Moving away from DC may not involve shifting all the risk to the individual. Maha Khan Phillips examines some of the other options that pension funds, particularly Dutch ones, are coming up with

Last year, the UK saw its first national postal strike in 11 years. Postal workers, protesting about pay and conditions, established picket lines all over the country. They stood outside sorting offices appealing to customers to understand that they had no choice but to make their demands heard. Public opinion was divided between those who sympathised with the worker’s complaints and those who just wanted their mail to arrive on time.

Now, postal workers are threatening to strike again. This time, they are furious at the Royal Mail’s plans to overhaul its pensions offering by shutting down its defined benefit, or final salary arrangement scheme. And once again, public sentiment is divided.

For many observers in the investment industry, the decision was inevitable. It is costing the sponsoring company $850m (€554m) a year to run its expensive defined benefit fund, and the shift to a defined contribution solution would be in line with the large majority of pension funds both in the UK and Europe that have made the transition over the last decade. In fact, DC assets now comprise of 44% of global pension fund assets, compared with 34% in 1997, according to research by Watson Wyatt.

Others, however, say the trend is worrying. “There are a number of concerns,” says Amin Rajan, chief executive of UK-based consultancy CREATE. “Returns that have accumulated in these schemes so far are well below expectations. This is partly due to the fact that individuals are having to make their own investment choices, and end up making poor asset allocation decisions.”

He believes that fund managers do very little tactical asset allocation once capital has accumulated. “The money is there and they think that clients have made the choices that they want to, regardless of market movements. There is very little capital protection built into the strategies.”

But industry experts accept that DC is here to stay. The adoption of international accounting standards has made it very difficult for employers to put risk on their balance sheets. “If liabilities and assets of a pension fund fluctuate, employers have to put that value on their profit and loss sheet,” says Bart Heenk, managing director with responsibility for the Benelux and Nordic regions at SEI Investments. “IAS is pushing the world towards defined contribution.”

Research conducted by Watson Wyatt reveals a series of problems that members of DC schemes are grappling with. For one, they spent a limited time considering their decisions, they have a limited understanding of the likely outcome from their decisions, and save too little, and they have ill-informed choices of funds. “Investors have generally found that the complexity of the task at hand and the amount of choice available has led to inertia rather than better decisions,” says the consultancy. “DC plans and products have tended to be sponsor-and provider-led rather than designed from the perspective of the member.”

Collective DC

Employers and providers have realised that members need to have better options, says Ashish Kapur, UK DC product specialist at SEI Investments. “The needle is slowly moving back, not to defined benefit, but to figuring out ways to pass some of the risk to employees.”

While hybrid schemes have been in existence for some time, the Netherlands is leading the way in new innovative solutions. Several schemes, such as those for Dutch retail and banking group SNS Reaal and engineering company Arcadis, have adopted collective defined contribution (CDC) arrangements and are talking about them publicly. CDC schemes are being so widely and so quickly adopted in the country that Gerard Roelofs, head of the investment consulting business at Watson Wyatt in the Netherlands, believes that in excess of 50% of pension schemes in the Dutch market have made or are making the transition to CDC. Others say the figure is much lower, but growing. Participants agree that the model could be exported to other parts of Europe.

Put simply, the model does away with the individual accounts of traditional DC schemes. Employers make a one-off payment into the scheme to put it in a strong solvency position and are then only liable for fixed annual payments. Money is pooled together and employers and employees contribute a fixed percentage into the plan.

“In Holland we’ve had defined benefit schemes sharing risks for some time,” says Theo Kocken, CEO of risk and derivatives consultancy Cardano Risk Management. “Besides the employer, the beneficiaries in the pension fund assume parts of the risk as well. For example, when the funding ratio is too low, indexation is postponed and they don’t get it unless the funding ratio is above a certain level. So indexation is conditional on the health of the pension fund. CDC goes one step further, with the employer acting solely as a fixed contribution payer and the beneficiaries sharing the risks.”

Kocken believes CDC has become successful because individuals did not want to move to a DC scheme and “end up very insecure about their pensions because two days before they are due to retire the markets could drop by 20%, or longevity figures change suddenly and reduce their pension arrangements overnight. Now they can still share risks between generations.”

However, the new schemes come with their own accountancy complications, which are leaving some pension funds wary of adopting the structures. Crucially, CDCs work because they act like a DC structure for the employer but DB for the employee. Sponsors do not put the risk on their balance sheets. “Pension funds and their corporate sponsors were a little afraid about the accounting implications,” says Kocken. “They were worried that accountants would not accept that you don’t have to put CDC on the balance sheet. Accountants are interpreting CDC as a hybrid between DB and DC and that makes people hesitate about how accountants will cope with it.”

