I start from a belief that the contribution rate is one of, if not the, most meaningful pieces of information for a DC saver. It reminds them how much current pay they are giving up month in, month out, and how generous or otherwise their employer is. It is certainly more meaningful than an annual statement of the accumulated account balance. However, the thought here is whether we could convey even more meaning through the contribution rate, perhaps via a set standard, akin to performance reporting following GIPS.
The thought was triggered by a comparison between the Dutch and Canadian DB markets. In essence the Dutch system is run on a solvency basis, so the accrued liabilities should be fully funded at all times in case the sponsor suddenly goes bankrupt. The liabilities are therefore discounted at a government bond rate – say 2.5% for indicative purposes. All safe and secure, but the contribution rate needs to do most of the heavy lifting as any mismatch between the assets and liabilities is very risky and can get closed down quickly if things start to go wrong. The Canadian system is run on a going concern basis, where the sponsor is assumed to continue into the future making contributions, and discount rates tend to be around 5.5-6%. Here the heavy lifting of future provision is split between the contribution rate and investment returns. There is much that could be debated between the two systems, but let us instead lift this thought back into a DC context.
A DC saver could smooth their lifetime consumption needs the ‘Dutch way’ or the ‘Canadian way’. For the time being, let’s keep the ‘pension’ the same in both cases. We could therefore offer a choice to our DC saver between a ‘zero-risk’ pension outcome albeit at a contribution rate of, say, 45% of pay per annum (Dutch) and a contribution rate of, say, 20% (Canadian) but with a higher level of risk associated with disappointing investment returns and sponsor failure (albeit hard to quantify).
While observers may have a strong belief in which is ‘better’ we have actually set these up to produce the same result. What differs is the risk. And my question is, are we doing a good-enough job in communicate risk to the end saver in terms they can understand? Now I admit, quoting a 45% contribution rate in a DC context may not be the best way to go – in fact it could have the unintended consequence of lowering pension saving (“what’s the point!”). But a 45% contribution rate buys you the DB gold standard: retire at 65 on 67% replacement ratio, likely inflation indexed, and payable no matter how long you live. Perhaps we define the DC gold standard at a lower level.
In Australia the industry body, ASFA, publish income levels associated with a ‘moderate’ or ‘comfortable’ retirement. We could re-label these as we liked – ‘bronze’ and ‘silver’, say – but we could agree a set of parameters that were consistent with a number of retirement outcomes – so ‘moderate / bronze’ requires a (say) 15% contribution rate, while a 20% rate ‘gets you silver’. I am not under-estimating the difficulty of agreeing the necessary parameters / assumptions (mortality, inflation, returns, age of retirement etc) but that would only be necessary if the idea has any merit.
This framework could be developed further. Ongoing member engagement would now be centred on the contribution rate. Imagine the following possible communications:
- “Investment markets have been weaker than expected, so we calculate that you will need to raise your contribution rate from the current 15% to 15.25% to maintain your target of ‘moderate / bronze’ outcome. Alternatively, you could raise the level of your investment risk and leave your contribution rate at 15% – but this is highly likely to increase the future variability of your contribution rate. If you leave the investment risk at the current level and do not raise your contribution rate by 0.25% now, we calculate that you will need to raise it by 1% in 5 years’ time to stay on track.”
- “Investment markets have been stronger than expected, so we calculate that you have built a small buffer relative to your target of ‘moderate / bronze’ outcome. We would advise that you take no action as the buffer is small, but the following options are available to you…” Where the options would include lowering the contribution rate, lowering investment risk (to lock in gains), raising investment risk (buffer), or raising the target outcome (with accompanying contribution rate / investment choices).
To recap: the point of this thought piece is to consider one way to improve member engagement and better empower the end saver, by offering them choices in terms that are meaningful and understandable to them. The underlying belief is that the contribution rate is very meaningful to the end saver. The idea proposed is that we should make more of the contribution rate, and the associated risks it brings or addresses. Feedback on whether the idea has merit would be appreciated.