GLOBAL - The regulation of investment choices and default options in defined contribution (DC) pension schemes need to be more carefully implemented than has been done in the past, the Organisation for Economic Co-operation and Development (OECD) has warned.
In a working paper on ‘Investment Regulations and DC pension’ the OECD analyses the impact of different quantitative approaches to regulating investment risk on the retirement income from DC schemes, as the ongoing financial crisis had led to pension funds in countries with mandatory DC systems experiencing losses of 20-25% in 2008.
The working paper, which is the result of a joint research project with Allianz Global Investors (GI), Risklab (a subsidiary of AllianzGI) and the Institute of Finance and Actuarial Sciences, highlighted a trade-off between potential retirement income and protection from bad outcomes.
It noted that reducing the downside risk on retirement income from DC pension plans “requires moving into relatively conservative investment policies where the share of assets allocated to bonds may be quite large”, above 60%, which comes at the cost of renouncing potentially higher replacement rates that are attainable through riskier assets.
The OECD highlighted DC pension plans are “growing in importance throughout the world”, even becoming part of mandatory retirement systems in countries such as Estonia, but added DC systems are subject to “a great deal of uncertainty”.
Pablo Antolin, principal economist at the OECD department of financial affairs, said: “In countries, where payments from DC plans are the main source of retirement income the cost to society of unfavourable outcomes are much larger - and where participation in DC plan is mandatory then concerns about risk may outweigh the desire to reach potentially high replacement rates.”
The OECD admitted “regulations can be designed so as to limit some of these risks and avoid situations where older workers and retirees are exposed to major losses on their retirement income”, but warned these rules need to be carefully designed.
Findings from the report highlighted some countries with mandatory DC systems are still not allowing investment options to individuals, instead providing a single default option irrespective of age or other factors, for example in Estonia, Hungary and the Slovak Republic the default for all members is a conservative portfolio with no equity exposure.
As a result the OECD warned, “regulations of investment choices and default options need more careful implementation than has been the case up to the present”, as it highlighted the risk-return trade-off of different investment portfolios should be assessed in relation to projected retirement benefits and not short-term investment risk and return.
Brigitte Miksa, head of international pensions at AllianzGI, said: “Despite their many advantages, DC systems subject retirement benefits to a great deal of uncertainty. While regulations can limit some of these risks and prevent older and retired workers from suffering major losses to their retirement income, it is a complex task to design these regulations and it requires careful consideration of a number of factors which are explored in this paper.”
The research also suggested “life-styling” approaches - generally used in default options where a more conservative strategy is adopted closer to retirement - “may not be the optimal investment strategy for an individual contributing regularly to a DC plan and intends to purchase an annuity at retirement”.
It noted: “More careful analysis is needed on the design of suitable life-cycle investment strategies, especially when used as default options”, as it revealed while these strategies reduce retirement income risk “they do so at the cost of lower pensions on average”.
Meanwhile the working paper highlighted risk-based quantitative regulations, such as absolute minimum or target returns or an investment Value at Risk (VaR) limit, are broadly equivalent to setting ceilings on investments in equities and other risky assets and so they come at the cost of losing potentially higher returns.
Therefore it suggested simple regulations, such as a quantitative limit on equities of say 30-40% “could achieve the same results than more complicated regulatory approaches”, provided the stochastic model is validated by real events.
It also warned “some of these more challenging risk-based regulations [such as VaR] can also lead to inefficient, pro-cyclical investment strategies, forcing pension funds to sell equity holdings at times of negative returns”.
Gerhard Scheuenstuhl, managing director of Risklab, added: “The limitations of some of the more sophisticated risk-based regulations have been magnified amidst the rapid changes in market conditions. Comprehensive risk assessment under a long investment horizon has to make sure risk models suit this purpose and its underlying parameters capture the reality of the financial markets.”
If you have any comments you would like to add to this or any other story, contact Nyree Stewart on + 44 (0)20 7261 4618 or email firstname.lastname@example.org