Heenk believes this could be a problem in the future. “The CDC system has not been tested in court. There is no jurisprudence around what CDC actually means, so everyone has their own interpretations. It’s largely a negotiation process between corporate sponsor and their accountants about whether they have to take the risk off their balance sheet. But if 20 years down the road collective DC schemes are not able to pay their pensioners, then nobody knows what will happen. You could conceivably see a situation where pensioners could take the sponsor to court.” 

Adopting the model

Still, practitioners are eager to see the model adopted elsewhere. Vodafone in Germany has adopted a similar structure, as have some Nordic pension schemes. But it is unlikely that CDC will make its way to the UK in the near future. “I think adopting CDC in the UK would be one step too far,” says Kapur. “UK investors like the option of making investment decisions, even if they don’t sometimes make them, and CDC constrains them from doing it by limiting the options that are offered to them.”

Michelle Lewis, a senior policy advisor at the UK’s National Association of Pension Funds (NAPF) argues that the UK has had hybrid schemes for several years, and that a one-size-fits-all approach does not work. “What works well for one scheme may not work for another,” she says. Nevertheless, she notes that the NAPF is encouraging the UK government to legislate for greater risk sharing.

It is a move that seems to be gaining momentum. The UK’s department of work and pensions recently agreed to consult on the issue of conditional indexation. But, it added: “The government is concerned that it would introduce practical complexities and moral hazard issues and, as employers would still be expected to fund in expectation of providing indexation, the government is unsure if it would provide employers with sufficient incentives to continue to provide defined benefit arrangements. The government, therefore, remains to be convinced about conditional indexation.” 

Individual DC

Investment managers and employers say they are working on building new structures to help individuals in the DC system. A strategy that has proved popular in the US and is gaining traction in the UK is lifecycle investing, say fund managers. Lifecycle funds match investment strategy to the stage members have reached in their lives, explains Lucien Carton, (pictured left)  global product specialist at ABN Amro Asset Management (AAAM).

Typically, lifestyle investing starts with a comparatively high-risk, high-return strategy when the investor is a long way from his or her savings goal and gradually moves to low-risk, low-return strategies as the investor approaches retirement. AAAM points out that by 2012 all employers in the UK that plan to auto-enrol their workforce into existing DC schemes will have to offer a lifestyle default, as stated in the Pensions Institute Report.

AAAM, which recently rolled out its Capital Protected Lifecycle funds for the UK market, says the UK has proved more difficult than Europe and even Asia. Carton says it is about finding the right distributor. “A lot of investors and advisors are very interested in the product but they need to figure out where it sits in their product range.” 

Fiduciary management

Others providers are looking at bringing fiduciary management type structures to the DC space. Last year SEI launched its DC Master Trust, a fully bundled DC product with an outsourced trustee body and investment management via it’s multi-manager product range. Scheme communication and administration is conducted via a partnership with UK’s Capita Hartshead. “We are able to offer employers a pan-European defined contribution scheme [and] give continental Europeans the type of investment options which are similar to those that you would see in a collective defined contribution structure,” says Kapur.

SEI claims it reaches economies of scale by pooling members’ assets from multiple schemes and by spreading the legal, administrative and accounting costs across the Trust. Each participant can still formulate its own investment strategy and establish scheme-specific design options, says SEI. “Companies in the UK are attracted to this idea, rather than outsourcing everything to the employee and washing their hands of it,” says Kapur. “It’s a good middle road for companies that want to offer a bit more to their employees.”

Still, SEI has yet to build up its client base. “We launched this less than a year ago, and we’re in discussions with clients now,” Kapur says. “But it’s not a small decision, especially when you talk about pan-European pension schemes and various labour laws.” 

Bringing change

For Rajan change cannot come fast enough. “What we have done in Europe amounts to what I call baby steps,” he says. “We need some giant leaps here. The other problem is if I have saved money from defined contribution, what do I do at the end of it? We need more post-retirement products.”

He says countries should think about following the Dutch example. “The Dutch model is by far the best for a number of reasons. It relies on a co-operative approach. Individuals do not have to make big decisions.” Most importantly, risk is born by both employers and employees, and investments are marked to market so there is huge transparency in the underlying investments.

He predicts: “Future defined contribution plans will be along the Dutch lines. But we are still miles away. In the US, for example, defined contribution plan holders would have been better off if they left their money under their mattress. The system hasn’t worked so far. The only people the system has benefited are the fund managers and the sponsoring companies.”