The combination of ultra-low interest rates and high longevity is putting a major strain on retirement systems across the globe. A recent report by the World Economic Forum predicts that the global gap between retirement savings and retirement needs will reach $400trn by 2050.
Even traditionally resilient pension systems are feeling the squeeze. Take the case of the Netherlands, whose system has long been recognised as one of the world’s best. Most Dutch pension plans invest the majority of assets in low-risk bonds which have allowed the plans to maintain stable funding ratios. The problem – in an era of ultra-low interest rates – is that these bonds now have a negative yield, meaning that plans can no longer leverage the power of compound interest and deliver adequate benefits without significantly raising the level of contributions from plan members. This problem has become so severe that it is causing the Dutch and other systems like it to reform entirely, marking a new era of pension system design.
One such reform is the launch of collective defined contribution (CDC) plans. CDCs are hybrid plans where members bear the risks of their investments (as in defined-contribution or DC plans) and pension assets are collectively managed by a professional team (as in defined benefit or DB plans). CDCs also feature a solidarity reserve that enables plan members to share risks: in good times, individuals pitch in a portion of the gains from their investments to the reserve and, in return, they get to draw from the reserve in bad times.
In theory, the hybrid nature of CDCs could help resolve a number of limitations in existing pension plan models.
One problem for DB plans is that the guaranteed nature of pension benefits limits the amount of risk that these plans can take in order to earn higher returns. Moreover, guaranteed benefits impose a disproportionate burden on employers and young active workers, who must increase contributions to close the funding gap. In the Netherlands, DB contributions now amount to approximately 30% of the salary of the active worker. By comparison, contribution rates of DC plan members in the US are typically under 10% of salary.
In contrast, DC plan members have the ability to earn higher returns through greater risk-taking and are only responsible for their own savings shortfall. However, DC plan members generally do not have the same level of discipline and financial sophistication as professional asset managers and therefore tend to under-save and invest inefficiently. What is more, because DC plan members are on their own, they run a significant risk of outliving their savings.
By combining features of DB and DC plans, the proposed Dutch CDCs have the potential to invest assets efficiently and provide adequate and equitable risk-sharing across generations.
In practice, designing the right CDC plan is a complex challenge. How much risk should CDCs take in their portfolio? How much risk should plan members share with each other via the solidarity reserve? How much should plan members contribute to their plan each year? The complexity lies in the fact that all these questions are interrelated. For example, a safe asset mix that yields low returns will require greater contributions from plan members. By contrast, higher returns may require a riskier asset mix but may also be sustained by lower contributions.
Designing the right CDC requires a holistic and integrated approach that clearly acknowledges the concerns of every stakeholder. The transition from DB and DC plans to the new CDC structure is politically sensitive because it brings together mature and young members with different concerns and goals. It is critical that all members accept the transition to CDCs and fully understand how they can benefit from it in the long run. In other words, the real challenge is to design CDC plans that are not only technically innovative but also acceptable to thousands of individuals who aren’t financial experts.
As pension systems grapple with these same questions, I have encouraged our next generation of fund managers to think about optimal CDC design as part of the McGill International Portfolio Challenge. In the autumn of 2021, we asked 114 university student teams from 26 countries to design an optimal €30bn CDC plan that would integrate six DB plans from the Dutch construction industry. More than 50 experts from the world’s largest asset managers reviewed the proposals, which identified innovative considerations that would benefit the design of the Dutch CDC model. Here are four takeaways from Copenhagen Business School’s winning proposal that combines plan efficiency with an equitable stakeholder approach:
• Keep a high contribution rate and a safe asset mix in the short term to smooth generational concerns: mature members, who have worked long to secure DB benefits, may be the most reluctant to enter the CDCs because the plans have no initial reserve and they have the most to lose. In light of these concerns, CDCs should keep a high contribution rate and a high allocation in safe bonds for the immediate term. The transition phase should instead focus on building strong rapport and trust with all plan members, setting up clear risk-sharing rules, and establishing a stable governance system that will boost internal value creation.
• Phase the approach to enable more risk-taking in the long term: once CDCs start to accumulate a solidarity reserve and existing DB guarantees are phased out, CDC managers should take on more risks and earn higher returns. The level of risk-taking could even exceed that of standard DC plans, since the solidarity reserve will act as a buffer in the event the portfolio incurs a loss.
• Focus on alternative assets to drive yields: as CDCs take on more risks, they should leverage their large asset size and invest more in private infrastructure and real estate. By generating payouts that exceed those of government bonds and are relatively stable and linked to inflation, these investments combine benefits of stocks and bonds for long-term investors.
• Transition fund management to active, in-house managers: drawing on the success of large Canadian funds, CDCs should progressively increase the proportion of their assets managed in-house. A high proportion of assets managed internally will lead to greater cost efficiency, better risk management, greater value creation, and a more integrated ESG strategy.
What we’re looking for is a CDC model that takes the best elements of DB and DC plans, in what would be the Goldilocks solution that combines the right amounts of risk-taking and risk-sharing needed to make our retirement systems resilient.
Sebastien Betermier is associate professor of finance at the Desautels Faculty of Management at McGill University in Canada