LP Radar: Ill-defined commitments

During a lively discussion recently with a limited partner, our chat led onto an issue that I’d always considered a serious threat to private equity’s future prospects, but one that was still a way out on the horizon: the rise of defined contribution pension schemes. 

But the issue is not so distant, according to this LP. US public pensions are already undergoing what he describes as an “inevitable shift” away from a ‘defined benefit’ model, where a retiree is guaranteed a specific pension, to a ‘defined contribution’ model, where the retiree’s pension is based solely on what he or she has paid into their personal retirement account.

The move towards ‘DC’, as industry insiders typically refer to it, stems from pensions’ inabilities to meet rising liabilities. In the US, a number of city authorities have gone bankrupt in part due to liabilities related to defined benefit plans they can’t afford.

Last year, at least eight states made structural changes to their retirement plans, according to a report from Pennsylvania’s state office of the budget. Pennsylvania governor Tom Corbett has proposed closing the state’s defined benefit programme to new employees, who would participate instead in a 401k-style offering (a type of retirement savings account controlled by the retiree and typically associated with private company pensions). 

The change that’s taking place appears to be a gradual shift from a purely DB model to a hybrid structure that leaves intact the benefits promised to existing members, but puts more responsibility on future workers to fund their own retirements. That’s why this shift requires such a long horizon; it’s not going to take place overnight. But the seeds are being planted.

Rhode Island is perhaps one of the most notable cases so far. The state’s retirement system was woefully underfunded for many years until Gina Raimondo was elected state treasurer in 2010 on a platform of pension reform. Under Raimondo’s leadership, the state put into place a hybrid model that shrank the defined benefit portion while requiring employees (other than those retiring by June 2012 who saw no change in their benefits) to contribute more to their own retirements. Raimondo’s reform also tied cost-of-living adjustments to the fund’s investment performance.