the employee bears
the cost of a reduced expected rate of return. Second,
labour market theory suggests that the employer
would reduce other forms of compensation to employees
if its costs of providing a pension benefit are
increased. The probability that the guarantee will not
be fully met increases as the ratio of the participant’s
pension assets to his/her wages increases. Thus, generally,
the probability that the supplementary contribution
will be insufficient to fully satisfy the guarantee
increases with worker tenure.
There are at least two different perspectives in
analysing the rate of return guarantee with respect to
employee tenure. From the portfolio perspective, the
security of the guarantee generally declines with
longer tenure because the probability that it will not be
fully met increases. From the compensation perspective,
however, the value of the guarantee increases
with longer tenure because the likelihood that the
employer will make the maximum supplementary
contribution increases.
The guarantee has several features that may affect the
behaviour of workers. The feature of the scheme that the
expected match rate is higher at longer tenure causes the
scheme to effectively be backloaded, meaning that it is
more generous for long-tenure workers. This feature
encourages worker tenure, which is a common feature of
defined benefit schemes. For schemes where worker participation
is voluntary and the worker has choice as to
the amount to contribute, the guarantee has the desirable
feature that the expected match rate increases with
the amount the worker contributes (relative to the
worker’s pay), encouraging contributions.
This scheme will not appeal to many workers, who
would prefer more risk and greater expected return.
Consequently, the scheme may not appeal to scheme
sponsors whose main goal is to favour higher income
workers, since higher income workers tend to be more
willing to bear financial market risk. The scheme will
appeal to workers who are particularly risk-averse, and
to their employers. An employer who wished to attract
risk-averse workers, perhaps considering that to be a
desirable characteristic of workers for a particular occupation,
may find this type of scheme attractive. The
guaranteed defined contribution scheme may be an
appealing option to paternalistic employers, concerned
about the amount of risk their workers are bearing.
Such a scheme may be appealing to low-wage
employees and other employees who have been traditionally
difficult to cover under voluntary schemes,
because it is a low-risk scheme that is relatively simple
to understand.
A criticism of the guarantee is that it may increase
the cost to employers of compensation during economic
downturns when they would prefer to reduce
compensation costs. This negative effect occurs if the
rate of return on the portfolio declines during periods
when the demand for the firm’s product, and thus its
demand for labour, also declines. That correlation can
presumably be reduced by reducing the share of equities
in the pension portfolio, something that would
probably be done anyway to reduce the cost to the
employer of providing the guarantee. Alternatively,
the guarantee could be structured so that it was also
contingent on the profits of the employer, but with
the guarantee applying to the rate of return received
over the previous two years. Under an alternative
method, the liability for a single year’s guarantee could
be carried forward one or more years, with the
employer making the supplementary contribution
during a year when profits were relatively high.
A large employer might offer several different guarantee
options, with a lower guaranteed rate being
backed by a larger supplementary contribution, but
with the guarantees having equal expected cost. If this
guarantee were applied to a mandatory national
scheme, it could be advance-funded, with employers
(or employees) making a small annual contribution
that would go to a fund that would be used to back the
An alternative type of guarantee would be more like
a catastrophic guarantee. A prototype scheme for that
type of coverage could be a guarantee of a 1% rate of
return, but with a supplementary contribution of 3%.
With this alternative, employers would presumably
maintain a conservative investment portfolio. For this
type of guarantee, it could be structured so that it
worked like a reber, the employer would contribute 2%
every year except years when the rate of return
exceeded a fixed level, say 8%. It could be phased in so
that the employer contributed 1% when the rate of
return exceeded 7% and made no contribution when
it exceeded 8%.
Guaranteed defined contribution schemes can provide
a low-risk, low-cost retirement scheme or option that
may appeal to some workers and employers. They can
be viewed as a modification of the traditional scheme
with employer match. Because the guarantee has limits,
it is appropriately considered to be a risk-sharing
arrangement. For a given portfolio mix, these schemes
provide less risk than is currently available in defined
contribution schemes because of the risk-sharing by
the employer. It provides a scheme option that falls
between a traditional defined benefit scheme and a
defined contribution scheme in that the employer and
employee share the financial market risk. For some
workers and employers, it may combine the best features
of traditional defined benefit and defined contribution
This option increases the flexibility of the retirement
income system to meet the needs of diverse employers
and workers. By providing an additional option for
workers and employers, a guaranteed defined contribution
scheme makes it possible to better meet the
needs of workers who are particularly risk-averse.