While it makes sense for corporate sponsors seeking to limit their pension liabilities, it means plan members, with often limited financial appreciation, are let alone to make sophisticated long-term investment decisions about exposure to a variety of financial market risks, including return volatility, the effects of inflation and the dangers of outliving one’s assets.

To help individuals plan wisely, all involved parties, especially regulators, should have strong interest in designing DC plans and offering default options that meet members’ reasonable expectations. To achieve this, DC plans need to address explicitly the main risk dimensions and must clearly define what members can realistically expect as real retirement income. However, a convincing and comprehensive solution has yet to emerge.

IN THE UK AND US, derivative-based products are often perceived as too complicated. For example, investors can misunderstand target return funds, which set targets but do not guarantee the target return. Target-date funds that mature on a specific future date (for example, the 2040 or 2045 fund) are at first glance appealingly simple. But life-styling mechanisms used to determine the asset allocation of a fund over time are subject to debate over their individual adequacy. Diversified growth funds are moving into the traditional managed fund space. But recent market turbulences raise doubt if multi-asset strategies can mitigate volatility effectively and deliver attractive long-term real returns.

Longevity is an idiosyncratic risk. Employers with large plan memberships can diversify some of this risk. For one, they can hedge systematic life expectancy risks by using longevity derivatives. Individuals in the retirement phase don’t have this option. Instead, they primarily avoid the risk of outliving their retirement assets using various types of (variable) annuities.

Inflation is another often underestimated challenge that can cause retirees to suffer the indignity of old age poverty by eroding retirement income and reducing buying power. Although inflation has been low, and break-even inflation rates indicate that financial markets expect it to remain low, the way it will develop is uncertain. An unexpected rise of inflation will melt the purchasing power of retirement income. Nominal bonds may compensate, but only for expected inflation. But in a world of rising inflation, many retiring workers may find that what seemed sufficient savings on a nominal basis, may not be enough to maintain their intended lifestyle. Individual plan members will find it difficult to create a sophisticated strategy to counteract inflation – and should not be left alone to face the challenge.

One option might be a DC fund that aims for (or even guarantees) a real rate return on contributions upon retirement. It could offer an annual rate of return above price inflation adjusted each year to take account of market conditions. By embedding such an inflation hedge into the DC plan, members would accumulate a series of annualized contributions, each with a guaranteed real interest rate. The annual rate would vary, but, once allocated, would remain fixed throughout the accumulation period.

At retirement, a member’s fund could be converted into a (real) income generating vehicle, depending on the legal framework in the relevant country. From the member’s perspective, such a fund provides simplicity and security. Additionally, a real rate target plan lets members easily see, in terms of today’s prices, how much they can expect and afford later from contributions they make today. In this way, instead of falling victim to illusions of future fortune, members can plan around realistic expectations for retirement income.

OFTEN, DC PLAN DESIGN and execution still lies with the employer. The most likely legal entity for such a real rate target fund would be a pension trust with the fund managed by an asset manager or insurance company. To support annual guarantees, providers would need to construct a real liability driven investment mix and invest in a combination of financial instruments to deliver the required real future cash flows. An investment strategy would include a wide choice of instruments including, for example, inflation-linked bonds and inflation swaps for longer maturities.

A sophisticated, sustainable real rate return strategy requires professional investment management with profound financial derivatives know-how, advanced counterparty risk handling, multi-asset expertise and competitive market access. Also, a variety of funds may be needed to suit a range of risk tolerance levels. Employees with low risk tolerance may be content with stable, secure funds. Younger employees may prefer equity funds’ higher risk/reward profile, at least in the early years as they accumulate contributions. This flexibility can be achieved by combining the real rate concept with a life-cycle strategy and increasing inflation protection toward the end of work life.

What can an employer gain? If a paternalistic employer offers solution-oriented DC plans – and perhaps pays part or all of the administration costs – he may be rewarded with higher employee retention effects, which have been decreasing in part due to this switch toward the DC world.

Published by PROJECT M in June 2009