Defined contribution: strike or spare?
Defined contribution schemes are by and large associated with either the US or the UK. In these markets, defined contribution schemes have become the dominant form of pension arrangements. The ongoing debate remains whether these schemes are attractive enough to be implemented in a country such as the Netherlands where fully funded defined benefit systems are the norm. As defined benefit schemes entail collective solidarity, any discussion about adjustments in the pension structure towards defined contribution is potentially at risk. However, even in the Netherlands the question seems to be how defined contribution schemes will be implemented rather than if they will be implemented.
In short, defined contribution will play a more prominent role in the future. Labor relations are stricter in comparison with the US and the UK. Therefore, a more structural discussion will have to take place on how defined contribution best fits in the existing defined benefit pension agreement instead of just throwing the defined benefit concept overboard.
Public data provided by the local regulator, PVK, shows that defined contribution is already partly established in the Netherlands. Chart 1 shows the percentage of the total pension assets that are invested in defined contribution schemes: around EUR 39 bln in 2004. The chart illustrates that the use of hybrid schemes is slowly increasing whilst the use of pure defined contribution pension arrangements is stable. One would expect the use of defined contribution schemes to be higher for corporate pension funds when compared to the overall market. Indeed, chart 2 shows a rising growth rate in pure defined contribution schemes of corporate pension funds when compared to the overall market.
The current development of defined contribution makes it necessary to re-evaluate what is available, the implementation framework, and the considerations involved. In other words, can defined contribution be seen as an opportunity rather than a threat to the Dutch pension system?
The relevance of defined contribution schemes must be seen in relation to broad trends in society amongst which the costs of ageing and the increased interest in individual responsibility. The cost of ageing in relation to pensions has two interconnected elements. First, the viability of the basic pension provision, or AOW, is an issue of state finances in the longer term. Being a “pay as you go” arrangement this provision can have a huge impact on the costs to be covered by future generations being faced with ageing. However, all second pillar defined benefit schemes are taking this AOW provision explicitly into account in their pension calculations thus making adjustments painful and difficult. Second, ageing slowly but surely impacts defined benefit schemes in turn. It is expected that the average lifetime of people will continue to grow over the coming years creating a bigger mismatch between premiums paid and actual pension payments received by participants. At the same time, the use of premiums paid by active pension participants to smooth asset volatility comes under pressure. More and more of the assets reflect inactive participants (either pensioners or sleepers) that no longer pay premium but still have a fixed entitlement. This reduces the ability for pension funds as a whole to steer through unforeseen circumstances.
In terms of individual responsibilities for pension participants it is striking that pension arrangements are the most underrated labor agreement. Although there are no reliable figures available, anecdotal evidence strongly suggests that most employees have no idea what their pension promise exactly entails. Some firms even start to wonder if a good pension arrangement is a competitive edge of any kind: potential employees rarely seem to pick an employer based on its pension arrangement. It is a secondary consideration at best. Given the premium and management costs involved, the size of the assets involved, and the increasing importance to society and individuals, it seems that retirement provisions need to be re-evaluated substantially by pension fund participants.
In the case of defined contribution, a few critical arguments can be raised to evaluate its usefulness when compared to defined benefit schemes. To be realistic, defined contribution is just another way of building up retirement provisions. No more, no less. The arguments raised in favor or against come in a variety of categories. A couple seems to stand out in this regard.
q What’s positive about defined contribution schemes?
First of all, defined contribution schemes make pension arrangements very real for individual participants. When people are faced with financial choices that directly influence their future income, awareness about their importance is more or less forced upon them. Under defined benefit schemes there is a stronger inclination to have a “do not bother” attitude as all participants are subject to the same investment policy that cannot be influenced. A defined contribution scheme provides participants with freedom of choice in this regard.
Secondly, it is often a surprise that defined contribution schemes seem to come at a premium. As risk and responsibility are transferred to the individual participants it is only fair that the net premium received when compared to a defined benefit scheme is higher. Most of this higher premium reflects the additional effort and risk an individual has to accept in order to safeguard future income.
Thirdly, a positive side effect is created by the major simplification (and thus cost reduction) in terms of administration. Administering various, often complex defined benefit schemes that change over time is not an easy task. In fact, it is often referred to as one of the major bottlenecks facing pension funds today. As a defined contribution scheme consists of individual investment accounts for participants, better communication is made possible in terms of lower costs involved and higher speed or frequency of information.
q What’s negative about defined contribution schemes?
A major issue is the notion whether the average participant is able to make the relevant investment decisions necessary on a cost efficient basis. Even when plenty of advice is given and there are just a few basic investment rules to obey, it is probably not a matter of whether participants are capable of making the relevant decisions but whether they bother to do so. The answer is: probably not. Making individuals completely responsible for their pension investments could therefore be dangerous and irresponsible.
