As part of the 2016 DC research stream we have been reviewing various papers written by members and academics. We will summarise several of them within this discussion forum stream. Our first summary is a paper written by Schroders, in which they looked at various aspects of DC plan design from an investment perspective and they identified a number of key lessons that can be learnt:
- A ‘high-enough’ (however defined) contribution is paramount to achieving DC investment success. Schroders’ simple illustrative model suggests that for a 40-year career, contributions of at least 15% of salary and real investment returns of 3% pa are the minimum for an adequate standard of living in retirement. In theory, at least, the contribution rate is something that DC members can control and therefore can potentially be influenced by the pension delivery organisation. Lessons learnt from behavioural economics: auto-enrolment is a must; auto-escalation of contributions is also recommended in certain situations.
- In terms of the design of the default funds, the paper points out that many funds (particularly target date funds in the US) can benefit from a diversified line-up of risky assets as opposed to relying purely on equities in the growth phase. In markets where members do not have to purchase an annuity at retirement, the glidepath design should encompass both accumulation and decumulation stages, striking the right balance between investment risk and longevity risk particularly when members are deep into the decumulation stage. Innovations in default design can be powerful in keeping members invested in the DC plan. For example, the National Employment Savings Trust (NEST) in the UK has developed an unusual lifecycle approach where members start in lower (not low) risk assets for around 5 years to mitigate the likelihood of an individual ceasing contributions if faced with a significant loss in their early stage of DC investing.
- Explicit guarantees in downside protection can be very costly (the rare exception is a guarantee protecting the nominal value of the contributions, provided that the contribution period is long enough). As a result, the recommendation of the paper is a combination of good diversification, active management of downside risk (that inevitably introduces the challenge of assessing manager skill) and some sort of “back-stop” protection, provided either by another active manager or in the form of sponsor support.
- Daily liquidity and daily pricing are provided at the expense of illiquidity premium and the fact is that few use this flexibility anyway. The paper argues that in markets where the majority of contributions are invested in default funds and few change this selection, there is little requirement for anything more than monthly liquidity. When daily pricing is strongly preferred, liquid proxies for illiquid assets can serve as access points.
Today’s DC members are facing a very challenging environment: increasing life expectancy, a low growth environment and very low or even negative bond yields in many markets. The paper calls for contribution rates to be increased significantly although we in TAG have previously suggested (see our paper here) that it might not be possible for society to collectively save significantly more without significantly pushing down the rate of return on investments – the paradox of thrift at play in the investment world.
Despite supporting auto-enrolment and fit-for-purpose default fund, the paper concludes that fiduciaries should not give up on trying to get members to engage with their DC plan. In order to do that, fiduciaries should be protected from legal action (eg safe-harbour protection in the US) from unhappy DC members when the outcome is not as expected.