Best practice for the DC payout phase
As DC pension systems grow, it is crucial to ensure scheme members get the best possible value from their savings at the payout stage, finds Gail Moss
With the continuing shift from DB to DC schemes across Europe, most of the attention has been concentrated on enabling scheme members to build up their pension savings (the accumulation phase).
But equally crucial is the payout (decumulation) phase. However well a DC scheme has performed in building up sufficient funds to retire on, it is still critical that the member makes the best possible use of that money when it is paid out on retirement.
As part of its wider objective of promoting adequate pension provision throughout the continent, in April the European Federation for Retirement Provision (EFRP) published research on the payout phase in DC schemes throughout Europe.
The most striking finding was the sheer diversity in national designs of the payout phase. In spite of this, there are still four main ways in which pension pots can be distributed over the payout phase:
• Lump sum payments, allowing members to use their capital however they wish;
• Income drawdowns (or scheduled withdrawals) under which the pension pot becomes an investment fund with restricted access to ensure a regular income stream. Pensioners remain the owners of the assets, so if they die, the remaining capital will be left for their beneficiaries;
• Temporary annuities, which provide a regular income stream for a fixed period of time during retirement. These are less flexible than income drawdowns, but provide cover against mortality risk. They normally yield a higher retirement income than income drawdowns because the pensioners forfeit the assets used to purchase the annuity if they die prematurely.
• Life annuities are the only payout method which provide protection against longevity risk. The pensioner receives a regular retirement income until death; pensioners dying prematurely pay for those who reach a relatively old age.
DC pension plans throughout Europe may provide more than one payout method within each scheme. The survey showed that just under 20% of schemes provide members with lump-sum payments. A further 26% distribute capital as a limited lump-sum payment, together with an annuity.
Nearly half (47%) of schemes commonly distribute accumulated capital solely via a temporary or life annuity. And 8% frequently distribute pension capital through an income drawdown.
Best practice for pension schemes
Choosing between the four main payout types is essentially a case of horses for courses: an individual's view on what will give the best value for the size of pension pot will depend on his or her preferred risk profile, expected lifestyle in retirement, and lesser factors, such as bequest intentions.
Whether in economic terms an individual has made the best choice, however, will depend on his or her actual lifespan (possibly also that of the spouse or dependants), on future inflation, and on issues such as how the assets would have performed if they had not been used to purchase an annuity. In the vast majority of cases, all these matters are going to be unknown at the time of retirement.
The OECD working party on private pensions tackled this question late last year, publishing a report which set out the pros and cons of the different types of payout for different situations. Stating the obvious, it says that where the member lives beyond the average life expectancy of their cohort, higher accumulated pension benefits are generally provided by life annuity products.
In particular, variable life annuities, which also offer retirees participation in investment portfolio gains throughout retirement, provide the highest overall benefits, as long as returns on equity-bond portfolios are higher than on bond-only portfolios.
However, for retirees whose overriding concerns are the risks of low investment returns throughout retirement, high inflation, or insufficient asset accumulation at retirement, the report says a more attractive arrangement would be a standard fixed or index-linked life annuity.
For retirees whose life span is no greater than the average for their cohort, variable programmed withdrawals provide higher accumulated pension payments, because they avoid paying a premium for an event (outliving their resources) which might not occur. In doing so, they get access to portfolio investment gains. And the bond-equity portfolio of variable programmed withdrawals should provide bigger returns than the implied bond-only portfolio used to finance annuity products.
As a default option, the OECD report suggests retirees can balance the probabilities of living within or beyond their cohort life expectancy by combining a programme of variable withdrawals with a deferred (inflation-indexed) life annuity bought at the time of retirement that begins paying at a later age, say 85. The report says: "This provides liquidity, flexibility, the possibility of leaving bequests, and access to investment portfolio returns in the first part of retirement, and protection from longevity risk at very old age."
"In the end, life expectancy is unknown and as a result, life annuities will always be a better product when looked at from the perspective of protecting against longevity risk," says Pablo Antolin, principal economist, Financial Affairs Division, OECD.
It is clear that no specific payout method is going to be the best solution for everyone. However, it might be possible to determine a ‘best practice' model for specific sets of circumstances and member risk profiles.
The best that DC pension schemes can be realistically expected to do is give members access to advice on the best payout method for them, and the flexibility and facilities to help them achieve this (although this will be subject to national laws).
But superimposed on the basic issues of life expectancy and risk are other factors. For example, the disparity in state pension provision between different European countries means that private arrangements assume varying levels of importance throughout the continent.
Pensions organised by the state are relatively high in France, for instance, while pension savings through occupational schemes are often made on a voluntary basis and typically only for a small number of (highly compensated) individuals. This means that French retirees might have little to lose by opting for a programmed withdrawal or lump-sum payout, rather than an annuity.
In contrast, the UK state pension is more modest, so that retirees get the bulk of their income from company schemes or individual initiative.
However, Alfred Gohdes, head of actuarial consulting, Towers Watson in Germany, believes it might be better for a person with a small amount of retirement savings to opt for an annuity. "He might get 10% or so less than from a programmed withdrawal but it is a less complex product and will typically be a safe haven for the rest of his life."
