Axa IM analyst Sander Zboray suggests ways of managing DB expectations in a DC world.
Investment professionals looking to take pieces of the defined contribution (DC) pie should be wary of the pending political risk associated with a possible situation in which DC pensions do not enable plan participants to get a 'fair' pension. Most people expect their pension schemes to deliver this 'fair' pension - for example, a pension that represents a fair proportion of the wages they earned during their working life and enables them to maintain their purchasing power until their death.
Yet few have a clear idea of what needs to be put in place for that to happen. A large majority of people operate with defined benefit (DB) expectations in a DC world. Also, there is a significant risk that those people who receive low or irregular salaries will not be able to find a proper pension at a reasonable cost, as the administrative costs of individual DC schemes are typically higher than those of hybrid DB and collective DC schemes. The asset management industry has started to give real thought to how to help savers mitigate these risks. This is all the more necessary as an accumulation of 'inappropriate' decisions by a few individuals could resonate loudly and severely damage the industry's reputation.
There are several solutions that can help mitigate these risks. Some countries have created a default state fund that can benefit from economies of scale, such as Sweden (AP7) and the UK (NEST). Another answer is individual solutions within a collective framework, such as hybrid DB schemes, used in Switzerland and the Netherlands, and collective DC schemes, popular in Italy - in such schemes, the existence of a governance body ensures the individual does not make decisions alone.
Innovative solutions such as target maturity funds (TMFs), combined with portfolio insurance - CPPI/TIPP, for example - can be sought to minimise maximum losses. Within a TMF, the allocation of assets evolves with the investor's age: a higher allocation to equities for the young investor and a more 'defensive' approach for the investor nearing his retirement age. With CPPI or TIPP, the portfolio is split into non-risky assets and a risky part that can be invested in higher-return assets. The size of the cushion depends on a statistical estimation of the possible lose of value. They preserve most of the growth potential of the underlying asset classes and offer a protection during a market drawdown.
So what could be the future for European DC? Open-architecture DC, where savers make their own choices about their investments? Or a multi-asset DC solution with some kind of embedded protection? In the UK, which already has a strong history of open-architecture in the mutual fund industry, we expect to see open architecture expand to DC much like that which is taking place in Australia, where individuals are increasingly opting to handle their retirement savings themselves. Conversely, continental Europe - which has a stronger culture of collective agreements for catering to individual needs and a mutual fund industry that is based on much more of a guided architecture - will probably turn to multi-asset solutions with embedded protection. Ultimately, any solution must above all seek to narrow the gap between a DC pension framework and an individual's DB expectations.
Sander Zboray is a senior clients and markets analyst at Axa Investment Managers