Defined benefit (DB) plans are going away. Yet, we know traditional defined contribution (DC) plans struggle to meet expectations. The newly introduced collective defined contribution (CDC)1 plans in Japan provide companies with a third option, an innovative plan design to eliminate DB risks, while providing their employees with higher and more stable benefits than with DC plans.
The need for a new solution
Before the introduction of CDC plans, the Japanese framework for employer-provided retirement arrangements consisted of DB and DC plans, or both (offered as complementary plans).
Traditionally, employer retirement plans in Japan have been DB plans but there has been a gradual shift to DC plans since they were introduced in 2001, as DB plans entail investment and actuarial risks that companies are no longer willing to support. The trend is not expected to change. Also, interest rates are at historically low levels, making DB plans more expensive than ever to offer.
Although DC plans in Japan have grown in popularity, they have their own challenges. One issue is relatively low tax-favored contribution limits2 which force companies, when introducing a DC plan, to maintain a top-up DB plan. Another issue is a general sub-optimal approach to investment by plan participants. DC plans often require employees, who are not usually investment experts, to make complex investment decisions. In Japan, employees tend to be risk-averse and often struggle to make these decisions. According to the Japanese Pension Fund Association, about 54% of total DC assets are invested in cash or short-term deposits, likely resulting in lower benefits for employees in the long term.
CDC plans aim to address both the risks encountered in DB plans for companies and the investment issues for employees with DC plans.
What is a CDC plan?
But what is a CDC plan? The principle underlying CDC plans is simple: fixed contributions are invested in a common pot with the objective of delivering pre-defined benefits that are not guaranteed. A CDC is essentially a funded pension plan with pooled assets, fixed contributions, and target benefits:
- Pooled assets: Like DB plans, CDC plans are pooled arrangements (i.e. participants do not have individual accounts) with assets managed centrally by a pension committee on behalf of the plan’s participants.
- Fixed contributions: Like DC plans, CDC contributions are fixed. They are set before introducing the plan and do not depend on the plan’s investment performance. The plan sponsor has no obligation to pay additional contributions if the plan does not hold enough assets to pay the target benefits.
- Target benefits: To set expectations, CDC plans have explicit target benefits defined based on a DB formula. They are, however, not DB plans from a risk perspective: the target benefits are not guaranteed and can be adjusted downward or upward depending on the plan’s financial situation. In extreme circumstances (in the case of a significant market shock for example), employees may receive less than the target benefits. On the other hand, if the plan’s investment and actuarial experience is favorable, benefits can increase.
CDC plans share common features with both DB and DC plans, allowing for a more balanced approach to pension risk management as illustrated in figure 1.
CDC plans come with many advantages
CDC comes with many advantages for both the employer and their employees:
- No risk for the employer:3 CDC plans involve no investment or actuarial risks for the employer because contributions are fixed and there is no obligation for the employer to fund any shortfall in funding.
- DC accounting treatment:4 CDC plans can be accounted for as DC plans under International Financial Reporting Standards (IFRS) and under Japanese Generally Accepted Accounting Principles (J-GAAP): CDC employer contributions are simply recognized as an expense when they are paid. Accounting valuations are not needed, and companies do not have to recognize a liability on their balance sheet for the plan. Companies with an existing DB plan can therefore strengthen their balance sheets by converting it to a CDC plan.
- Greater investment efficiency and economies of scale: When compared to a DC plan, better investment decisions can be made in a CDC plan because it does not require individual participants to make investment choices. Rather, a CDC has a pension committee that is responsible to set and monitor the plan’s investment strategy and funds. The committee can be supported by investment professionals and actuaries. In addition, CDC plans, as pooled arrangements, should benefit from lower investment management fees than DC plans. Lower fees mean better net performance and therefore better employee outcomes.
- Greater predictability of benefits for employees:5 To reduce the prospects of a benefit reduction, Japanese CDC plans have a protection mechanism in the form of a risk margin. This is essentially a capital buffer held in excess of the benefit target, in case things do not go as expected. The risk margin can be funded through risk contributions that collateralize the target benefits and reduce the volatility of the employee benefits.
- No DC limit related issues: The traditional DC limit does not apply to CDC plans. Companies can consequently introduce a CDC plan without any additional top-up DB arrangement and therefore simplify their pension structure.
DB to CDC conversion made easy
To facilitate the introduction of CDC plans, Japan has passed legislation to make it possible to convert an existing DB or DC plan to a CDC plan.
To illustrate some of the conversion options available, in figure 2 we outline how companies having a combination of a DB plan and a DC plan can move to CDC.
The companies can convert their existing DB plan (including the associated past service benefits) into a CDC plan within the same funding vehicle (alternative 1). The conversion does not require changing the plan’s lead manager, administrator or asset managers. Depending on the existing DB plan, the design of the preexisting DB benefits can serve as the base for the design of the CDC target benefits. The legislation gives flexibility to companies in the design of the CDC target benefits. Some designs are, however, better-suited than others for a CDC.
Companies concerned about benefit adequacy in their DC plans can also convert future service DC benefits to a CDC plan (alternative 2). This alternative can reduce the operational and administrative burden of maintaining multiple plans. The current DC plan could also be maintained to receive employee voluntary contributions (salary sacrifice DC plan).
Current status and future direction
About two years have passed since the introduction of the first CDC plan in Japan. Japanese companies have taken the lead so far, but earlier this month, the first CDC plan of a foreign multinational company was established, marking an important milestone in the development of CDC plans in Japan.
We are at the early stages of CDC plans in Japan, but they are undoubtedly a promising new option for both employers and employees. On the employer side, CDC plans are now getting traction from companies looking at eliminating the risks associated with their DB plans. On the employee side, we have seen unions reacting positively to CDC plans. Unions appreciate the collective nature of the plan, the possibility of a benefit increase, and the fact that employees are not left on their own making important investment decisions in an increasingly complex investment world.
With well-balanced attributes taken from the best of DB and DC plans, CDC plans are an attractive third option for companies to provide pension benefits to their employees.
Footnotes
1. In Japan, collective defined contribution plans are also called risk-sharing plans.
2. The current DC limit is JPY 55,000 per month. When a DC plan is combined with a funded DB plan, the DC limit is reduced to JPY 27,500 per month.
3. In a CDC, the plan participants support the risks. They do not support the risks individually, like in a traditional DC plan, but together as a group.
4. The US GAAP accounting treatment of Japanese CDC plans is to be clarified. There is no existing case, as companies reporting under US GAAP have yet to introduce a CDC plan in Japan.
5. When compared with DC plans.
