Pensions.qxp

Agenda
Advancing economics in business
The shift towards defined-contribution
pensions: are the risks overstated?
There is a clear shift towards pensions in defined-contribution form, although the nature,
extent and pace of the shift differ between Member States. This article examines the risks and
advantages of DC pension schemes, focusing on one key aspect of pension scheme design—
namely the framework for DC pension investment
The pension landscape in Europe has been, and and structure of DC occupational pensions schemes continues to be, undergoing significant changes. These emerging in the EU, the report examines not only the changes have led to a shift towards individuals having to investment framework but three other aspects of scheme take more responsibility for the provision of adequate design which are not examined in this article: the income for their retirement. This shift manifests itself in measures introduced to facilitate individual choice and decision-making; scheme governance; and the scope forcost efficiencies in pension provision.
The shift to defined-contribution pensions
There is greater reliance on private sector pensions
Advantages of DC schemes
to substitute or supplement state pension benefits.
The shift towards DC has been subject to extensive Pension schemes increasingly take the form of
commentary and much criticism—often unfounded, defined-contribution (DC) schemes, in which
since, as discussed below, the risks associated with DC individuals’ retirement wealth depends on the
schemes are often overstated while their advantages are contributions made and the performance of the
often downplayed. As such, there is sometimes a investments in capital markets, as opposed to
mismatch between perception on the one hand, and defined-benefit (DB) schemes, in which the scheme
economic reality and the fundamental characteristics of sponsor guarantees a certain income level (usually
different pension scheme structures on the other.
in the form of an income replacement rate) at
retirement.
Pension provision is not a free lunch
All pension arrangements are premised on the payment
The shift towards pensions in DC form is occurring of income at a future date. In a funded system, assets across Europe, although the extent, nature and pace of accumulate to meet the cost of future pension payments, the shift vary between countries. Existing DB pension and for a pension scheme to be self-financing, the schemes offered by employers are being restructured contributions made to the scheme in the accumulation and/or new schemes introduced that are mainly of phase, plus the return on the investments, must generate DC-type, including in those countries where private an accumulated asset value that matches the value of pension provision has historically not been significant.
pension payments. This applies to all types of funded Given that the shift towards DC is an economic reality pension scheme, regardless of whether the scheme is and DB pensions are not, and may not become, defined as DB or DC. However, contribution rates to DB accessible for many individuals, the relevant policy and DC schemes tend to differ in practice. For example, question is how DC schemes can be designed to deliver where the shift from DB to DC is explained by the need effective retirement provision for individuals. of employers to reduce their pension costs, it is oftenaccompanied by a reduction in the overall value of the This article considers DC pension schemes, and focuses pension contributions and, therefore, a reduction in on one key aspect of pension scheme design—namely pension benefits. Lower contributions imply lower levels the framework for DC pension investment. It draws on of retirement wealth but for reasons that have little to do Oxera’s recent study for the European Fund and Asset with the shift to DC pensions per se, as discussed below. Management Association. Using evidence on the growth This article is based on the Oxera report ‘Defined-contribution Pension Schemes: Risks and Advantages for Occupational Retirement Provision’,prepared for the European Fund and Asset Management Association, January 2008. Available at www.oxera.com. Oxera Agenda
The shift towards DC pensions: are the risks overstated? All types of pension carry risk
Figure 1 Illustration of spectrum of risks and scheme structures
The fundamental difference between DBand DC pensions relates instead to the allocation of risk between the parties. Themain source of risk to an individual in a DC given level of contributions, assetaccumulation in the individual account Wage path and job tenure risk shifts to member depends on financial market returns andthe chosen investment approach. In a DB scheme, this risk is borne by thesponsoring employers who will have to change their level schemes can be regarded as two ends of a broad of contributions as the investment returns vary in order to spectrum along which lie a variety of arrangements that differ in their allocation of risks (see Figure 1). While pure DC schemes expose individuals to – DC schemes can be structured to achieve specific investment risk, they are not necessarily riskier for target outcomes or reallocate the investment risk individuals than DB schemes. The latter expose away from the scheme member—eg, by implementing individuals to other types of risk, and this riskiness is a minimum-return guarantee by the sponsoring – DB schemes tied to the final years of earnings expose – In DB schemes, the scheme sponsor can assume the individuals to risk associated with changing wages wage path or job tenure risk that would otherwise be and jobs during their career. As confirmed in a borne by the individual by adopting average-salary growing body of academic literature, DC schemes, schemes rather than a benefit formula that depends where contributions depend on life-time earnings and pension rights tend to be more portable, can deliverbetter value (in terms of what individuals will get for – Through implementing hybrid arrangements, the plan their direct and indirect contributions) if the wage path sponsor can shift some, but not all, investment risk to individual members. Such arrangements include, forexample, sequential or combination hybrids where a – In DB schemes, there is a risk that employers may member can join a DB scheme after a period of DC reduce promised pension benefits ex post (eg, in the membership, or where they are accruing both DB and event of bankruptcy). Employees are exposed to this risk unless a mutual guarantee scheme has been setup (or another subsidy or bail-out mechanism exists) The distinction between DB and DC is blurring somewhat, to pick up the pension liabilities of the insolvent with DB schemes shifting towards structures that have a employer. If investment in company stock is restricted DC element, or DC schemes being structured (eg, through and assets are properly segregated, default risk is not guarantees or specific investment strategies) to replicate DB-type outcomes. Thus, the pension structures that areemerging involve a diverse and often complex set of – DC schemes can have advantages in terms of the allocations of risks (and responsibilities) between control they give individuals over their pension assets, individual scheme members, employers and financial allowing them flexibility and choice to adjust their institutions, which often cannot be unambiguously pensions in line with their needs and preferences. DB described as being either of DB- or DC-type.
