An industrial revolution

There used to be a stark divide in pensions, particularly in the UK and the US, with a high level of security in defined benefit (DB) and a low level in defined contribution (DC), where the risk shifts to the member. 

However, in future we are much more likely to see hybrid systems or individual DC plan design that is better tailored to the needs of the end-user. In any case, there is likely to be much more individualisation. For instance, most participants in the debate on Dutch pension reforms see the need for retirement accounts with individual account balances within a collective risk-sharing framework.

But greater innovation is needed to improve plan design and there needs to be a stronger focus on retirement income. In the UK there is still no market for deferred annuities, although there are slow moves towards income drawdown products for the mass market in the light of the 2014 pension freedoms. 

In a recent paper for the Journal of Investment Management, Prof Lionel Martellini of EDHEC Business School and director of the EDHEC-Risk Institute points to the high levels of innovation in institutional investment, like liability-driven and risk-factor investing, and in the retail segment with such developments as exchange-traded funds. This has not been matched by innovation in mass-market areas like defined contribution investing.

Speaking at a recent conference, Martellini echoed the views of Prof Robert Merton, who sees the need for a strong focus on target income in retirement and away from a pure focus on account balances. An individual may not appreciate that an increase in account balance may not be associated with an increase in future annuity purchasing power if interest rates fall at the same time. 

So there is a need for DC pension design – for instance, one that is certain to provide an individual with a minimum income floor but with a greater probability of achieving a higher target income that is dependent on personal circumstances.

Martellini predicts an industrial revolution of mass customisation in the next 5-10 years, in which financial engineering is put to play in areas like DC pensions, just as innovation has revolutionised DB pensions over the last decade or so as managers have focused on liability-driven investment strategies.

In any case, Martellini argues that investment managers must harness the engineering resources needed to design the necessary portfolios. Second, they need to create reporting tools and platforms to help them understand what the individual is trying to achieve. To this, he might add the precondition that contribution rates should be sufficiently high to create a meaningful incentive for the firms involved. 

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