Survival of the Fittest

As countries seek the best ways to create universal coverage for their workers, the weaknesses in both the defined contribution (DC)and the defined benefit(DB)systems have been thrown into the spotlight. While there is recognition on a broader scale that the traditional DB model is dead, says Ambachtsheer, there is also growing frustration with the weaknesses in the traditional DC model. “We can’t just give people a whole bunch of investment choices and say good luck. You need to actually organize the investment program, and you need autoenrollment- type rules and autopilot-type rules, and you need an annuitization back end,” he explains. “There is an increasing recognition that it’s neither DC traditional nor DB traditional. We’re going to a lifecycle approach that starts out as an individual pension account and converts to an annuity along the way.” And as policy-makers and plan sponsors begin to realize this, it’s leading to innovative new approaches to coverage that elude strict DC versus DB labels. No two countries have been grappling with the DC-versus-DB issue like Australia and the Netherlands. In these countries, the struggle to provide mass pension coverage is leading to some interesting innovations along with the recognition that new approaches can’t follow the old DC/DB rules.

Innovations in plan design: A tale of two countries

Australia, for example, has had universal coverage in place for years, with individuals putting aside 9% of their gross pay into one of the country’s 300-odd superannuation funds. Based on the DC model here in Canada and in the U.S., these funds operate essentially like mutual funds, where investors pick a set of portfolios in which to place their money. When they hit 60, they are given a lump sum payment. Through compulsory contributions to retirement savings, the aim is to ensure that all Australians have adequate savings at retirement. It’s a great start, according to Leo de Bever, chief investment officer of Victorian Funds Management Corporation in Melbourne, however, there’s still a long way to go before the system can become truly effective.

The main weaknesses stem from the DC-like model currently being employed. It’s expensive, says de Bever, and it’s the consumer who ends up bearing much of the cost. After factoring in the costs of distribution to individual accounts, for example, the funds don’t perform much better than index funds. There are other inherent costs in the system, since most of the funds “farm out their management to external managers,” he explains. “That’s relatively expensive compared to the Ontario Teachers’ Pension Plan, where 90% of the assets are managed internally,” de Bever explains. The number of investment choices involved also means there is a costly network of advisers to help consumers with their options. “Between the advisers and the super plans and the cost of maintaining them and the cost of people switching around means that the investor loses 1% or 2% over index returns,” he notes. The fact that there is no standardized annuitization approach at the end is also a big problem—leaving people with lump sums at the age of 60 doesn’t help them when it comes to stretching that money through their retirement years, de Bever says.

However, Australia is now tackling the weaknesses in the current superannuation approach, closely examining the DC-based approach that’s in place and seeking ways to standardize the system to protect consumers and reduce the inherent costs, and creating a single annuitization process. “My aim in life is to help squeeze the cost out of these plans,” says de Bever, noting that contribution rates will also need to rise to ensure that Australians paying into these funds have enough to retire on. The current 9% just doesn’t cut it, he says. Moreover, he says there are going to be far fewer funds to choose from in the future —another advantage for consumers. Why? Although choice can be a boon for investors, too much of it could encourage investors to chase shortterm returns, particularly during a market downturn. That can lead to “horrendous decisions,” de Bever explains. Fewer funds could help ensure that doesn’t happen.

The third way

In Europe, the Netherlands has been a country on the forefront of innovative approaches to pension fund design and management. Unlike the DC-based Australian system, the Dutch are major proponents of the DB model. However, that is changing, according to Jeroen Tielman, managing director of commerce, strategy and innovation with Cordares Holding N.V. in Amsterdam, one of the country’s largest pension administration companies. He says that a new Dutch-style DC approach is in the works to address universal coverage. Called the “Open Pensioen,” this new supplemental pension product is aimed at self-employed people in the Netherlands and is based on the concept of “defined risk.” Tielman calls this “the third way of defining a pension plan in addition to defined contribution and defined benefit.” How does this new “third way” work? It’s based on a “risk-defined target capital” that incorporates time-dependent dynamic asset allocation and embodies the future pension capital wallet with which annuities can be bought. In fact, it sounds a lot like the type of model Australia is looking for—a kind of DB-DC hybrid, if you will.

Tielman sees a bigger role for such supplemental individual pensions based on this concept of defined risk. “This supplemental pension will be part of a holistic approach from the viewpoint of the individual and will include other capital sources as well, such as net savings, home equity,” he explains. The new model would also be flexible enough to work in tandem with other social programs in the Netherlands: “The actual pension payout could be partly in kind, including new concepts of housing, social interaction and healthcare.”

