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W hy have defined contribution (DC) retirement plans delivered such uneven--and, on average, inadequate--results? How can DC sponsors, who are charged with most of the responsibility for retirement security in the United States and elsewhere, do better--much better?1 Can DC sponsors learn from defined benefit (DB) plans, which did achieve desirable outcomes in many cases? Can they hold on to the best features of DB plans while simultaneously taking advantage of DC plans' structural advantages, such as full portability and unambiguous ownership of the assets by the participant?2
These are challenging questions, each requiring detailed analysis. Our basic thesis is that in order to provide more satisfactory results, DC plans need to look and feel more like DB plans.
To figure out how to do this, we'll emphasize the essential similarities between DB and DC plans. Both are mechanisms for spreading the income from one's working life over one's whole life; both are forms of lifecycle investing. Moreover, neither kind of plan can, in the aggregate, pay out more than is paid into it (plus investment returns). DB and DC plans both must obey the basic ground rules of economics--including the existence of limits, the universality of tradeoffs, the power of incentives, and the tyranny of accounting identities. The challenges faced by the two types of plans are, therefore, similar in their economic content, although quite different in execution.
This article asks what we can learn from history on both the DC and DB sides and suggests possible ways to design much better DC plans. We do so by borrowing the best ideas from both DB and DC structures. We identify the three levers that influence DC outcomes: (1) portfolio construction and investment return, (2) the savings rate and length of the savings period, and (3) decumulation strategy and longevity pooling. We assess opportunities to improve upon current practice in each of these three areas. But first, we begin with a brief history of DC and DB plans and identify the challenges currently facing both types of plans.
LIFECYCLE INVESTING
The best way to understand a retirement plan is as a way of spreading the income from one's work life over one's entire life. This is inherently difficult because one's work life...