Because DC funds don’t have a pension payout mechanism, the member is subject to “conversion” risk when converting the pension wealth into an annuity at retirement.
The paper proposes a solution where interest rate and inflation derivatives protect the purchasing power of the DC investment over time, making the conversion risk a non-factor.
Essentially, the paper, How to mimic DB-like benefits in a DC product, describes a way to match long-term future benefits with investments now.
Van Egmond describes it as using a traditional lifecycle solution, with an allocation consisting of a safe and a risky asset. Instead of using bonds as the safe asset, an asset mix replicating a real deferred annuity is used.
“When you invest into the safe asset, the investment amount is translated into future real monthly pension payments, or at least into a very close approximation of these cash flows. The safe asset can be converted into a real annuity at retirement day since it uses an investment strategy that moves the same way as the real deferred annuity moves when market variables change.”
Lundbergh says that while APG is not necessarily producing a solution from this research, it is committed to a different way of looking at the pension payout problem in DC funds.
“There is a gap in the market between standard DB and the more traditional DC models,” he says.
“In the long run, it would be great to have a hybrid product that combines the best from DB and DC for those who only have access to the current DC models.”
It seems Australian funds are lacking such a mission-driven approach to this problem. They are looking for a product or solution, without first realising what they are trying to achieve.
Working out what they want to provide is the first step, then deciding how or who will manage it comes later. In that regard, funds in Australia still have a lot of work to do.
Amanda White is the head of institutional content at Conexus Financial, publisher of Investment Magazine