Creating a new future with the best of both worlds

Only 11% of 126 million Americans working in the private sector participate in a defined benefit (DB) pension plan. In 1980, this number was 46%. The seismic shift from DB pension plans to defined contribution (DC) arrangements (i.e., 401(k) and 403(b)) plans is no secret. When DB plans became associated with high and volatile costs, employers shifted that risk onto individual employees via DC savings programs. However, those programs are only working for some Americans. By taking the best features of the DB and DC universes, we can create an innovative plan design that works better for everyone involved – workers and employers.

For decades, pension plans were built around the promise of a lifetime benefit calculated using a formula. They were poorly understood and opaque, resulting in volatile financial impacts for the plan sponsor. Still, they provided participants with stable, predictable lifetime income security while requiring very little involvement. They were called DB plans because the plan's rules focus on determining the benefit. At the same time, the costs are untethered and can fluctuate as investment returns, interest rates and other vital factors change.

Then, as concern about the financial impacts of pension plans pushed employers to demand an alternative, an odd thing happened. The pension and corporate worlds decided that the answer was to reverse the model entirely. Instead of promising a benefit, the idea was to provide a fixed contribution amount, making the value transparent and dependent on participant actions while completely untethering the benefit side. The benefit would no longer be paid as a pension but simply as a single lump sum value of the accumulated contributions. Rather than trying to manage the fluctuations or the risks inherent in a long-term pension promise, the promise was simply eliminated, resulting in fixed costs but with outcomes that are unpredictable and unsuited to supporting people's need for lifetime income. This model is defined contribution because the contributions are fixed while the outcomes or benefits are now undefined. The most common of these plans in the U.S. are named for the Internal Revenue Code section that defines them, section 401(k).

The strange thing about the shift is that some aspects of DB programs were very successful – particularly their ability to deliver high levels of pooled invested returns and efficiently convert assets into guaranteed lifetime income without resorting to expensive insurance products. Similarly, some features of defined contribution plans work very well – the clear line of sight to the value being provided, fixed employer costs, portability and flexibility in retirement. Each plan type is well suited to support specific aspects of retirement and poorly suited to others. But the discussion about pension design has devolved into DB or DC dichotomy, with no room for anything in between.

Finally, partially due to recent legislative fixes in SECURE 2.0, we see growing interest in a model that takes advantage of the best features of each type of pension plan to produce something new - Market Return Cash Balance plans (MRCBs). These plans effectively blend the best of both worlds to deliver better outcomes for employers and employees.

MRCBs are registered as defined benefit plans. Participants accumulate individual account balances based on employer and sometimes their own participating contributions. These accounts grow based on the investment returns of the underlying assetssimilar to DC plans, but those assets are professionally overseen and invested collectively, more like DB plans typically producing higher long-term returns. As members approach retirement, employers can incent loyalty by providing additional value at critical points in an individual's employment. At retirement, these plans pay their benefits as a guaranteed lifetime income from within the plan. They take advantage of defined benefit plans' greatest strength – the ability to cost-effectively convert assets into guaranteed lifetime income by leveraging asset and risk pooling rather than resorting to expensive insurance products. In addition, they offer participants the flexibility to split their benefits, so that some are paid as efficient, guaranteed lifetime income. At the same time, some are retained to be spent flexibly as needed.

SIDEBAR: MRCBs should be distinct from their less efficient cousins, traditional cash balance plans, which credit a significantly lower fixed or bond-yield-based return on accumulated assets. These plans produce a lower accumulated account balance for members and result in lower income while at the same time promising a rate of return that cannot be hedged, increasing the short-term risk for the employer.

In a world where choices have been reduced to an either/or battle of flawed extremes, it is gratifying to see an innovative approach that realistically tackles the needs of participants with understanding and flexibility, without compromising the needs of employers. There's no need to choose between traditional DB or DC when we can offer the best of both.

Find out more about how this approach can produce better outcomes for your plan.