The challenges and problems of defined contribution (DC) schemes were among the points discussed at the Global Forum on Private Pensions organised by the OECD in conjunction with the International Organisation of Pension Supervisors (IOPS) at a conference in Istanbul.
“The herd trend from traditional defined benefit (DB) to pure DC will not continue at the speed it has up to now because the risks of DC are understood better,” OECD consultant Colin Pugh said. “DC is not wrong but inevitably some of the negative aspects of DC are beginning to show like inadequate contributions and complete transfer of all risks to the plan participants. There is also some evidence that a well-managed DB scheme generates significantly higher investment returns than a DC scheme.”
Pugh sees the reasons for this out-performance in various factors such as the use of complex modelling techniques by trustees to determine their investment strategy, carefully calculated risk taking by trustees and as a result of a longer-term strategy the fact that they rarely are required to liquidate assets in a down market unlike some individuals approaching retirement.
“Given almost complete freedom of investment choices, many decades of experience under DC plans show that individuals simply make poor, and generally overly conservative investment decisions. They do not even make ‘efficient’ investment allocation decisions, meaning the best asset mix for the degree of risk they are prepared to assume,” he explained.
This comment is backed by OECD figures presented at the conference. “Where there is a personal account system already in place it can be seen that 70-80% choose default option,” said Fiona Stewart, administrator at the OECD. “Those who do choose do not necessarily do so wisely as they are not considering costs.” As solutions she proposed the limiting and structuring of the number of choices, the careful choice of a default option and the provision of financial education.
However, Bernard Delbecque, head of Economies and Research at EFAMA, was sure that “in the medium term with more financial awareness and education it will be easier for people to make the right choices between investment options. In the short term there should be a default option”.
Promoting the European Personal Pensions Account (EPPA) idea developed by EFAMA, he said: “Individual accounts are an interesting concept in DC schemes because of flexibility and portability. They also help to increase transparency with regard to costs. Some see them as too individualistic and too far removed from the state’s social security provision promise. In reality, individual accounts can be offered on a collective basis in the second pillar, with or without protecting solutions.”
EFAMA will revise its ideas on the EPPA next year after the results on two independent studies have been evaluated. One will be on the perceived risks of DC and individual accounts; the other on the solutions that can be offered by asset managers for the payout-phase.
In her outline of challenges concerning individual accounts Stewart also mentioned various advantages of this system like transparency, actuarial fairness, portability/flexibility or individual choice. On the other hand, she pointed out major concerns in regard to the governance in DC schemes. Questions raised were: Who monitors the provider’s on-going service quality? Who ensures an optimal range of investment choices? Who ensures external fiduciaries are fulfilling their duty to guard against a conflict of interests?
Stewart pointed out that governance was important as it “may improve the performance of the fund and create trust amongst stakeholders - a vital element for an efficiently functioning pension system”.
Her DC governance solutions included ensuring a transparent process for the appointment of external trustees with employee and beneficiary approval, clarifying the plan sponsor’s on-going fiduciary responsibility for oversight of external trustees, and establishing a body to undertake this role such as the pension commission in Spain and Portugal.
As Aerdt Houben, chairman of the IOPS technical committee and head of supervision strategy at De Nederlandsche bank, pointed out many of these problems do not occur under a DB scheme: “The advantages of DB systems are globally underrated. Under a DB scheme beneficiaries generally have lower costs, higher returns and less uncertainty. They are also better protected from making wrong decisions. Furthermore, the problem of time inconsistency where people save too little, too late does not occur. And it means that people do not have to learn about things they often do not really want to learn about.”
He went on to stress that “the change to DC is happening too abruptly. Hybrid solutions that preserve core advantages of DB schemes and that need a lot of thinking and discussion, are often overlooked.”
However, Pugh said he was worried about trends towards DC schemes with a minimum interest guarantee. “When the minimum guarantee is imposed by the regulator, e.g. 3% p.a. what the employee gets is the better of a DC and a cash balance plan. For the employer it is a lose/lose situation because if the actual investment return is less than 3% annually, he has to contribute more. And, if the actual investment return is higher than 3%, the entire excess is credited to the employee.”