schemes, on the other hand, require individuals toaccumulate the pension in the form of deferred life Investment risk in DC pension
annuities and thus limit the risk–return choice. While there are valid concerns about the ability of individuals DC pension schemes are in essence vehicles for to exert choice and make the right decisions, this long-term savings and investment. Contributions are paid does not necessarily imply that a DB pension provides into individual accounts and invested over the long term to deliver a pension upon retirement. For a given level of There is a spectrum of risks and scheme
contributions, the level of retirement wealth accumulated structures
depends on the net investment returns accrued in the Pension scheme design can vary in how the different account, and hence the performance of the investments risks are allocated, and the stylised pure DB and DC Oxera Agenda
The shift towards DC pensions: are the risks overstated? Distribution of pension wealth accumulated over
mitigated, either by investing in ‘safer’ assets or 40 years under different investment strategies
by shifting the risk to another party (eg, a financial institution providing a guarantee).
Indeed, in a number of countries, regulationimposes minimum guaranteed returns or other constraints on pension investment. The result of such regulation may be investment that is excessively conservative or inappropriate for – ‘Safer’ assets (eg, government bonds) may have lower risks, but also imply lower returns on average. Holding a significant proportion of the portfolio in equity during the pension before retirement) can result in significantlyhigher average retirement wealth, at a comparatively ‘life-cycle’ approach whereby 90% is invested in equity small increase in the risk of receiving very low levels (10% in bonds) for the first 30 years, switching to 30% of retirement wealth, given the long investment equity (70% bonds) for the remaining ten years until horizon over which pensions accumulate.
– Minimum return guarantees limit the shortfall risk for The outcomes under the 100% bonds strategy are individuals that may result from financial market clustered at the lower end of the pension wealth volatility, but they also limit individuals’ participation in distribution, whereas outcomes are more dispersed the upside benefits. The cost in terms of forgone under both the lifestyled or 100% equity approach, with returns, and hence lower retirement wealth, can be more pension wealth being accumulated. The differences significant if the guarantee is used throughout most or – The median wealth accumulated when investing The results of a simulation exercise undertaken by Oxera 100% in bonds is around €62,000, which is less than illustrate these points by quantifying what different half of the median wealth accumulated when investing pension asset investment strategies mean in terms of 100% in equity (around €140,000). Given the wealth accumulation for retirement.2 In the base model, it bond–equity mix, the wealth accumulated under the is assumed that the individual (or the employer on behalf life-cycle approach falls in between (around of the individual) starts to contribute to the individual account in the DC plan at the age of 25. The retirementage is 65, so the maximum investment horizon is – The probability of accumulating pension wealth of 40 years. The assumption is that yearly contributions more than €90,000 is much higher when the equal 5% of salary, which starts at €20,000 and grows investment contains only, or at least some, equity— annually in real terms at a rate of 2%. The modelling is in 72% of individual accounts that follow the 100% real terms. The individual account is invested in equity approach, respectively, accumulate more than government bonds and equity. The management fee is €90,000, compared with only 20% of accounts that set at 1% of assets per year, and returns in the individual account are assumed to be exempt from tax. The modelis based on a simulation of real bond and equity returns, An important consideration in pension wealth with the estimates for the parameters (ie, means, accumulation is how likely it is that individuals will end standard deviations, covariance) obtained from historical up with very low pension wealth or, more generally, how data.3 Taking the investment strategy, the contribution variable the outcomes are. Based on the simulations levels and the asset management fees as given, the using historical returns, an analysis of the bonds-only accumulated pension wealth for 10,000 individuals is investment strategy in terms of the percentage of then simulated, based on this generalised historical individuals worse off than the median or bottom percentiles of the equity-only strategies suggests that: Figure 2 shows the simulated wealth distribution for – if the entire portfolio is held in bonds, in 96% of cases three investment strategies: 100% investment in the level of pension wealth accumulated is lower than government bonds; 100% investment in equity; and a the median level of wealth (about €140,000) under the Oxera Agenda
The shift towards DC pensions: are the risks overstated? simulations are after all based on a set of assumptions, Table 1 Pension wealth accumulated over 20 years
including historical risk–return parameters that may not under different investment strategies
