The general framework for occupational pension plans can be described as intra- and intergenerational hybrid pension plans, with risk-sharing mechanisms between members and with sponsors. We define the degree of hybridity of a pension plan as the extent of risk sharing with the sponsor. At one end of the spectrum lie traditional defined-benefit (DB) funds, where all the risk is with the sponsor – as long as it can bear it – and the pension benefit is independent of plan returns. In a DB scheme, the sponsor gives a guarantee to the fund, in exchange for the possibility that its initial cash contribution is reduced so that the pension fund has an underfunded guarantee value. As the degree of hybridity of funds is linked to the degree of risk sharing with the sponsor, collective defined contributions (CDC), which are hybrid pension plans with collective risk sharing, and conditional indexation but without a sponsor, and DC funds, where the risk is entirely borne by individuals. These two systems lie at the other end of the spectrum. However, because the market value of the pension rights in individual DC funds is always equal to the market value of the investment fund where all pension assets are invested and risk is individualised, they stand apart because they are not collective solutions.
How they do it in the developed world
Individual DC plans are dominant in Commonwealth countries and have progressively replaced traditional DB funds in the UK and in the US. Continental European countries have opted towards more risk-sharing in the form of hybrid funds – defined as collective pension plans that benefit from some risk-sharing between participants and with the sponsor, and usually offer guarantees and conditional indexation.
The demographics of developed countries have led the retirement system to rely less on sponsor guarantees. In fact, demographics imply that the unfunded part of the pension diminishes as a proportion of labour revenues – an analysis that also applies to pay-as-you-go social security systems. In the UK and the US, the rigidity of laws governing pension arrangements – conditional indexation is prohibited in the UK – has meant that the reduced aggregate reliance on sponsor guarantees has been obtained by a mix of DB and individual DC funds rather than by more hybrid funds. In hybrid systems, where participation is often mandatory, the system can only adapt through greater hybridity, which means lower sponsor guarantees and lower overall (nominal) guarantees.
The UK and the US rely mainly on individual DC and traditional DB funds. Individual DC funds are usually sub-optimal since they are plagued by poor governance, inferior default options, are significantly more expensive than DB funds and, in the US, do not offer annuitised income. Traditional DB funds are often plagued by unhedged exposure to the risk of sponsor bankruptcy. The failure to transfer systematic longevity risk has been a major risk and has contributed to exhausting the sponsor guarantee. Given current practices, the sustainability of traditional DB funds is not guaranteed.
In continental European countries, hybrid pension plans are professionally managed and cost-efficient vehicles. Participation in pension plans is usually mandatory and most of the population is covered by hybrid pension plans. Yet, as they are regulated, they must provide the same type of solution for all categories of investors. An assessment of the type 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 in practice, and given the current yearly investment horizon, they may result in pension funds being locked in low interest-rate investments.
More flexibility in risk sharing
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 vehicles, benefitting from no risk sharing at all, being extremely underdiversified, lacking default (annuitisation in the US) 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.
There is no need to wait for regulatory change to improve practices, which should be driven by a genuine aim to service investors’ needs rather than to adhere blindly to regulations, to incentives and to usual market practices. Today, DC funds have the means to avoid the pitfalls of short-term retail funds, as they can diversify their 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.
Manage risks on top of suitable building blocks
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.
Traditional DB funds, although in decline, still have a place in retirement provision. To ensure that the remaining DB funds remain a sustainable option, they must be insured against the risk of their sponsor defaulting and mortality should be hedged. The risk of greater longevity could be partly shared with employees, who in theory would need to work longer.
When it comes to hybrid plans, nominal guarantees on premiums are usually required in continental Europe. Yet for the younger participants, these guarantees can be reduced – as long-term investors they have little need for nominal guarantees if this comes at the expense of real indexation. This reduction in nominal guarantees gives way to more flexible and better performing funds and produces more sustainable hybrid plans. Nominal guarantees can be important for older participants, because they can be considered a proxy for real ones over the short term. The system should be flexible enough to accommodate different indexation policies, in line with the life-cycle approach where the risk and reward change with age.
Change must include practice, demographics and short-termism
However, the effort should not lie with regulators alone – practices need to evolve, as there is empirical evidence that pension funds behave sub-optimally. Even though pension funds have been praised for their ability to diversify, empirical evidence suggests that they do not fully use their ability to diversify and invest in illiquid assets. They often have a strong home bias, which is not only contrary to standard academic prescriptions that recommend diversifying assets geographically, but also runs the risk of insufficiently protecting the purchasing power of retirees in maturing economies.
The demographic theme should also be taken into account in investment policies as it is an important driver for growth. It can be expected that in the future – as has been the case in China and India over the last decade – the production of future retirement goods will shift towards countries with a growing workforce. Their internal organisation and resources are certainly important, with infrastructure, education and democracy often associated with economic growth.
Lastly, the short-term behaviour shared by many pension funds that are locked into minimum funding ratios and nominal strategies can be avoided through adequate definition of the investment strategy.
Samuel Sender is applied research manager at EDHEC-Risk Institute.
