Jorrit de Jong, Joeri Potter and Alwin Oerlemans argue that a collective approach can improve the outcome of DC pension plans for both employers and employees

Pension plan sponsors are increasingly transferring the risk of their pension plans to participants. IFRS accounting rules and a fair-value approach for pension obligations have made employers aware of the open-ended risks in defined benefit (DB) plans. In the UK this has contributed to the closure of many DB plans and a shift to defined contribution (DC) provision. In the Netherlands, DB provision has held steady but the pension ‘deal' has been redefined so that active and non-active participants share risks that were previously borne by the employers.

These trends have contributed to greater sustainability of pension provision but they have also made this provision less secure for participants. The replacement of DB pension schemes with traditional DC pension solutions turns out to be particularly risky for the participants. Current DC solutions contain several serious flaws:

contributions are usually low; participation levels in voluntary schemes are low; many participants lack the knowledge to invest for the long term; costs and returns are disappointing; and the payout phase is neglected.

Better solutions are needed. In 2007, employers in the Dutch flower and plant wholesale sector decided to introduce a pension scheme in a sector that employs 15,000. The employers favoured a DC type of solution, while the employees wanted a DB-type outcome. A solution was developed that addresses the pitfalls of DC and used the strength of the collective pension plan to decrease the risks inherent in individual accounts.

Collective strength to improve DC

Cordares, the Dutch pension provider developed a fiduciary solution in co-operation with Cardano, in which collective asset management was the starting point. The pension plan also provides disability and survivor pension insurance. Providing a single pension plan and a collective investment strategy for all workers in the sector already represented quite some progress. Participants were able to benefit from the expertise of professional investors, while costs could be kept lower than in traditional DC solutions.

A novel aspect of this particular plan is that the pension fund aims to grant a return for all participating members that is at least equal to actual European price inflation. In addition, participants can also benefit from an excess return resulting from investing in a diversified portfolio of risky assets.

Providing returns above inflation on average might not seem like a huge challenge. One way of doing so would be to create a sort of balancing fund and employ the concept of smoothing. In other words, a proportion of the profits earned during good years would be held back with the aim of ensuring that a return equal to inflation is paid during years of poor performance. Extensive modelling could help in deciding on the proper level of contributions. However, this solution would still bear the risk that the fund would run empty at some point in time, necessitating enhanced contributions.

A novel approach

A different approach was therefore developed whereby each contribution is split in two. The first, strictly individual segment aims to achieve a return equal to inflation and is be referred to here as the ‘secure' segment. It earns interest over the remaining investment horizon and is calculated so that it will eventually provide capital that equals the contributions plus inflation. For that purpose, derivatives are needed (nominal and inflation-linked swaps) that an individual retail investor cannot access - hence the need to manage even the individual segment collectively.

Obviously, the relative size of the secure part depends on the investment horizon and the level of real interest rates. When the real yield is high, the secure part will be relatively small and more money will be available for investment in the  ‘risk' segment. The same holds when the investment horizon is long. In fact, this latter characteristic is similar to lifecycle schemes in which the investments shift from equity to fixed income and cash as the retirement date approaches.

This risk segment is managed collectively and invested in a diversified, risk-seeking pool and it contributes significantly to the final pension. The goal is to create an excess return over realised inflation and without it only a limited pension would be secured.

There are several possibilities for enhancing the median return of the total portfolio. One way is to use a combination of options - an option collar - that exchanges high upside returns to cover for low returns.

A second, quite effective possibility that does not require the trading of options is to rebalance between the risky and the secure portfolio whenever the risky part makes up for more than, say, 60% of the total portfolio. Note that money can only go one way, from the risk segment to the secure segment. Money cannot be taken from the secure segment, as that would jeopardise the objective to pay back at least the contributions plus realised inflation.

The advantage for the individual participant is that the system is quite clear. Given the contributions paid in the past, and realised inflation, it is possible to calculate the current minimum value. Furthermore, the participant benefits from the collective risk portfolio. At retirement, the pension plan can help the participant to transfer the total capital into an annuity.

Traditional and collective DC

To illustrate the differences be-tween traditional and collective DC, we simulated the development of pension capital in both systems, with a simulation horizon of 30 years. We paid special attention to the probability that the capital at retirement might be less than the capital that would have been realised if the return equalled annual inflation. For the traditional DC scheme, we assumed the same amount is invested every year and the contribution is invested equally in equity and fixed income - a mix typical for the strategic allocation of many pension funds.

The simulation results for traditional DC show that returns deviate quite strongly, with extremes at 1% and 17%, with the vast majority of the returns between 3% and 8%. The simulation also shows that the outcome is often much less positive than people would believe in advance. In 8.4% of the cases, the return is even less than inflation, with the average shortfall in those cases no less than 14.6% of the indexed contribution.

The second strategy is based on the concept of making a split between secure and risky assets. The secure assets are invested in cash, interest rate swaps and inflation-linked swaps. The risky assets are mostly invested in equity, so that the total portfolio resembles the one implemented for the Dutch flower and plant wholesale pension fund. The portfolio is automatically rebalanced: as soon as the value of the risky pool is worth more than 60% of the total, the surplus is transferred and treated as an additional contribution into the secure part.

The simulation results show an internal rate of return above realised inflation in all scenarios. In the bad scenarios, the results have improved strongly, with the 5% percentile of results jumping from an average annual return of 1.6% to 2.7%. The downside of the choice for more safety - for example, rebalancing - becomes visible when the economy prospers. The good scenarios do less well and in certain extreme scenarios, several percentage points of return are lost.

More important than those extremely good results - although it might be said that annual returns above 10% will never constitute a problem - is the effect they have on the average result. The average annual return of all scenarios drops only slightly, from 5.2% to 5.1%, so the new approach improves the extremely bad scenarios, while making the entire result distribution more compact.

A new road for DC

The solution presented in this article offers a new perspective for DC. By creating a new type of ‘collective DC', current and new DC plans can be improved considerably.

Individual participants are generally not equipped to manage their own pension investments wisely. New plans can take away the burden and responsibility from the individual client and propose a safer, better arrangement, using the tools that only large pension funds currently have at their disposal.

Existing DC plans can benefit as well, and strategies can be developed for improving existing DC plans. Furthermore, the proposed approach can be extended to the payout phase by securing a sound annuity for the years after retirement, rather than a capital on the retirement date.

This approach to DC redesign shows that collective thinking really can improve the outcomes of individual plans.

Jorrit de Jong and Joeri Potters are consultants at Cardano and Alwin Oerlemans is deputy director for sales and strategic innovation at Cordares