DC risk sharing and how to go about it
The investment losses suffered in the last two years of downturn have inspired new thinking - not least on how to improve the risk-return profile of defined contribution (DC) pension investing and how to secure cheap DC guarantees. Many of these ideas were discussed at a conference on DC risk-sharing in January hosted at The University of Exeter Business School. And they could be useful to the pension regimes of most countries, according to participants.
Several of the papers were designed to fill gaps in research and theory. But others sought to find ways of showing the value of DC pensions and how guarantees or improved risk sharing might be achieved.
Guiseppe Grande from the Bank of Italy's economic research department kicked off by suggesting that governments themselves might be able to improve take-up of DC plans if governments financed a cheaper guarantee than can be achieved through private insurance guarantees.
The idea is for governments to spend approximately 1% of GDP, which they will recoup over time, to purchase nominal GDP-growth swaps for the years when nominal GDP is not worth more than a chosen equity market. Individuals would pay anything between 0.2% and 1.33% a year for 40 years to receive a guarantee worth the return of their contributions or up to nominal GDP growth.
This might be a credible guarantee solution, delegates agreed during coffee breaks. However, when governments are seeking to encourage individual responsibility for pensions as well as tackling the fallout from the financial crisis the reality is that few would be willing to meet a huge commitment, according to other audience members.
Other ideas, however, might gain favour with pension scheme members. Xiaohong Huang, a doctoral researcher from Erasmus University in the Netherlands, presented a proposal for a new DC scheme design, which splits members of a single scheme into age-based funds and then allows them to trade certain benefits between each other.
The new scheme framework, according to research by Huang, and Ronald Mahieu, associate professor of financial econometrics at Tilburg University, would split members into separate ‘generational' funds based on their age and give them the ability to invest under specific lifecycle or target-date strategies. The scheme's design would then encourage risk-sharing among the age groups either by allowing groups to buy and sell either the surplus assets once all members die, or buy and sell some of the benefits that members might own.
What members would do is select one of three guarantee options - a nominal rate, an accrued rights rate, or a higher value real rate guarantee. The anticipated cost would be approximately 5% of an 18% contribution rate over 40 years under a real rate guarantee (at 60% cost over 40 years or 1.2% per annum above existing charges).
Moreover, it would suit the Netherlands, according to Huang, where solidarity and inter-generational risk-sharing have become a big topic, especially among the younger generation, which believes it is carrying the burden of high-cost DB plans for older generations.
The issue of cost across the generations was a significant concern. Analysis by Fieke van der Lecq, holder of the pensions markets chair at the Erasmus School of Economics, and investment staff from Cordares/APG, concluded that the cost of replicating defined benefits via a DC pension is 2.45 times more than a contribution to a DB plan. Younger generations feel they are carrying that cost at a time when they have just started to contribute to their own pension plans.
The issue of risk sharing is also especially important, further evidence from APG suggested. The ABP pension fund for Dutch civil servants is aware that only 25% of its participants will be actives after 2019 - down from 40% at present. This might explain why APG is investigating hybrids. One of the collective DC design proposals presented by Eduard Ponds, head of research for collective pensions, corporate ALM and risk policy at APG, and co-authored by colleague Roderick Molenaar, was viewed by many delegates as a fresh and potentially feasible solution to balancing DB income guarantees with DC investment strategy.
Rather than place individuals in DC plans for life, the APG solution would provide age-differentiated lifecycle investing, which is 90% DC in the early years but around 90% DB by the time the individual retires.
Such a move might solve some of the solidarity and funding debates the Netherlands is experiencing, and which other governments are watching closely. While pension funds are battling funding pressures, the wider issue is about instilling confidence in the investment plans and pensions as a whole.