DC - a blueprint for the future
Despite the growth of defined contribution (DC) pension plans worldwide, there is widespread unease that the DC model is not working that well.
The biggest problem is simply that DC members in vast numbers struggle with either the aptitude or the appetite to work on their DC investments and therefore opt out. DC has introduced a lot more uncertainty into their retirement planning relative to the DB model. A Watson Wyatt survey showed that 65% of DC plan members surveyed had ‘no idea' or only a ‘vague idea' of their likely income in retirement, whereas only 31% of DB plan members surveyed gave this reply.
This is of great concern, because there is naturally a public interest in seeing that all pension plans offer future generations of workers financial security in retirement. The Government is uncomfortably aware of the savings shortfall that is arising from inadequate contributions to DC plans. Inefficient investment approaches to DC are compounding the problem. If we score DC investment in efficiency terms it surely only gets a two or three out of 10. How can we fix these problems?
A key criticism of DC plans is that they leave too many decisions to the employee without sufficient guidance. It is generally up to the individual member to decide whether to enrol in the scheme or not, how much to contribute, and how to invest the money to achieve security in retirement.
Most members find the role they are cast in - as CIO of their own pension fund - fairly daunting. They are caught between the rock of adopting the default investment strategy and the hard place of too much choice. It is the same with more fundamental questions such as whether to join a plan and how much to contribute. How can we support their decision-making cost effectively for millions of individual members?
The answer, we think, lies in automation, and we turn to an unlikely source for illumination. In 1914 Lawrence Sperry invented the aircraft autopilot. What this did was automate the pilot's role in response to varied conditions. Today, more than 99% of commercial aircraft miles are piloted by computer.
Applying this concept to the DC world could support three aspects of decision making:
❑ Auto-enrolment in DC plans
❑ Auto-contribution programmes
❑ Auto-investment strategies
Auto-enrolment and auto-contribution programmes have already been successfully used by some plans to improve DC take-up, and manage members' life-time contributions to build benefits up to an appropriate target.
Auto-investment strategies are a more difficult concept to grasp and implement. But a simplistic version of this approach already exists (in fact it has been around for nearly 20 years) in the form of lifecycle strategies, which allocate assets according to the member's age. The younger the member, the greater the equity allocation, to match their higher risk tolerance. Older members' funds are automatically weighted towards bonds.
The problem is that this is a one-size fits all solution. We need to devise auto-approaches that are more flexible and dynamic, to cater for people's different risk tolerances and life circumstances - such as their savings, assets, outgoings, future earning power - as well as their age.
This sounds very challenging. But the mechanics from an investment perspective need not be too difficult. The investment needs of individuals could be met using different combinations of only two multi-asset funds: a safe assets fund and a growth fund. Into the safe assets would go the usual cash, bonds and other low risk investments. The growth fund would follow best practice in institutional portfolios, and invest in equities and a wide array of other assets - likely to include property, private equity, hedge funds, commodities and credit. The fund would be invested globally with appropriate currency management. This wide asset diversity approach is critical to success in a long-term growth fund. Far too much DC investment is currently over-concentrated in equities, particularly domestic equities.
The missing piece from this framework is how individuals would arrive at their ideal mix of ‘safe' and ‘growth' assets. This is a risk-based allocation which we know should alter with age, but should also change as life circumstances change. What is clear is that this allocation is critical to success. I would even suggest that this optimal risk exposure over time (‘just-right risk') is the single most important element in DC success. But no DC plan has yet created a flexible process for determining it. The technical challenge involved has been too great and while this is not going to happen overnight, the investment industry is surely talented enough to make it happen one day.
I think we have to make three big steps forward to achieve this goal: improved technology to capture life circumstances efficiently; more extensive research into how risk affects members' thinking; and streamlined fund design.
Ranking alongside the issue of appropriate risk exposures through the member's working lifetime is the issue of post-retirement investment. The annuity route can ruin all the good work done in building a decent pensions pot if this is then allocated to an unduly cautious bond-like investment that underlies annuities. With average longevity for many retirees exceeding 20 years, this is surely a form of ‘reckless conservatism'. New solutions that combine post-retirement lifecycle investing, with mortality pooling†, can combine to give the ideal mix. This will result in secure income streams likely to be significantly superior to the classic annuity solutions.
DC members must again be given guidance on how much risk is ‘just-right' for them. A slightly different set of life circumstances enters the decision-making framework on retirement. Again I am convinced that soft factors can be hard-wired into a desirable investment glide-path, with the growth fund content appropriately tapered. For many individuals there will come a date when purchasing an annuity is a sensible answer - but not generally until a number of years after retirement.
We believe that there is a lot of scope for employers to improve their DC plans, and for reasons that are not altruistic but make sound business sense. Companies with progressive and effective DC plan design stand to gain significant competitive edge, because of their enhanced ability to attract and retain talent.
Our suggestions, of course, represent more of a future vision than a practical DIY kit for new DC design.* But we are convinced that with some more ingenuity and advanced technology the industry will have the means to boost DC investment design to an efficiency score closer to eight or nine out of 10. This is where it needs to be for our pensions system to play its vital part in the vibrant economy of tomorrow.
†Mortality pooling aims to provide most of the benefits of an annuity, by sharing the mortality risk in a pooled fund, but without the obvious cost and is particularly attractive because of increasing longevity
* See Watson Wyatt's Achieving the Goals of DC Members - The Forward Thinking Company DC Pension Plan
Roger Urwin is global head of investment consulting at Watson Wyatt