Chapter 4 // Defined Benefits plans : convincing Unions there are other solutions ( Part 1 )

Defined Benefit (DB) schemes have long represented the pension solution offered by the majority of employers in certain countries. Even though almost all newly created schemes are Defined Contribution (DC) with or without a guarantee (unit linked), DB still accounts for the majority of pension assets under management today.

But are they the better option? Let’s take a look

DB scheme performance

Typically, DB contracts promise an amount equal to 2% of the last salary (or the average of the last years) per year of presence in the company. On a 40-year career, that’s a replacement rate of 80% of the participant’s final salary.

This is a great promise that no one, especially the unions, wants to question.

It should be noted that according to the Organisation for Economic Cooperation and Development (OECD) in the Panorame des Pensions 2019, the average of the developed countries barely reaches a replacement rate of 58%. It is therefore understandable that no one, especially the unions, wants to question a system that would make it possible to reach 80%.

But it is a mistake to believe this result can be obtained without risk. Also, if the average replacement rate at the level stated by the OECD is so low, it is because other countries have either contributed insufficiently or were invested in DC schemes with a guarantee that, as I have discussed in previous blogs as part of this series, are going through difficult times. So, it is not the case that the one who has invested in a DB pension has managed his money well, but rather that others have done badly.

And at the risk of sounding pretentious, I believe results of 80% are also achievable via DC schemes without a guarantee.

How DC and DB schemes compare

Take the case of a company that went from a DB to a unit-linked DC scheme (without a guarantee) in the mid-2000s. The unions only accepted the DC option, to which the employer promised to contribute 12% of eligible employees’ salaries, for new employees.

The company therefore ended up with two pension plans: one DB and one DC. The expected rate of return for the DB was 4.7%, while the expected profitability for the DC was variable because employees could decide their own asset allocation between three SICAVs (shares, bond, or cash).

But for comparison purposes, I assigned to both schemes the same expected asset gain of 4.7%. At this rate, the initial results showed the DC plan arriving at only a 50% replacement rate, which explains why the unions in the mid 2000s were not happy to abandon DB.

However, at the end of 2020, when checking the reserves of certain DC plan participants, I was amazed to see some had actually performed better than the DB plan. 

The employees in that situation had invested heavily in the SICAV that was 100% invested in equities, and had enjoyed an average performance of 8.12% over the period.

But even for employees who invested 50% equities and 50% in bonds, the average performance was 5.6%.

Consequently, any individuals who stayed with the company for the first 20 years of their career could benefit more by investing in the DC plan rather than the DB.

Indeed, the longer their assets remained invested at a rate of 5.6%, the more time they had to catch up with the larger employer contribution to the DB scheme, which hits a ceiling at 4.7%.

In conclusion

It’s a fact that DB remains less risky than DC, while still offering excellent performance. It’s also true that the advantages of the unit-linked DC are only realised in our examples due to a performance rate of 5.6% or 8.12%. Because the expected rate of the DB scheme concerned was 4.7%, the DC plan comes out as a better option only if it produces a rate above 4.7%.

So, I’m not saying that a DC unit linked is better than a DB plan per se. However, under the right circumstances, it is possible for a DC scheme to perform better in the long term.