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The importance of planning your DC risks

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Sacha van Hoogdalem discusses the complexities associated with considering DC offerings as an alternative 

In the current economic environment managing a pension fund has proven to be challenging. Many pension funds have seen the value of their defined benefit (DB) pension promises balloon due to historically low yields. In addition, the size of these liabilities increases over time, as the fund accrues new benefits. These effects, combined with uncertain market conditions, leads to ever increasing variability of the absolute funding gap; assets minus liabilities. 

As the sponsor’s ability to bare these risks remains relatively stable, more and more DB funds are starting to question the long-term viability of this benefit structure. The covenant simply cannot absorb this much risk, without serious implications for its own solvency or adversely affecting the tax payer. These covenant risks very often drive sponsoring employers to close DB pension funds to new entrants and to consider offering defined contribution (DC) benefits. 

In this article I aim to highlight the complexities associated with considering DC offerings as an alternative and emphasise the importance of accurate, useful information to support decision making with an unbiased assessment of the interests of each stakeholder. 

Challenges when comparing DB and DC

In a DC pension fund a set contribution is paid into the DC pot of each member. At retirement the member can access his pot and either drawdown funds periodically, take a lump sum, purchase an annuity or combinations of these options. Any market risk is borne by the member in a DC arrangement, whereas the sponsor bears this risk in a DB fund. If the member chooses drawdown and keeps his pot invested, uncertain investment returns can lead to variable pension payments. In addition, if the member does not purchase an annuity, they are exposed to the risk of living longer than their funds can support, which creates a longevity risk.

The challenge for trustee boards is to design an appropriate and affordable DC offering in line with member needs, whilst providing suitable information so people are made aware of their financial outlook when they retire.

Accurate and insightful independent analysis is essential in better understanding the effects of decisions on the expected pension payments for members and equally important, the variability of these outcomes. For example; a fair and affordable contribution from both employer and employee needs to be determined. As well as an investment strategy designed to reflect the risk appetite of the member throughout their investment lifetime, the fund should provide the information needed for each member to determine whether they should take their pension as cash, as a secure annual payment (annuity), or as a drawdown.

If the range of potential member benefits at retirement are still deemed too volatile, trustees could consider options to share additional risks between members - longevity, disability and even investment risk for example. The Work and Pension Committee (WPC) recently announced it was seeking views on Collective Defined Contribution (CDC) funds. These hybrid DC structures could serve as a solution sitting between DB and DC and as a result, the probability of unacceptably low member benefits at retirement could be reduced. Ultimately, the success of DC or hybrid DC fund depends on both the capacity of members and employers to share risk and the willingness of all parties to collaboratively work towards a solution. 

Written by Sacha van Hoogdalem, Manager Asset Liability Management and DC planning, Ortec Finance.