hold going forward. Rather, the point is a more general one: there is a trade-off between risk and return, and limiting risk usually comes at the cost of forgoing potential returns and retirement wealth. The cost can be particularly high if the pension assets are invested in ‘safer’ or guaranteed investments over most or all of thepension accumulation phase. Diversifying instead into equity can deliver higher returns, at comparatively low equity-only strategy. Investing in bonds delivers a 96% risk, not in the short run but over the long time horizon, chance of accumulating less than €140,000, but only a 50% chance of receiving less than this amount if the Concluding remarks
In DC pension schemes, investment risk is borne by – accumulated wealth under the bonds-only strategy is individual scheme members. This risk can be managed, lower in 42% of the cases than the bottom tenth and DC schemes can be designed to deliver outcomes percentile of wealth (€57,000) under the equity-only along the broad risk–return spectrum. While there are strategy. Thus, investing in bonds delivers a 42% valid policy concerns about pension benefit adequacy, chance of accumulating less than €57,000, but only a policymakers should consider the cost of imposing 10% chance if the investment is all in equities. minimum-return guarantees and other constraints onpension investment. Such constraints can imply The above results are based on a time horizon for significant forgone returns and hence lower average pension accumulation and investment of 40 years.
retirement wealth for individual scheme members. In However, similar conclusions still apply if the time addition, over long time periods, the additional reduction horizon in the simulation model is shortened to 20 years.
in the risk of an unfavourable outcome that is actually Table 1 summarises the results of the simulations, achieved by investing in ‘low-risk’ securities may be holding all other assumptions the same, but shortening minimal. Constraints on pension investment restrict the risk–return set available for individual scheme membersand may result in a lack of innovation in the product The outcomes are, on average, still better when the investment strategy involves at least some investment inequity, and even the ‘bad’ outcomes still deliver higher Product solutions are being developed in the market that wealth than under the bonds-only strategy in the majority are designed to suit the retirement needs of individuals of cases. For example, for the lowest tenth percentile of and their risk–return preferences, ranging from life-cycle outcomes under the equity-only strategy, retirement investment approaches to tailored investment solutions wealth is €18,915, which is still higher than the lowest that seek to achieve specific retirement outcomes for tenth percentile under the bonds-only strategy (€16,155).
individuals, taking account of relevant factors such as Indeed, the probability of a worse outcome under the age, retirement date or the expected public pension of equity-only strategy is less than 1% for a 20-year individuals. Further research into how DC pension investment period (and less than 0.1% for a investment can be tailored to meet individuals’ retirement needs would no doubt be useful, and new productsolutions are likely to develop accordingly. The aim of this is not to advocate a particular form ofinvestment for DC pension scheme assets—the 1 A simplified example can illustrate this point. A worker who accumulates four periods of final salary DB pension benefits with four employers,where the reference salary is the (real) final salary that the worker has with each employer, will receive less pension than someone with exactlythe same wage path who stays with the same employer, if their real wages increase with age. With a salary of 20,000, 25,000, 30,000 and35,000 at the end of each subsequent ten-year period, and a defined benefit of 1/80th of the final salary per year worked, the job mover obtainsa pension of 13,750, compared with 17,500 for the worker who stayed with the same employer. 2 The detailed assumptions and further results are described in Oxera (2008), ‘Defined-contribution Pension Schemes: Risks and Advantages forOccupational Retirement Provision’, a report prepared for the European Fund and Asset Management Association, January. 3 Barclays Equity and Gilt indices are used; annual total returns, including income reinvested, on these indices are provided in Barclays Capital(2006), ‘Equity Gilt Study 2006’. Estimates for 1900–2005 are used. In this period, mean (arithmetic average) log real returns for equities andbonds were 5.14% and 1.15%, respectively; standard deviations were 19.4% and 13.2%; and the covariance between equity and bond returnswas 1.54%. The results for different time periods would have been similar. For example, estimates for 1950–2005 would have been: 6.75% and1.34% mean real log returns for equity and gilts; 22.85% and 12.56% standard deviation; and 1.6% covariance. Although simulations areparameterised with estimates based on log real returns, the simulated series are transformed back to levels, and the return on investments isthen calculated. Oxera Agenda
The shift towards DC pensions: are the risks overstated? If you have any questions regarding the issues raised in this article, please contact the editor,
Derek Holt: tel +44 (0) 1865 253 000 or email [email protected]
Other articles in the February issue of Agenda include:
malaise in the markets: the impact of equity volatility
set free by competition? transitional access regulation of telecoms incumbents
untangling FRAND: what price intellectual property?
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Oxera Agenda

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