With defined contribution (DC) rapidly becoming the dominant pensions model across the globe, Richard Lowe assesses whether it really is more desirable than defined benefit (DB)
A global pension landscape dominated by defined contribution arrangements looks to be an inevitable reality. While certain countries, particularly in the European Union, look more likely to buck the trend, many international experts argue that DC is the most appropriate model for occupational pensions in the 21st century and that defined benefit arrangements are no longer financially sustainable.
Markets like the US and Australia have certainly seen their pension landscapes transformed into what might be described as mature DC markets, although each has evolved in very different ways. The UK is following behind and is arguably past the tipping point from DB to DC. But one of the problems with establishing DC systems in countries where there has been a long history of DB pensions is that direct comparisons between the two types of provision are inevitable. And as such, DC is always going to be seen to come up short.
The degree to which DC can, or indeed should, replace DB is questionable
That is not to say that DC pensions are necessarily inferior, but rather it is a case of comparing apples with pears. “The degree to which DC can, or indeed should, replace DB is questionable,” said Watson Wyatt senior consultant Gary Smith. He argues that pensions sector is moving into a “fundamentally different environment”, one where the responsibility of building up an adequate level of income for an individual’s retirement is with the individual, not the employer.
Financial instability
There is much evidence to suggest that DB schemes are becoming financially unsustainable, given tougher accounting standards and the potential for runaway demographics. Evidence that DC is the most relevant and fit-for-purpose model can be found in many developing economies, such as countries in Eastern Europe. Here governments and regulators have opted to go straight to DC, missing out DB arrangements completely, when setting up private occupational pension sector.
“Countries in Eastern Europe have come from the state providing everything from cradle to grave. There had been a shift from state to individual responsibility and went straight to comprehensive DC,” said Watson Wyatt senior international consultant Michael Brough. “There is no DB to compare with, although governments and those designing pension systems would have looked at the options and other systems in operation around the world.”
However, if it is held that DC is the most logical and appropriate model to apply today, it’s still not necessarily good news for individual pension savers. Unfortunately, more often than not DC schemes are not likely to offer the same level of retirement benefits as their DB counterparts. This is not because DC schemes are inherently incapable of offering the same levels of retirement income, but rather they are more likely to have lower contribution rates and have a greater chance of being invested inappropriately.
Mercer principal Steve Charlton, said that DC schemes have the potential to be “worked hard” for members and provide benefits comparable with those delivered by DB schemes. In fact, he said, it is relatively easy to attain good replacement ratios for employees on low earnings. Obviously, the higher the salary, the more challenging it becomes to match DB benefits.
But the reason DC schemes by and large do not meet this potential is because members need to take responsibility and become engaged with their pension savings, something that was never needed for DB schemes. This is perhaps the most difficult piece in the DC jigsaw.
“That is why a lot of the criticism that is aimed at DC is fair,” Smith said. “The individual hasn’t accepted that responsibility in a practical sense and therefore they are not making decisions, they are not thinking whether what they are actually contributing is going to be enough, whether they are investing in the right place given their needs for risk and return.”
For many years the most obvious solution to the problem was to focus on member communication and improving the financial education of individuals, enabling them to make informed decisions and to take control of their DC pension pots. This, it was deemed, was necessary to ensure individuals understood why they should join DC schemes, why they should look to contribute more rather than less and why they should pay close attention to the investment options available to them.
But there is a growing consensus that this approach is flawed and there should be more of a focus on automation and improving aspects like default investments. AXA head of consultant relations Mark Rowlands, said countries where the DB-to-DC transition is still very much in progress, could learn a lot from the experiences of more mature DC markets like the US.
“The US has realised that you can spend millions and millions on communication, trying to get the message across to employees, trying to educate them around financial matters, and you might have a small impact, but you won’t change people’s behaviours,” he said.
Instead, Rowlands recommended the use of tools like auto-enrolment, automatic contribution increases and better designed default investment funds, which members are automatically placed in unless they actively opt for other investment strategies, to ensure take-up rates are high, members are paying in sufficient amounts and their capital is being invested most appropriately. The communication piece can then be aimed at other more productive areas.
“The communication is then aimed at mid-career counselling and pre-retirement counselling and annuity decisions rather than spending all the effort and cost on sitting down with people and convincing them to pay 8% rather than 5%, or to join rather than not to join,” he said.
Learn from the UK’s example
Smith agrees that the UK is in a good place to learn from markets like the US and Australia. The 401(k) system in the US, which is dominated by insurers, is very different to Australia’s master trust model. Interestingly the UK essentially combines both approaches via trust-based schemes, which are regulated by The Pensions Regulator, and contract-based DC arrangements, regulated both by TPR and the Financial Services Authority.
There is growing realisation that there needs to be improvements in DC governance (the TPR in the UK is particularly focused on this area at the moment) and a greater level of fiduciary oversight on behalf of members. But Smith is concerned that while trust-based schemes in the UK appear to be addressing this the same cannot be said for contract-based schemes.
“In the trust-based model we are seeing much more of an emergence of the trustees providing that fiduciary structure,” he said. “Many of the leading DC plans in the UK are beginning to adopt structures whereby the trustees are providing a lot of the help and support in terms of presenting the options and making some of the key decisions, etc. They are beginning to embrace that need to provide support to the member. In the contract-based world, there is clearly no inherent fiduciary.”
Charlton agreed, saying there is no overall governance at an employer level on a compulsory basis, although there are employers who do implement voluntary governance structures. These are useful for employers who want to ensure they are getting as much out of their contract-based scheme, although they have to be careful that they do not too closely resemble trustee boards, since they have little in the way of legal power. The UK’s regulator is certainly in favour of such voluntary structures and Charlton wondered if as a result of TPR’s upcoming review of DC pensions whether such voluntary provisions could be “firmer”.
The final outcome of a DC pension – how much it delivers in retirement – is of great interest to its members, but it should be remembered that it is in the commercial interests of employers as well. When the first generation of true DC members come to retire in the UK, companies will be hoping they have adequate pension pots to retire on or they may be looking to work for longer, something they will be able to do thanks to European anti-age discrimination legislation. If not, employers are faced with potential human resources issue: an ageing workforce unable to retire, allowing younger recruits to come in behind them.
Mercer’s head of European DC Craig Burnett, said it is easy for companies to focus on the shorter-term advantages of cost saving and risk mitigation that comes with DC, while forgetting longer-term issues. “Without a healthy liquidity in the workforce – people retiring and having other less experienced employees come up behind them – the impact is growing labour costs,” he said.
DC comes of age
How this plays out in the UK is unclear – only time will tell. Meanwhile, countries like the US are already seeing people retiring on DC benefits. Unfortunately, due to the recent financial crisis and falls in equity markets, many have been left with a retirement pot worth less than the contributions paid in, prompting legal action in some cases.
“With DC being relatively young in most countries, relatively few people are actually retiring with a dominance of DC benefit. So a lot of the things we have been talking about around the inadequacy of DC haven’t really come to light yet,” Smith said.
“Most of the DC problems around the world are still under the surface. Unless somebody really recognises and begins to tackle this head on, it is likely to explode in a few years when people start to get to retirement and people realise there isn’t anywhere near enough money put aside for generations of workers.”
