An independent trustee in the UK is the latest to attempt to provoke a debate on whether DC funds can create a sense of certainty for savers by removing some of the investment risk borne by members

Richard Butcher, managing director of Pitmans Trustees, has said that reducing the uncertainty around retirement incomes for DC members could bring a greater level of saving for the schemes. Up until now most of the attempts to innovate in the DC market have focused on improving communication by offering corporate wraps complete with internet platforms where savers can see how much they are saving in illustrated charts. 

Butcher said that "The focus has traditionally been on input - i.e. what you can afford. The member has then simply had to hope and eventually make do with the resultant output. This needs to change."

"If we can focus on output (i.e. the benefits that emerge) and then innovate to reduce the number of moving parts we are much more likely to get good member outcomes."

Early proposals to build in some security to DC outcomes are yet to convince. A pair of researchers from the Bank of Italy produced a paper in 2009 that proposed governments could easily fund a guaranteed GDP link to DC retirement pots although there appear to have been few takers yet in an era of global austerity.

Giuseppe Grande and Ignazio Visco wrote that "the recent financial crisis has clearly demonstrated the exposure of defined contribution pension scheme members to extreme financial market risks. The government might offer DC plan members a minimum return guarantee, funded by risk-based premia and implemented through a swap between the Treasury and the worker nearing retirement."

Grande told Pension Funds Insider that providing this kind of guarantee to all DC savers might amount to 0.7% of a country's GDP, which he deems a "sizeable but not untenable amount" if members stump up some of the insurance. Grande added that "a long-term guarantee scheme backed by the government is also more credible that any private arrangement in as much as it is able to better withstand systemic financial crises".

He said that while no government has yet to take on board their idea "is has been unofficially examined by some public authorities." Grande spoke of mandatory Danish DC fund ATP's minimum return guarantee, which since 2009 has been linked to interest rates, as showing there is plenty of possibilities for the UK short of a full government guarantee.

Fidelity International's head of DC business Julian Webb recently told Pension Funds Insider that working towards a guarantee of DC saving outcomes "has been talked about for a number of years but the structures that are being promoted by fund groups primarily rely on an underlying drag on the yield to cover the guarantee. The way these have been structured so far has seen a high drag on the yield and so trustees and sponsors have rejected these due to cost and complexity."

Webb also said that as there is no way to fully guarantee DC outcomes without government funding, any partial 'guarantees' could create all manner of confusion for savers, adding: "if there are any caveats or situations where the guarantee would not apply then I think trustees would be reluctant to put that structure in place."

Webb raised the prospect that floors could be built into DC plans to keep any fluctuations due to volatile market conditions within defined boundaries. He said: "You could link some broad floor to the FTSE for instance, by saying it would be linked to no less than 80% of the previous highest value of the FTSE, albeit with no implicit guarantee." Webb explained that automatically swapping equities for cash once they drop to a certain value would allow the tactic to work.

Webb also said "it is interesting that NEST is not offering any guarantees on performance". The government's giant catch-all savings vehicle has, however, made a rough target for returns on savings of CPI plus three percentage points per annum for most of their members' saving cycle.

Butcher said that "if we adopted some of the techniques common in DB schemes, DC investment returns could become less volatile." Nigel Aston, Business Development Director at DCisions, the consumer insight firm, explained that "it would be possible to use dynamic liability driven investment (LDI) type engineering in DC schemes on an individual basis where an individual's mix of return-chasing assets and risk-mitigating assets varies according to an end goal."

Aston concedes though: "The problem is, that would be extremely expensive and the question you would have to ask is whether this clever engineering would be worth it." 

You only get out what you put in

In reality, any ideas to build a safety net into DC schemes are yet to show any strong signs of being able to take away from the fundamental burden of defined contribution which places investment risk on the shoulders of savers.

A recent study from Professor Paul Sweeting at the University of Kent suggests lifestyling remains the most sensible way to manage a retirement income generated from a DC scheme. Savers not being put through this process of gradually being switched out of high-risk equities to low-risk bonds are at risk of losing upwards of a fifth of a pension pot in their last year of working should they encounter poor equity markets, claims Sweeting.

NEST's innovative foundation phase concept will introduce lifestyling to the start of a member's saving cycle in order to reduce risk in the crucial first years of membership. DCisions provided NEST with a piece of research on how customers react to market volatility; Nigel Aston explained that "negative reactions to financial losses are typically double the positive reactions to financial gain which underscores the idea of lifestyling people into equities".

Aston commented that the attitudes of default funds (in which most DC members save) to risk can be a bit cavalier with most appearing to be automatically heavy on equities. The converse is true for low risk funds with Aston saying "lots of people are keen to take very little risk but there is no purpose in putting these entirely into cash and bonds."

Lifestyling cannot remove investment risk of an equal magnitude before it kicks in though. That is why for now, amongst all the calls for innovation, the most success in giving DC saving a boost has been limited to encouraging schemes to help their members put in enough to their pension pots. 
 
It was in this vein that the National Association of Pension Funds (NAPF) launched its Pensions Quality Mark in October 2009, with over 100 DC schemes since signing up.

Richard Wilson, senior policy adviser at the Pensions Quality Mark told Pension Funds Insider: "Primarily we want employers to see the benefits of a decent investment in a pension scheme and recognise good practice in terms of improving governance, communications and contributions." He echoed Webb's call that guarantees risk giving members a misleading impression and although he insisted that trustees are best placed to decide fully on investment strategies, he said that regular reviews of investment are vital ways to ensure that schemes could implement any future innovations.

Wilson added that the fundamentals were increasingly falling into place at UK DC schemes, and "contributions are slowly increasing overall". He repeated the widely held view that the onset of auto-enrolment would be a crucial crossroads in the development of DC plans, with his hope being that "instead of levelling down we see auto-enrolment sparking competition for better things."

There are at least encouraging signs that some employers will take a pro-active approach to auto-enrolment. NEST's communication offensive is running in full gear and B&CE, provider of a sectoral DC fund to the construction industry, recently announced that it will scrap its management charges for employers during the first year of their auto enrolling.

In light of the certain developments to come, there is no need to be alarmed at the lack of innovation in DC investing to date, says Aston. "We haven't even begun to explore the possibilities of DC; it's a really immature market in an environment that is notoriously slow moving. But we are starting to see some innovation, and in the next five years I expect we will see some really interesting research and development that serves consumers well."

First publishsed: 20.04.11

dbillingham@wilmington.co.uk