Converting small capital values into any income stream will often be accompanied by proportionately high administrative costs, eroding the member's retirement income. According to the EFRP study, almost three-quarters of European pension schemes are covered by trivial commutation rules, which allow the distribution of all the accumulated pension capital as a lump-sum payment.
In some countries, trivial commutation may be allowed on the initiative of the pension provider, while in other countries it is only allowed at the request of the plan member. Clearly, best practice would be served by universal flexibility, with providers able to offer trivial commutation to all members, on demand from the member if necessary.
Where pension savings remain invested under a programmed withdrawal scheme, pension or investment funds should, wherever possible, offer flexibility of investment choices to match the member's risk profile. They should also offer sensible defaults - for instance, a lifestyling option to reduce risk as the retiree gets older. In some countries, for instance France, this is now mandatory. However, national legislation will vary regarding how much flexibility is permitted.
Probably the most important aspect of best practice in the DC payout phase is educating scheme members on their choices. Schemes should offer one-to-one advice and generic information on investment options, data on specific funds, and so on, which can be provided by call centres or websites.
It is crucial for schemes not only to help members decide on the best payout route, but also to inform them of their legal right to choice.
For example, retirees in the UK who are purchasing an annuity can shop around for the best rate (the open market option). Yet many scheme members still buy the annuity from their pension provider, which might not give them the best rate.
A good DC scheme should also tell members about options such as income drawdown and temporary annuities, which they can use until they are ready to buy a life annuity. It should highlight the difference between level annuities and those with profit-sharing, indexation and investment-linking. And it should point out that annuity rates improve for members purchasing them at a later age.
Scheme websites should also include information on the future replacement rate at retirement, employer contributions and investment options.
"Although more work needs to be done on education, websites for French DC schemes have improved a lot," says Laure Delahousse, director, retirement savings schemes, French Association of Investment Funds and Companies (AFG). Besides information on the options available, she points out that these websites already include a calculator that members can use to work out how much they need to save, or in what type of assets they need to invest, in order to own €X-worth of capital by age Y.
Website should be easy to use, and well advertised. Whatever the means of communication, however, information should be correct, understandable and durable. It should also address the needs of the less financially literate.
Best practice for the industry
There are some aspects of the payout process where best practice is more likely to be achieved if put into place by the industry as a whole, rather than individual pension schemes. The purchase of an annuity is an obvious candidate for this.
According to the EFRP survey, at least part of the accumulated capital must be converted into a lifetime annuity for almost half of DC schemes. However, the purchase of the lifetime annuity may be delayed in 35% of these plans by buying a temporary annuity or using a scheduled withdrawal during the intervening period.
But the survey notes that there is still no homogenous EU-wide annuity market. The way the annuity market functions differs markedly between countries. Survey respondents from larger European countries are typically positive, and those from mostly smaller countries more negative.
In the UK, Denmark, Germany, France, Austria and Italy, it is felt that the market contains many providers offering a wide range of products at fair costs. In Belgium, Ireland, Portugal, Poland and Croatia, respondents complain that annuity markets are small, with a limited number of providers and little product variation.
However, even in the better-functioning markets, there is room for improvement. "There is an argument for saying that annuity rates could be better advertised, for example on comparison websites," says Sandeep Maudgil, partner, Slaughter and May. "So a retiree could see, for example, the five best rates which might be achievable for his age even if... this is just to provide a starting benchmark for what could be out there."
Best practice for governments
The European Commission's green paper on pensions published last summer sought views on whether, and how, the EU-level pension framework should be adjusted to enable member states to achieve adequate and sustainable pensions for EU citizens. This, together with the EC's recent Call for Advice on the revision of the IORP directive, suggests that moves are afoot for further EU regulation of the payout phase of pension plans.
But the consensus seems to be that a ‘one-size-fits-all' framework would be unworkable. "You cannot impose a one-size-fits-all DC scheme throughout Europe, because each country is different," says Delahousse. "Some countries have stronger state pension schemes than others, some have mandatory private pension schemes, and some have schemes run on a voluntary basis. You cannot impose the same rules on all countries."
"Given the variations between the role of private or company provision in different member states, and also the fact that in reality this is going to be a decision which individuals need to make for themselves, it is difficult to see regulation at the EU level regarding a ‘best practice' standard for DC payouts as the right way to go," says Maudgil. "More generally, it's hard to see the value of new laws which would probably be so prescriptive that they would just end up as a box-ticking exercise. We've had legislation on the open market option in the UK for some time, but still a remarkably limited take-up. What we need is some form of cultural wake-up call rather than new laws."
"Certainly, in the euro-zone, innovation and competition, rather than regulation, should win the day," says Gohdes. But he does consider ways in which a minimum amount of capital conversion into an annuity could either be state-organised or regulated, to provide a low-cost safe haven for all EU citizens who have DC funds when they retire.
Furthermore, it would obviously be beneficial to increase flexibility for stakeholders during the payout phase: at present, 17% of DC schemes give little choice for employers, social partners and plan members to determine the way pension capital is distributed, according to the EFRP survey.
The EFRP's DC Decumulation Phase Survey can be dowloaded from www.efrp.org.