Although Tielman sees the DB model persisting in his country, he does see it evolving. “DB is here to stay, but I think it will become more lean and basic. Also, I think the DB model could be formulated more for specific age cohorts as the aging population puts pressure on intergenerational solidarity.” So, with a leaner, meaner DB system in the Netherlands and a more focused DB-style DC program in Australia, it looks as if the lines between these two pension forms are starting to blur as these countries innovate for the future.

A new approach to risk management

As more countries seek ways to provide adequate coverage to larger segments of the population, sponsors of private pension plans are also grappling with similar challenges, seeking innovative ways to meet their needs. Risk management is front and centre, with global plan sponsors looking at new approaches such as risk budgeting and liability-driven investing(LDI). But while these new tools can help, too few plan sponsors are actually implementing them, says Ian Markham, director of pension innovation with Watson Wyatt Worldwide in Toronto. Watson’s research shows that there is still a Chinese wall between businesses and their pension funds—and that makes proper risk management tricky. “A lot of people are talking about LDI, but it seems to me like the world is still seeing the pension plan as an entity with large walls all around it, with plan members on the inside and the sponsoring organization on the outside.” The two need to be managed together. Innovation, says Markham, needs to come from risk budgeting and LDI. “The innovation is looking at how you manage not the assets alone, but the differences between the assets and the liabilities together,” he adds. In the Netherlands, it is already changing its approach to risk management. Tielman explains how his organization is expanding its pension risk management framework to include the pension balance sheet, management skills and tools. “We are approaching the risk management theme by unbundling pension risks into investment(including interest rate risks), mortality, longevity and solvency risks,” he adds. At the same time, new solutions are being developed to allow for the more efficient transfer of pension risk, he explains.

Markham also says that the move to mark-to-market accounting is going to have a major global impact. It’s already been felt in the U.K., for example, when mark-to-market accounting was put in place in 2003, prompting a large percentage of big DB plans to be closed to new employees. Markham notes that it’s about to happen in the U.S., and it will ultimately lead to some key improvements in communication and understanding of market volatility in order to cope with the transition and manage expectations. “There will be more advanced planning and communication to stakeholders of the reasons and effects of volatility,” he explains. “When you’ve got uncertainty and volatility, you have to help people understand and put it in context.”

Smarter boards

Although universal coverage and innovations in risk management are starting to take hold around the world, there is another area that still needs work, according to Ambachtsheer—pension delivery organizations. Right now, he says, too many pension funds are tethered to trust laws that impede good governance and organization design. “What it does is create a structure of individual trustee responsibility and a layperson approach to people sitting on these boards.” A lack of expertise at the board level means that most of the decisions are left to outside experts. “You end up with this structure that’s weak on the inside and a coterie of outside experts running the show,” says Ambachtsheer. “It’s cumbersome and ineffective—and widely used.” Some pension funds are making changes, however, managing from the inside out by building significant internal expertise. “This starts at the board level. Not lay boards, but professional boards,” he explains. “People who actually know what a board looks like [and] sounds like, and what it does.”

With the increasing complexity of investment approaches and strategies, internal expertise at the board level appears to be more important than ever. In the Netherlands, for example, Tielman sees alternatives taking an increasingly large role in pension portfolios at the expense of more traditional asset classes. Cordares, with €26 billion under management, recently announced that it is diversifying into international real estate and that it plans to more than double its 3% allocation to alternatives and infrastructure investments in the next two years. At the same time, plans are afoot to cut allocations to fixed income and equities. Clearly, an entirely different investment landscape is emerging.

In the U.S., public megafund CalPERS, with assets totalling US$243.9 billion, is also leading the way when it comes to expanding and refining its investment program, with an inflation-linked asset class in the works that would include investments in commodities, timber and inflation-linked bonds, as well as infrastructure. CalPERS has also taken a leading role in examining the environmental footprint it is making on the world through its investments. The fund has been looking at the impact of carbon emissions on its investments—something that many pension funds are doing around the world. It is one of many plan sponsors and institutional investors to have signed on to the Carbon Disclosure Project, a U.K.-based initiative that sends requests to major companies for information on their greenhouse gas emissions. There are currently 225 institutional signatories representing more than US$31.5 trillion in assets.

Although coping with such demographic issues seems daunting, no doubt global pensions will rise to the challenge. They’ve certainly proven they can survive even the toughest conditions, evolving into leaner and meaner forms to ensure that the pension promise, and keeping the pension promise, is alive for future generations.

Caroline Cakebread is the editor of Canadian Investment Review. caroline.cakebread@rogers.com

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