Looking for the third way
Plan sponsors are under pressure to innovate the pension plan offered to their employees. Currently, defined benefit (DB) plans are under pressure because of regulatory changes and increased awareness of the cost of pensions in a low interest rate environment. Also, plan sponsors are looking for ways to offer more tailor-made solutions to their employees. As a result, defined contribution (DC) arrangements receive quite some attention. However, current DC offerings lack important features in order to provide a real(istic) alternative. Participants in countries such as US, UK and Sweden have experienced this to their disappointment.
DC requires a lot of professional investment management and financial planning skills typically not available with the average participant. It is like giving the keys of your car to your 11-year-old son, who is unaware of the risks of taking the driver’s seat until an accident happens. Similarly, participants in current DC plans may end up with poor pension benefits.
Defined risk (DR) is introduced as a further option. It provides the participant with a total picture of easy to understand basic elements of a pension deal. DR not only makes explicit what the costs of guarantees are, but makes also clear who bears what risks.
In 2004 a Dutch consumer organization found that less than one out of six participants of DB plans knew what their future pension income would be. The reasons cited for this ignorance was the complexity of the pension deal as well as the inadequacy of the communication by the pension fund. Furthermore, a general lack of interest by participants could be explained by a false sense of comfort that their pension income would be well taken care of by the employer.
A Dutch Central Bank study in 2003 also shows the lack of awareness of the general public on pension issues. That survey reveals that nearly half of the respondents are not aware of the type of pension plan they have, whether the benefit is dependent on investment yields or whether pension rights are indexed. Nearly two-thirds has no idea about accrued benefits or future benefit levels.
The observations are especially worrying against the background of a ‘watering down’ of DB pension rights with adjustments from final to average-pay, the conditionality of indexation of benefits, and the increasing number of supplementary DC arrangements. The reasons for this change are obvious – increasing awareness of the cost of pensions and risks related to pension assets and liabilities following the introduction of market value accounting at the plan sponsor level as well as (in the Netherlands) on a pension fund level. These introduce an increased measure of volatility of the pension coverage ratio and reported financial statements. Volatility is something stakeholders want to avoid.
When looking for ways to formulate an alternative supplementary pension arrangement, one can look at a way to combine the strengths of DB with DC, while aiming to take away the weaknesses.
Strengths of the design of a DB scheme include the comprehensiveness as an offering (future benefit) with several insurance elements like mortality, disability and longevity. DB plans allow for solidarity within and between generations. Also, DB as a pension deal is defined in a user friendly way. It is promising a future pension income, instead of agreeing on a saving amount which the participant needs to translate into risks and future income. Furthermore, DB plans are run at low administrative cost. The weaknesses of DB plans include complexity in detail and huge variety in type of benefit offered, the hidden cost element (perception of a premium-free pension), lack of communication to participants – and their lack of awareness. Also, some DB funds have to take measures to solve underfunding.
On the other hand, DC plans are attractive for employers, because they allow them to place the risks of the pension plan fully with the participants and there are hence no liabilities arising from covering future pension payments. It is also simpler to formulate and to operate. For the participant it is not clear how the employer’s pension contribution will translate into a future pension benefit. Most participants are not able to make the right decisions in order to end up with a decent pension benefit. They are not aware of the level of contributions to a DC plan that is needed in order to provide an expected future benefit. These factors probably explain the low participation in voluntary supplemental DC schemes. For participants, a plus of DC might be that they can see what capital they have saved. In recent years, DC plan offerings have increased in number and choice with regard to investment options, but the basic structure with aforementioned shortcomings has not changed.
Our objective is to find a better solution where interests between the employer, employee, pension fund as well as the regulator are aligned as much as possible. Interests shared by employer and employee include clarity about guarantees and expectations, cost efficiency, simplicity, flexibility and ‘what you see is what you get’.
In aligning interests between pension fund and regulator, the clear identification and control of risks are obvious as determining the premiums paid in relation to the pension promise made.
