Defined benefit (DB) pensions often use inferior tools or apply the wrong rules when managing their portfolios, which can lead to suboptimal results. While actuaries and accountants have developed their own custom tools, pension plans can’t simply borrow those tools or apply the rules from those professions and expect the best outcomes. Pension plans need their own specific tools, accompanied by a healthy dose of common sense.
Common sense tells us that pension tool development should start with a strong understanding of the long-term economics of a pension plan—like reviewing cash flows instead of CAAP earnings or actuarial reports. The potential of the life of a pension plan is calculated with a combination of contributions and net returns. Using a pension plan for a single employee as an example, an employee paying into a plan for 30 years and retiring for 30 years with a pension payout of 60% of pre-retirement salary and a guaranteed net return of 3% should pay 12.5% of their salary when that percentage is matched by the employer.
But pension plans rarely involve a single employee, and the duration of an employee’s retirement can’t be determined ahead of time, adding significant complexity to pension plans. Combine those complexities with the volatility of returns, and it’s easy to see why specific tools are needed to help pension plans satisfy liabilities at the lowest cost and the least amount of risk—particularly given the context that volatility and risk in the pensions space are not the same as for actuaries and accountants.