EUROPE - Defined contribution (DC) pension schemes are "under-diversified" and need to adopt asset-liability management strategies to tackle inflation and longevity risks, according to EDHEC-Risk Institute.

In a new survey sponsored by AXA Investment Managers (AXA IM), EDHEC argues that companies must improve their DC product offerings "considerably" by implementing more guarantees and improving transparency, as well modifying the traditional investment strategy.

The report concluded that DC funds needed to adopt asset-liability management strategies in the manner that defined benefit (DB) funds do, since participants in DC schemes were "first and foremost" exposed to inflation and longevity risk.

"Today, DC funds are under-diversified, and they need to stop solely investing in equities and government bonds, thus observing the first principle of modern portfolio theory," EDHEC said.

"Such a diversification of asset classes should allow them to invest in illiquid assets in order to benefit from their risk premium over the long term."

According to EDHEC, DC pension schemes also need to adopt professional risk management practices.

The research company argued that, when the investment horizon, liabilities and eventual guarantees were taken into account, dynamic risk management strategies needed to be put in place.

It also stresses the role regulators can play to promote the adoption of professional management practices for pension funds and points out that the IORP Directive "facilitates" the adoption of professional financial management practices and economies of scale.

EDHEC warned that the current "lack of guarantees and transparency" could lead to a problem of trust.

"It is thus important that some guarantees are offered in DC funds and that their costs are clearly explained in order to avoid creating a biased risk/return illusion," it said.

"These changes would help to avoid future disappointment amongst employees, who would reduce their participation in such retirement systems and potentially question their perception of their overall remuneration."

Noël Amenc, director at EDHEC-Risk Institute, added: "It is clear complete reliance on sponsor guarantees for traditional DB funds makes little sense in view of the prevailing economic context and demographic trends in Europe.

"With more hybrid pension schemes in Europe, and a shift towards DC funds in the UK and the US, there is a requirement for improved governance, investment options and communication to employees."