In the DR approach we distinguish between the saving phase and the payout phase being separated by a target capital (TC) defined at one (or more) specific horizon(s). The TC is linked with an annuity pricing table based on the age of the participant and of the partner. This provides a simple mechanism to compare saving levels with estimated annuity levels (in real terms). In this way, the DR offers an individual account solution that mimics the characteristics of a DB plan.
The elements as seen in figure 1 compose the individual’s ‘pension cockpit’ – in one glimpse all the relevant information is provided to manage the pension saving.
The basis of the saving period is the guaranteed saving module. The product seen here is best described as a rated zero coupon bond. Each year an additional piece of target capital is bought at a smaller discount. The DR element is that the target capital has a rated guarantee, but also that the risk for the participant is the volatility of market rates at which future pieces of TC can be bought. Also, a premium-smoothing element can be introduced where relatively more target capital can be bought early in the saving period, creating an awareness of the high impact of early saving amounts.
In addition to buying (expensive) pieces of guaranteed TC, a risk-bearing top-up product can be made available for building up a ‘risky’ part of the target capital. An example is a hedge fund or global index tracker.
Like with DB, insurance options can be included in the saving phase to mitigate specific risks, eg, mortality or disability insurance. The payout of these insurances could be defined in terms of TC or annual income. A DR provider could opt to provide insurances from several providers.
When the horizon is reached for payout of the target capital, this amount will be used to buy a (real) annuity for either a fixed period or in combination with life insurance protecting for longevity. An alternative way to deal with this element of risk is to determine the exact date of pension based on the future actual mortality tables, eg, with a life expectancy of 15 years.
Another element in the payout phase is the partner pension option, with the price depending on among others age and gender of the partner as well as future mortality tables and future interest rates.
In the DR contract a summary can be made of the risks which are or are not hedged. In this way, transparency is created regarding the cost and benefits of hedging the specific risks. An example is shown in the figure 2. Risks that can be hedged are shown on the left, ie, the product can be defined in real terms (inflation is hedged), returns in the savings phase can be locked in, insurance with regard to mortality and disability can be included and deferred annuities can be bought in order to have certainty on future benefit level. On the other hand, a participant may decide to focus on the savings phase and accept risks with regard to future target capital or annuity prices. A participant may also accept longevity risk, eg, when the participant has flexibility with regard to retirement date. Also, the participant can decide to spend part of the savings on more risky investments in order to allow for additional return (in exchange of a lower secure benefit).
In coming years, financial markets are expected to provide an increasing variety of products that can be used as building blocks for DR pension solutions. These products include indexed bonds with longer maturities that can serve as safe benchmarks for the savings phase. A specific example concerns long-term zero bonds. Top-up capital products are widely available, but their use will increase for pension finance. Issues include pricing of longevity risks, the availability of deferred (real) annuities in euro market, rating level of zeros, development of participant administration platform including the link with salary administration, fiscal structuring and so on.
Some of these building blocks are also helpful in decreasing risks in current DB plans, ie, increasing availability of long-term indexed bonds will help DB plans to match liabilities at competitive pricing. The same is true for zero bonds and longevity bonds. Governments or government institutions may be instrumental in this respect by issuing the securities. The development of the annuities market will also provide benchmarks for transparent pricing.
DR also offers an alternative to DB in case a switch to individual accounts is considered. The liability consultant of the pension plan can provide the necessary information on individual pension rights and necessary target capital. The consultant can also advise on the level of future pension premiums in order to reach the planned benefit level (preferably in real terms).
DR aligns interests between employer and employee, combines the strong points of DB and DC. The development of the building blocks of DR is in progress. Furthermore, the current trend toward fair value will give a strong backwind for innovation in financial and annuities markets, providing further support for better individual pension products.
Jeroen Tielman is director Pension Business Development and Alwin Oerlemans is associate director research at NIBCapital