In the final article in the current series, Nicholas Lyster and Amin Rajan argue that despite the demise of DB plans, the baby is unlikely to be thrown away with the bath water
Among OECD members, governments are striving to reduce the cost of long-term retirement benefits. Employers, too, are de-risking their balance sheets by shedding volatile liabilities related to final-salary pensions. Insurance companies are pulling out of the annuity markets as low rates decimate their balance sheets.
Risk is being personalised. Individuals are obliged to bear the brunt of four key risks in retirement planning: investment, inflation, interest rate and longevity. Everywhere, risk is being transferred from those who were unable to manage it to those who do not understand it. So, a re-engineering of DC products is a welcome step in the right direction.
Currently, total pension assets worldwide amount to around $30trn (€22trn). Of this, 43% is held by DC pension plans compared with 35% in 2000. This proportion is expected to exceed 60% by the end of the decade. That figure has been already surpassed by Australia (82%), Hong Kong (78%), South Africa (73%), Brazil (66%), Switzerland (61%) and the US (61%).
A lethal mix of market losses, ultra-low interest rates, accounting changes and longer life spans has hastened the demise of DB plans. Yet attempts are being made to salvage their best features and incorporate them into DC plans, as they accumulate the bulk of the pension assets, according to 2013 Principal Global Investors/CREATE-Research Survey*.
In this context, our survey respondents have identified six features – clarity on financial needs in retirement (cited by 56%), higher and realistic contribution rates (51%), a seamless rollover of assets from accumulation to decumulation (48%), a liability-driven approach that targets a retirement income benchmark (47%), a broad diversification that exploits risk premia (44%) and dynamic asset allocation that exploits pricing inefficiencies (37%). Behind this snapshot, two related trends are evident.
Indeed, in the face of low returns, investment approaches are becoming more diverse in the markets where DC plans are run by trustees (Australia, Brazil, Germany, Hong Kong, the Netherlands). This is driving the popularity of lifecycle investing. The main thrust of this rise is driven by target-date funds. Originating in the US, they are gaining traction across pension markets, at varying speeds and in different forms. Recent innovations seek to deploy the best features of DB plans to close the gap between the ‘to’ and ‘through’ retirement phases.
Some asset managers are making a simple change in the target-date structure to provide guaranteed monthly income throughout retirement by replacing the traditional fixed-income asset class with a pool of unallocated deferred annuities. Typically starting at 3% at the outset, the annuity income allocation grows to around 55% nearer the target date.
Some managers are extending this approach around the ambitious concept of a target income fund, with a number of distinctive features. First, it shifts the focus from asset maximisation to liability matching, with a clear income benchmark (see case study). Second, it eschews peer-hugging and focuses on the retirement outcomes expressed in terms of income, inflation protection, healthcare and bequests. Third, it shifts the attention from short-term returns to overall lifestyle planning with the mass personalisation of advice.
Under the new approach, some Australian superannuation funds are devising pathways to annuity-type solutions with greater certainty. Not achieving the retirement income goal is the key measure of risk. This approach aims to be effective for members who are completely engaged, as well as those who are not at all engaged on retirement matters.
To conclude, the personalisation of risk is not as one-sided a deal as it sounds. It will be driving innovations in the defined contribution space.
Nicholas Lyster is CEO of Principal Global Investors (Europe) and Amin Rajan is CEO of CREATE-Research
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