Traditional DC is unsuitable as a savings vehicle for many employees, it is often said, but what are the alternatives? Ilonka Oudenampsen looks at collective DC and managed DC as possible solutions

Just when the shift from defined benefit (DB) to defined contribution (DC) seemed near completion and irreversible, Pensions Minister Steve Webb launched his defined ambition (DA) proposal, providing the pension industry with a new challenge to improve pension outcomes and introduce risk sharing. Two of the possible solutions mentioned to improve the current DC system are collective DC and managed DC.

Collective DC
Collective DC is about smoothing out the returns over time, by pooling the assets and risks. In traditional DC the retirement benefits are variable and can therefore be lower when times are bad and higher when times are good. However, in a collective DC pot, this can be avoided. Pitmans Trustees managing director Richard Butcher explains: “The way to manage this ebbing and flowing of benefits is by intergenerational support. So if in a poor year things aren’t looking too good, they can borrow money from the younger members in order to keep the older members topped up. In the years when things go really well, you can take a bit of money off the older members to reimburse the younger members.”

But while the economies of scale can bring costs down and bigger funds generally create more investment sophistication, one of the disadvantages of collective DC is that a lot of money is being moved around. Although this might give few problems in good years, the current situation in the Netherlands shows that it can have some undesirable consequences in financially difficult times.

In order to retain a healthy funding level, many Dutch pension funds have announced pension rights and benefit cuts for next April. This will ensure that the funds do not pay too much money to current pensioners, with the risk of an empty pot when the younger generation retires. The problem with this, however, is that it is impossible to predict what financial markets will do in the future. This has resulted in a discussion with one camp in favour of the cuts, who argue that the funds will otherwise pay out too much money now, and another camp against the cuts, who believe that the interest rates used to calculate liabilities are unnaturally low and will eventually increase, automatically solving the issue of the current underfunding.

Intergenerational fairness is current-ly one of the major discussions in the Netherlands, but AllianceBernstein head of DC David Hutchins mentions the lack of transparency as another issue, which cannot be easily solved.

“If you start bringing transparency to it, you’ll find that people won’t like it that much. Its beauty is its ability to shield the individual from the truth and transparency shows people the truth,” he says. “When they get a lot of investment volatility on their account, they probably get scared off. And there’s lots of cross-subsidies from youngsters to older people, which again is not necessarily a well-liked feature.”

Butcher adds that, for the system to work, there needs to be a constant supply of younger members, which cannot be guaranteed. While the government could legislate in favour of compulsion, it has no control over a stable population.

Hutchins sums up: “Given the mistrust about pensions generally, coming up with something that sounds like we have another cunning plan is not going to fly from a UK perspective. Given the history of pensions in the UK, collective DC is a hard thing to sell.”

Managed DC
But how about managed DC? Currently, members entering a DC scheme pay in their contributions, but research has shown they often do not know what income they can expect to receive in retirement. Managed DC would partly solve this problem, as it would not focus on the input but on the outcome.

Butcher explains: “Managed DC gets the individual to look ahead, at the output. And the output is: when do you want to retire, how much do you want, and what margin for error are you prepared to accept? If we can get people to answer those three questions, which are difficult questions to answer and ask, then we do everything else under the bonnet, as everything is implied by the answer to those three questions.”

Zurich head of corporate wealth investment strategy Jonathan Parker says that managed DC provides a greater degree of certainty around the ultimate outcome. “There are no guarantees to any of this - it’s simply gathering more information about what a member might want. So for example they want to retire on an income of 50 per cent of final salary. What managed DC will do is take this target, so a 50 per cent replacement ratio, turn it into a pot of money, let’s say £100,000, and work back from there to manage an investment strategy that gives a high probability of hitting that ultimate target.”

However, the managed DC model relies on member engagement, and as Hutchins points out, around 80 per cent of members are known to not engage. “In a non-engagement environment it can be quite dangerous potentially, because it makes achieving a certain objective important without knowing whether that is actually appropriate for the individual.”

But Parker points out that it does not necessarily have to be the member themselves who set the initial target outcome. It can be quite difficult to engage with individual members so if you’re not able to do that, then you might have to make some broad assumptions about what they may want. “What you can do is work closely with employers and their advisers to come up with a number that seems broadly sensible and obviously communicate that to the individual members, always giving individuals the opportunity to change that target if it is not right for them.”

A potential issue with the managed DC solution, Towers Watson head of DC investment Nico Aspinall notes, is that it might give slightly perverse scenarios if things change in the employee’s career. “Obviously it runs an algorithm in terms of salary and time to retirement. If you had a large pay rise close to retirement, would it do strange things, like put you 100 per cent into equities to try and catch up with the replacement ratio type target? I’m sure that can be designed out by trustees, but if you buy that off the shelf product, then you can get into the situation where it does slightly odd things.”

A more often cited downside of managed DC is that, when members are told a specific outcome is targeted, they might think they are getting some form of implicit guarantee. On the whole though, increasing member engagement is seen as a good thing and one of the big positives of managed DC.

And Butcher points out that, unlike collective DC which would require a change of the law, we can do managed DC now. “It fits within the current legislative framework and mechanically we can do it. We have the technology to do it, we have the legislative framework to do it and it doesn’t require any risk sharing.”

Aspinall concurs and believes managed DC is more of the direction than collective DC, but larger funds, such as master trusts, would be needed. “If we could see trusts of £10-20 billion, then there should be enough money for them to do these better things in-house and for them to be retaining the visibility of what’s going on in there. I think in a market where we have 4,000 DC schemes and an average membership of a couple of 100, it would be very difficult to think that anything better than we currently have can come to market.”

In the current economic climate it is unlikely employers and employees are willing to take on more risk or pay higher pension contributions. This is why Parker believes managed DC is more feasible at the moment, as it is “more on a best endeavours targeted basis and could well be very attractive in the current market conditions”.

However, looking forward 10 years, when perhaps economic conditions are a bit more benign, he expects some paternalistic employers will want to put in the effort to manage DC in a better way, which might mean taking on a bit more risk than they have done to date.

“I fully expect there to be a market for collective DC looking at 10 years from now. I think the one thing that everyone agrees on is that the current status quo is not sustainable for any extended period.”

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