The long march to DC
In terms of assets, Irish defined contribution(DC) plans are barely on the radar. A recent survey by the Irish Association of Pension Funds among members accounting for Ir£17bn (e21.6bn) in assets found that defined benefits counted for Ir£16.7bn of these and DC for Ir£157m, just 0.9% of the total.
But anecdotally the market for new schemes is almost completely DC and some glimmer of this transition comes from the fact that, of the total net cash flow of Ir259m to pension funds surveyed, around 7% is in respect of DC, the balance being DB contributions. Another sign of the shifting weight of DC is that 26% of schemes surveyed offer DC plans, compared with 22% in the previous year’s survey.
“The point from the figures is that DC is small in terms of current assets but increasingly important in terms of cash flow,” says John Grant of consultants Mercer in Dublin. “The long-term expectation is that DC will continue to grow, while DB will decline.”
How fast that will happen or whether it is going to be a smooth transition is not predictable. Tom Finlay of Bank of Ireland Asset Management in Dublin, a current chair of the Irish Association of Pension Funds, points to the fact that though all the new schemes are DC, the serious cash flows to the market have been DB-related, as the government paid for the pension funding liabilities of the state sector bodies such as An Post, the post office, and Eircom, the privatised telecoms group. The national pension reserve fund, hailed as the country’s biggest pension fund, will provide another massive boost of funds to the market, but for DB type funding of liabilities, he points out.
He adds: “There is still a very strong culture around DB in Ireland. All the major employers are DB still, only a few of the established DB schemes have taken the step of closing to new entrants and offering them DC only. It certainly is not widespread.”
Philip Shier, a partner with consultants Delany Bacon & Woodrow in Dublin, explains the background to the figures. There is little switching over of DB plans to DC. He agrees that where employers make the move it is likely to be closing the existing scheme to new entrants and opening a new DC plan for them, with the consequence that they are usually small initially, he points out.
“Similarly, most companies setting up are start-ups, where it is not efficient to run a DB scheme and particularly in the high tech or financial services areas, the reckoning is that employees will be mobile and require DC plans,” he says.
These are the new areas of the economy where the influence of trade unions is lower. “DB is still seen by the unions as being better for employees, particularly within manufacturing.” This point is confirmed by Fergus Whelan of the Irish Congress of Trade Unions in Dublin. “With DB plans, people are sure what they’re getting. The risk in DB is taken by the scheme, in DC by the member,” he says. “Most DC schemes are ticking time bombs, in that most members probably have very inflated ideas as to what they are going to obtain from their DC plans at the end of the day. They are going to be disappointed.”
Shier echoes the point: “Many DC schemes are funded at levels that are not going to give benefits anywhere near those that will emerge from a DB scheme.” The typical employer DC contribution he puts at between 5% and 10%, while funding for a DB scheme is around 15% on average, he points out. “However, at younger ages a 10% contribution by an employer will give the employee a bigger pot to take to his next employment than he would get under a typical DB scheme with a 15% contribution rate. So the argument is not entirely one-sided.” The message for employees is blunt: arrange additional voluntary contribution schemes. The IAPF survey shows 91% of DB and 94% of DC plans offer these facilities.
From the employers’ viewpoint, Shier says it can be beneficial to structure the DC contributions to overcome some of the drawbacks by having a service related scale, or one that increases with both age and service. “Another approach that can be good is to have the employer match employee contributions, this tends to be attractive to employees who are going to stay. It makes sense to pay more for those employees prepared to pay more themselves.”
Colum McDonald, group pension manager at AIB group (see box below), reckons that good investment returns have meant that DB plans have been performing well and contribution rates falling, so there has not been pressure from the to change. “We felt that the good times is when to make the change and not wait for the problems to come along. We have bedded our DC plan in with some good years’ performance and members seem reasonably happy and there’s a bit of a cushion if things going wrong.”
Group actuary at consultants Coyle Hamilton Joe Byrne does not expect to see DB funds switching in the present climate. “We are not seeing much switching and any that do are those that are not well funded.” But there are a lot of small to medium-sized plans with small assets, he points out. “The key question is whether DB funds will start winding up plans – the Irish have only been funding pensions for the past 20 or 30 years.”
The managed fund, which has served Irish pension funds well, is a mixed asset pooled fund with the allocation decided by the manager. It is the mainstay of the DC market, accounting for 79% of scheme assets, with three quarters of plans offering this as a choice, but it seems to be falling out of favour as, according to the IAPF survey figures, it accounts for just over half of DC plans’ cash flow. The challenge is clearly coming from that other firm favourite of Irish investors, the consensus funds, which are absorbing nearly 40% of DC cash flow. These funds take the average of the managed funds’ asset allocation and then track the different asset classes on an indexed basis, thus taking the ‘manager risk’ out of the picture. As they have only emerged in recent years, the IPAF survey shows that only a fifth of DC schemes provide them.
