Define your plans clearly

Consumers in DC plans must have their responsibilities spelled out to them, says Dietrich Hauptmeier, finance director of PensionDCisions.

When defined contribution pension plans were first introduced, some people may have hoped that employees would act as the perfectly rational consumers of classical economic theory by making optimal saving and investment decisions in accordance with their personal preferences; doing, effectively, everything that the professionals had done for them before.

Of course, this is not what happened. To start with, plenty of these new consumers simply didn’t bother to join the plan. And many of the employees who did join their new DC plan didn’t do much else. The vast majority of members relying on their pension plan’s default strategy.

These observations have led to the design of ‘auto-plans’. Members get auto-enrolled, their savings rates are auto-escalated over the years, and their funds are auto-invested into a default strategy. While everyone can opt-out and make choices, it seems to become accepted that most people will just rely on the defaults anyway.

Suddenly DC plans look almost like DB plans again, and all the parties involved appear to be falling back into their old roles. Sponsors and trustees negotiate about contribution rates, actuaries and investment consultants advise on appropriate de-risking glide-paths and asset allocations, and asset managers are busy adapting the ‘liability-driven-investment’ techniques from DB to DC.

Employees may therefore be forgiven should they also fall back into their old role and expect a safe pension income. And that is where the similarities break down. No longer will the employer pick up the bill if the experts get it wrong. It is now the employee who has to pay the price.

DC is a consumer product; this makes it fundamentally different from DB. Allowing the consumer to remain entirely absent from the DC decision-making process is wasteful and dangerous for two reasons. Firstly, if employees are not involved in DC, they will attribute much less value to this benefit, which certainly does not maximise the shareholder value of all the money spent on pension contributions. Secondly, by sponsoring a DC pension plan, employers are effectively seen to endorse the plan and by implication the default strategy. If employee expectations are not met, then what was meant to be a benefit may turn instead into an employee-relations disaster.

Currently most DC plan members seem to follow happily into equity or balanced funds, into any level of UK “home bias” in the asset allocation or into whatever else their pension plan uses as the default investment strategy. According to our recent survey some two-thirds of sponsors say they would like to see the number of investment defaulters decrease.

One specific issue revolves around the labeling of default strategies. The survey showed that the largest group of default strategies are all described as ‘global equity’. However, the distribution of absolute returns for those funds is wide [far wider than the distribution of benchmark-relative returns], because the funds’ regional asset allocations differ significantly.

This means that a large number of employees are all being told they are investing into something called ‘Global Equity’, and all see that their fund seems to be doing comparably alongside its benchmark, yet some employees are still doing much, much better and others much, much worse. DC needs to be understood by consumers – at least sufficiently for them to grasp what responsibilities they are delegating, to whom and why. Employers need their employees to realise that it’s neither the experts, nor the employer, but they themselves who are ultimately responsible for these decisions, delegated or not.

Finding ways to break through the inertia and help employees to accept that DC is their product and their responsibility remains the most important task facing the industry today.

Maybe, as a first step, ‘defined contribution pension plans’ should be renamed to something more catchy, both to underline their status as a consumer product and also to prevent practitioners from thinking that the ‘C’ in DC might look almost like a ‘B’.