Secondly, a great disadvantage individuals have in general is the problematic access to reliable information, the often higher fees involved, and the smaller opportunities to benefit from more risky, less liquid asset classes for diversification purposes. In short, their smaller critical mass makes them more vulnerable for bad advice or mismanagement due to inefficiencies in the market.
Thirdly, solidarity is a major component in current pension fund arrangements. Despite the broad individualization trend a decent pension should be attainable for all employees at a reasonable premium. In individual defined contribution schemes there is no solidarity.
Defined contribution: strike or spare?
So now what? A central issue seems how we can use the positive elements of defined contribution whilst avoiding the negatives. A lot of developments in the pension industry show that strong incentives are under way to reconcile the features of defined contribution with existing arrangements. Chart 3 gives an indication of the available extremes: hybrid solutions of any kind fill the wide gap between a complete defined benefit and a pure defined contribution system.
Filling this gap gives rise to a new breed of hybrid schemes of which a few seem very promising. The viability of each scheme obviously depends on the characteristics of each pension arrangement.
q Top-up defined contribution schemes
The major hybrid form of defined contribution is the top-up arrangement (“bovenbouwregeling”). In here the basic pension provision provided by AOW and defined benefit is supplemented by a defined contribution scheme to complete the arrangement. A key consideration is at which salary level a cut off is created between the defined benefit and defined contribution schemes. Setting a too low salary level results in more disadvantages of defined contribution schemes than advantages and vice versa. Another way of doing this could be to use the employee premium paid for the defined contribution build-up whilst using the employer premium paid for the defined benefit build-up (in effect a premium split up). Practice has shown that a completely voluntary defined contribution arrangement does not lead to great participation by individuals for reasons already mentioned.
q Guaranteed return defined contribution schemes
In order to reduce the investment risk in a defined contribution arrangement for participants, a minimum return guarantee can be provided, either with or without upside return potential. Such a guarantee can be given by the corporate itself or by a third party in order to reduce the liability for the corporate. Pension participants will have more certainty regarding a minimum or absolute level of return each year.
q Pooled defined contribution schemes
A pooled defined contribution scheme is closely related to an individual defined contribution scheme. In a pooled structure participants have individual accounts in which the pension premium is paid, but the total assets of all accounts are managed collectively by the pension fund or by an asset manager. In this case the solidarity of sharing investment risk remains, cost efficiencies in managing a larger pool of assets can be realised, and participants have no need to make potentially difficult investment decisions themselves.
Apart from implementing hybrid schemes other defined contribution elements are worth considering within the existing defined benefit schemes. A few examples:
q Defined benefit risk sharing between employer and employee
Under current defined benefit schemes corporate sponsors unilaterally run the pension risks. The introduction of the defined contribution elements enables the achievement of a certain balance between risks born by corporate sponsors and pension participants. The judgement of such a balance differs for each pension fund but it will certainly help in improving pension awareness. In a sense, corporates are as ill placed as individuals for taking on these risks given their core business is something completely different.
Due to its nature a defined contribution scheme can provide superior communication tools for participants. It is possible to get overviews of the most recent pension build up and status of investments frequently. With the current defined benefit system, communication is often a year or so behind making personal financial planning more difficult whilst also decreasing the relevance of the information provided. Pension planning can thus potentially become a more natural part of individual planning.
q Life cycle stage investments
Defined contribution has speeded up the thinking around life cycle stage investments. In short, if participants cannot decide for whatever reason on how to invest, then why not facilitate this by creating investment opportunities in line with their current life cycle stage. These stages could be set up such that younger participants invest in more aggressive structures (thus more equity or alternative assets) than older participants (thus more fixed income). Such structures can be grouped by participants’ age e.g. age 20-30, age 30-40, etc.
q Accounting treatment defined contribution
Incorporating defined contribution elements in a pension fund arrangement is helpful for those listed companies that are facing major accounting effects resulting from IAS 19. Under this accounting method the net funding position becomes an on-balance sheet item. This has a real impact on corporate figures. The unwanted volatility that might result from this can partially be countered by implementing defined contribution arrangements that create no liability and are thus not reported on the balance sheet.
The overall outlook in the Dutch pension market seems to support the continued development of hybrid schemes going forward (tailored combinations of defined benefit and defined contribution). In this way, defined contribution can be turned into an opportunity rather than being a threat to the current offering.
Slowly but surely defined contribution is making its way into existing pension plans. Looking at the options defined contribution schemes make available, it seems to result in a better balanced pension arrangement when its elements are thoughtfully implemented. ABN AMRO expects the development of hybrid defined benefit schemes to be one of the major drivers for Dutch pension funds. This development seems to fit closely with the drive to make pensions more cost efficient in terms of premium paid, administration, a better-recognized labor arrangement, and improved communication with participants.
ABN AMRO, supported by a cross product Dutch pension team and a superior open architecture product offering, is able to assist pension funds by putting forward viable solutions.
For information please contact:
Dutch Pension Team