While nearly a quarter of funds offer an equity fund, there has been poor take-up as they account for just 5% of assets, despite their supposed suitability for younger investors. That their cashflow proportion of DC inflows has increased to 10% may indicate that they are increasingly popular. Fixed interest, with profit and cash funds are offered by schemes, their take up by members is virtually non existent, says the survey.
All in all, the survey finds that DC plans use on average two investment managers and offer three different fund choices to members. A pretty universal 88% of schemes believe that their fund choice is adequate. Just over half of plans offer a default fund option where members’ contributions go if they fail to choose a fund. Nearly 60% of default funds are the managed, 25% are consensus and 17% are other funds, such as with profit, says the IAPF.
Grant says: “Many schemes with a single fund choice are taking the opportunity to offer a choice of funds, though not necessarily a choice managers at this stage. The majority of schemes we see have just one manager.” But the trend is for new schemes to offer more than just the managed fund. Some sponsors restrict the choice, so, for example, they do not offer a cash fund option as they do not want their younger members going into this. “What may be surprising is the extent of consensus funds in the market. These have the attraction of reducing the need to change manager, as they remove manager risk, and so appeal to employers and trustees.”
Overall, Grant reckons that there is a reasonable level of choice in the DC market, with some 17 groups offering managed funds and a half a dozen providing consensus funds of one form or another, but there is room for new entrants.
“Now there are euro-focused managed funds. New equity funds are coming with more specialist emphasis, so schemes may be able to get what they need from the Irish exempt fund range.” However, he points to what could be foretaste of the future, as UCITs funds from the financial services centre and previously only available to foreigners are now open to domestic investors, while the use of OIECs and Sicavs from the UK and Europe are already being considered.
Finlay of BIAM is very conscious of the difference between DB and DC, when pursuing mandates or investment briefs. “In a typical DB presentation you only have to persuade a handful of people, but in a DC pitch you could talking effectively to 300–500 people. They have to consciously decide that they are directing their contribution to us and we have to give them compelling reasons to do so. And you have to resell to them next year. It is much more retail than institutional.”
Finlay believes that the choice of consultant and administrator are as important as the asset managers in a DC context. The consultancy firms provide much of the stand alone administration systems, along with the life companies.
Byrne of Coyle Hamilton paints a picture of consultants under threat from the resurgence of the life companies into the administration business. “The insurers are moving to giving greater choice and improving their systems. Historically we consultants always said we can do it cheaper, provide better service and offer fund choice.” The big cost-competitive advantage that consultants had is being eroded in his view, as labour costs shoot up.
But Byrne sees a crunch time for consultants in the capital outlays the next generation of administration systems are going to require. “Many consultants use the Profund software, but the next version is internet- enabled. That is a totally different platform and migration to it will be complex and costly.” He adds: “This may be a step too far for the smaller players, so the life companies could profit.”
Irish Life believes it is one of the insurers who has not just caught up but is now ahead of the field with its DC administration system. Manager Ciaran Long says the company provides administration for 50,000 DC scheme members, giving it a market share of around a third.
When it went about developing its administration system, Long says they based it firmly around the members’ needs and designed it from that perspective. “Our driving question was what does the member need.” The company took a bespoke package and did a tremendous amount of development work. “In our view it is not the system itself, but the process and the discipline that has to be built around this.”
Long says: “In DB you only have to be right once, with DC you have to be right always.” The company will refuse to take on a scheme, if it finds it cannot obtain access to the payroll data. “We just do not get involved.” On the fund side, there has to be daily pricing. “This is crucial as employers do not run their payrolls on the same day.”
In the development work, most of what they did was not new or innovative and they would copy good ideas from all round the world. “The idea of constant access to information through interactive telephone voice was considered a gimmick when we introduced it five years ago,” says Long. “We now expect to get 10,000 calls annually on the system. When we introduced it we did not realise the degree of comfort it gave scheme members to check his account.” There is still little sign of it happening generally on the market.
Long says in the US many of the systems have a minimum requirement of 1,000 participants in order to make money. “It’s a different world in Ireland, where few big schemes would have that many members, and typically schemes could have five to 20 members.” The real issue for providers in a small country is whether the market is worth having. This question is going to become even more relevant with the arrival of personal retirement savings accounts (PRSAs), being introduced in the imminent pensions bill. These will only be successful if written in volume,” says Long.
As simple DC products PRSAs are designed to make uncomplicated yet well regulated products available to Ireland’s large number who are not in an occupational schemes, and are designed to be offered as a third pillar product, or as a simple group product that may well appeal to employers because of its uncomplicated structure, compared with the traditional DC pension package.
The next chapter in the Irish DC story is about to begin. Its future shape is unknown, other than it its going to be DC in one form or another.