In Europe, hybrid pension plans are professionally managed and cost-efficient vehicles. Yet, as they are regulated, they must provide the same kind of solution for all types of investors. An assessment of the kind of guarantee they offer is therefore necessary. Should hybrid pension plans offer nominal guarantees and if so, to which participants should they offer these guarantees? Nominal guarantees may be costly since they may result in pension funds being locked in low interest-rate investments.
Flexible frameworks
A general, flexible framework for pension funds would make different forms of risk sharing possible, including DB and individual DC forms of collective funds. It would also allow for a flexible definition and management of guarantees. In the UK and the US, individual DC funds run the risk of becoming inefficient, benefitting from no risk sharing at all, being extremely underdiversified, lacking default and being costly.
It is urgent to rethink the DC framework. There should be more involvement of states in the design of adequate solutions and in setting appropriate governance structures and organisations. Regulation of individual DC funds should be profoundly modified, and should be distanced from the inadequate retail-fund regulation it is inspired by. Individual DC funds should be able to diversify their exposures and invest in illiquid securities and have the same flexibility that DB funds have today, because ultimately they must also provide retirement income.
| It is urgent to rethink the DC framework. There should be more involvement of states in the design ofadequate solutions and in setting appropriate governance structures and organisations. |
There is no need to wait for regulatory change to improve practices, which should be driven by the aim to service investors’ needs rather than adhering blindly to regulations, incentives and usual market practices. Today, DC funds have the means to avoid the pitfalls of short-term retail funds, as they can diversify assets using international investments, corporate bonds, listed real estate, commodities and even funds of hedge funds. Current technology makes it possible to offer some guarantees in DC funds. Inflation guarantees or target inflation indexation are important for those who rely primarily on the income from (DC) pension funds, as is often the case in the UK and the US.
We recommend a pragmatic approach where risk is managed on top of suitably designed building blocks: a performance-seeking portfolio that is heavily diversified among asset classes and a liability-hedging portfolio with a significant anchor to inflation; the preference of investors towards guarantees should be the main choices that members should make, even if customisation is possible via supplementary funds. Transparency must also be increased. Nominal guarantees can foster confidence in DC arrangements, especially over the short run. However, the cost of financial guarantees must be made clear, for instance by showing by how much the participation in the upside is reduced.
| We recommend a pragmatic approach where risk is managed on top of suitably designed building blocks. |
Traditional DB funds still have a place in retirement provision. To ensure that DB funds remain a sustainable option, they must be insured against the risk of sponsor default and mortality should be hedged. The risk of greater longevity could be partly shared with employees, who need to work longer.
regulatory change, performance-seeking portfolio, liability-hedging portfolio, pension plans, risk sharing, intra and inter-generational hybrid, defined-benefit (DB) funds, collective defined-contribution (CDC) and DC funds, individual DC plans, defined benefit (DC) funds
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