DC in Europe: Avoiding a sticking-plaster solution

It is not enough that DB schemes have failed for investors to switch to DC schemes - the latter have to succeed in their own right, argues Amin Rajan

By the end of 2010, the total global pension stood at around $28trn. Of this, 47% was held by defined contribution (DC) pension schemes compared with 35% in 2000. A combination of restructuring and organic factors has underpinned this headlong growth.

To start with, there has been a secular trend away from final-salary defined benefit (DB) schemes since 2000, when a savage bear market followed by accounting changes wreaked havoc on their funding levels. Since the 2008 credit crisis, the trend has accelerated, especially in the hitherto strong DB markets such as Ireland, Switzerland, the UK and the US.

DC schemes have emerged as the only alternative. Indeed, so acute are the funding pressures that the crisis has fast-forwarded what has been long predicted: a cap on the future benefit accruals to the existing members of DB schemes. The IBM's decision to close the entire DB plan and transfer the cash balances - after a generous top-up - into a DC plan is a harbinger of what's to come in this decade. Canada and Japan might buck the trend due to a concentration of plans in the public sector.

Apart from closures, many DB schemes have also been restructured into hybrids. Under these schemes, investments risks are shared equally between employees as well as employers. The Netherlands is a pioneer in this area where the DC elements are activated in the existing DB schemes once a certain level of employee income is reached.

In contrast, in countries like Denmark and France, the restructuring has involved turning DB plans into collective DC plans with an infrastructure of advice and administration to exploit scale economies, with some schemes investing only in deferred annuities.
The final form of restructuring is evident in a country like Germany where, under the Riester reforms, many traditional book-reserve schemes have been converted into DC schemes with various guarantees on contributions and returns. Such guarantees also prevail in countries like Belgium, Slovenia and Switzerland.

Alongside this restructuring, there is also organic growth resulting from the creation of new schemes (Italy and Hong Kong), the extension of the existing state schemes (Sweden and Poland), and the rebranding of traditional funds (France).

Unfortunately, a combination of ageing populations and poor investment returns has forced DB schemes into terminal decline, turning DC schemes into just a default option.
For governments, they are neither the first nor the last choice - they are the only choice. Both the first-pillar, publicly-funded pension schemes and the second-pillar, employer-sponsored mandatory schemes have proved ruinously expensive. Likewise for individuals, the rise of DC schemes owes more to the failure of the old than the success of the new. Unsurprisingly, the largest component of their growth has focused on ‘pure DC' schemes where employees make all the investment decisions and bear all the associated risks.

Emerging imperatives
How the growing assets in DC schemes will fare in this turbulent decade is anybody's guess. Unlike their DB counterparts, most DC schemes are not obliged to publish returns on their members' investments. However, anecdotal evidence shows that many of the schemes introduced in the past decade are experiencing a baptism of fire in the face of extreme volatility sparked by systemic forces far removed from DC schemes. So recent history is no guide in deciding how DC schemes will fare in the long term. But there is hope.

To their credit, scheme sponsors and their asset managers are targeting the ‘best-endeavour' outcomes, which explicitly recognise five facts of today's investment life.
First, greed and fear will never go away. Even in relatively sophisticated DC markets like Australia, the UK and the US, clients have been prone to extreme herd behaviours. Chasing fads has been common, as has buying high and selling low. Reportedly, the trustee-run plans have fared no better than self-managed plans.

Second, default options need to be a lot smarter. Their risks stem from narrow diversification and an absence of tactical tilts. The mechanical 70/30 equities/bonds allocation, so prevalent in the English-speaking world until this decade, is far too risky in the face of frequent market dislocations.

Third, over-caution carries its own risks. Inevitably, schemes that guarantee capital protection tend to invest in insurance contracts with low nominal returns normally associated with traditional savings plans. To make matters worse, the total annual contribution rates - typically below 10% - are too low to generate decent retirement pots.

Fourth, the decumulation phase is just as important as the accumulation phase. Currently the emphasis is on accumulation products that can generate a decent retirement pot. The emphasis needs to widen to permit a rollover into decumulation products that allow regular income drawdowns. Annuities remain too expensive.
Finally, fees and charges are a key source of outperformance over time, via their compounding effect. Anywhere between 20% and 35% of asset values are absorbed by intermediaries and managers. In their pursuit of value for money, investors are also questioning their ‘heads-I-win, tails-you-lose' fees structures.

In response, the best-endeavour outcomes are invoking a variety of actions.
In hybrid DC schemes, trustees are resorting to dynamic asset allocation that focuses on a broad set of asset classes with regular tilts and a value-for-money fee structure. Diversified growth funds and absolute-return funds are becoming popular.

In the protected-DC sector, trustees are encouraging members to raise their contribution rates so as to influence the eventual pot size via prudent savings as well as returns. They are also resorting to member-education programmes that raise awareness about the limitations of the scheme's investment approaches, the importance of working beyond the retirement age and the need for supplementary sources of savings to meet retirement needs.

In trustee-based collective schemes, default options are now being augmented by lifestyle investing that has favoured-target-date retirement funds. As we argued in a previous article in IPE (September 2011), such funds are set for significant improvements that offer dynamic asset allocation, a cushion against big market dislocations, defence against investor foibles, protection from the gains as they build up, and their subsequent rollover into a retirement income stream. Their embedded advice features and glide-path mechanisms are seen as major pluses in this decade of prolonged volatility caused by large-scale deleveraging in the West. Their inherent scalability is another big plus for cost-conscious investors.

Starting out in the US in the pure DC space where members take all the risks, lifestyle funds are likely to be increasingly adopted in the collective space where the existing default options are too narrowly focused on asset choices and risk profiles - where the advice infrastructure is not strong enough to counter investor foibles. Australian superannuation schemes have started considering them, as have their peers in Hong Kong and the UK. Over time, the two segments - collective and pure - may well converge.

Indeed, ever more schemes will morph in this decade in the direction of pure DC schemes, forcing substantive decisions and the associated risks on the shoulders of individual members. Advice infrastructure and advice-embedded products will be at a premium. Asset managers with cost-effective options have the potential to transform the DC landscape for the better.

Prof. Rajan is founder and CEO of CREATE-Research


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