Around the world the trend is consistent – movement away from the unpredictable funding and expense requirements of DB plans toward the cash-oriented simplicity of DC structures. As this domino effect is played out around the globe, what is the impact on the true aim of superannuation plans in Australia and pension plans elsewhere – the provision of an adequate retirement benefit for retired employees?  Can the experiences of geographies that have a longer history with DC retirement vehicles be an effective indicator of what is to come for others? And let’s not forget that moving from a DB to a DC structure does not eliminate risk and responsibility, but rather transfers it from the plan sponsor to plan participants.  Individual participants in DC plans hold much greater control, and responsibility, for building an adequate retirement benefit, primarily through contributions and investment choices.  But are employees effectively prepared to assume this control, and if not, what measures are governmental agencies and plan sponsors adopting to encourage them to prepare?

An adequate retirement benefit

A commonly held belief is that an adequate retirement income (including income from all sources, public and private) should be 65 percent of pre-retirement income, after taking into account taxes (which may differ pre- and post-retirement). With a DB plan, it is readily apparent what the full-career benefit will be, because the benefit is usually defined as a multiple of pre-retirement income. But this outcome is not as obvious in a DC structure, in which benefits are defined in terms of the contribution flow into the program, rather than the income distribution out at retirement. Comparing the typical target benefit levels of different countries is also challenging, due to differing tax treatments and levels of government-provided benefits.

There are several key components of building a retirement benefit:

1. Contributions. It has been shown that to build a retirement income of 60-65 percent of pre-retirement income, annual contributions in the order of 15 percent to18 percent over a full career would be required. The range is sensitive to investment performance, but rarely are company contributions this high in modern DC plans. Hence, a significant contribution from employees is needed.
    
2. Investment earnings. Over a full working lifetime, modest increases in investment performance can yield considerable benefit increases, due to the compounding of returns.
    
3. Length of contributions. All other things being equal, doubling the contribution period more than doubles the resulting benefit. Hence, commencing contributions early in one’s career can have a large impact on the ultimate benefit.

So why do many individuals contribute less, start contributing late, invest conservatively and retire early? For some the answer could be the availability of other personal assets. More often, however, it comes down to a lack of knowledge about the level of contributions needed to build an adequate retirement income and how to take control during the accumulation phase. In geographies where DC plans are emerging, the fact that their role serves as a secondary source of income may well have created a false sense of security, ultimately stunting savings rates.  In the new DC world, there should be a greater sense of responsibility on the part of employers and trustees to provide the information, tools and knowledge to allow employees to take control more effectively and shape a secure retirement.

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The evolution of DC systems and member engagement

How did the DC movement begin? Increased reliance on DC structures typically results from one of three catalysts:

• Legislative introduction of a compulsory savings plan, which is often structured as a DC plan. For example:

    

  • Award superannuation and the Superannuation Guarantee legislation in 1987 and 1992, respectively, in Australia
  • The DC law in Japan in 2001
  • KiwiSaver in New Zealand in 2007
  • Compulsory DC savings in Israel, commencing in 2008
     
• Corporate reaction to balance sheet and financing risks, such as occurred in Brazil in the 1990s and in the UK and the US more recently.
   
• Market reaction to the (expected) reduction in previously generous social security benefits, as is currently the case in many European countries.

The catalyst on its own, however, is rarely enough to generate sufficient employee engagement to produce more than a basic retirement benefit.  Through analysing the evolution of a number of DC systems around the world, we can identify the key features of these systems that have developed to enhance member engagement. The following figure illustrates in broad terms the factors that may characterise the evolutionary process of a DC system.

The progression of features on this graph will not necessarily occur in this order, and may, in part, be driven by the nature of the catalyst. When triggered by governmental action, features may be introduced simultaneously in an attempt to capitalise on a broader launch. For example, both the Japanese DC Law and the New Zealand KiwiSaver require auto enrolment, so introducing features simultaneously, because of the laws’ significant effects on member engagement, outweighs any cost considerations. When a DC system is launched as a result of an employer’s changing financial environment, the evolutionary process tends to be longer, more difficult and potentially less successful.

Several interesting conclusions may be drawn from this chart:

• Features that force member participation, such as legislation, automatic enrolment or automatic contribution increases, are an excellent starting point to create an adequate DC system. However, the funding levels are typically far from the required 15 percent to 18 percent necessary to attain benefit adequacy. Additional voluntary contributions may be possible for the more highly paid populations, yet this will not avoid the inevitable division of the retired population into the “haves” and “have nots.” 
   
• Informational features, such as basic communications and online information, will help employees understand the need for saving. However, without corresponding tools to engage employees, they will not be fully effective.  Equally important, these informational vehicles are rarely inspiring enough to compel employees to take action.
   
• Enhancing information with basic tools, such as broader investment choices or a transactional website, encourages employees to take ownership of their savings. Yet the tools typically do not emphasize enough the importance of saving for retirement, in part due to fear of negative participant reaction, which only fuels inertia.
   
• More advanced education, alternative investments and individual investment advice are the current “pinnacle” to strive for, in order to provide employees with the full range of knowledge and tools to tailor their savings to their own needs. Where the education curve is perceived to be too steep to be tolerable, the alternative approach of Managed Accounts has been introduced, primarily in the US, which we discuss further below.

The countries in which a DC system has been in place for many years, such as Australia and the US, have generally been fairly slow to develop services that aid member engagement. Particularly in the US, where legislative initiatives have only recently begun to address the issue, the failure to effectively educate the working population, despite significant attempts to do so, has been disappointing. Geographies that are just now entering the DC market are able to build on the ideas and technologies of others, and hence are likely to have a faster progression along the evolutionary scale.

In the chart above, we comment on the relative position of each country in the evolution of DC plans, not on the appropriateness of what is being offered. Some interesting observations arise from a closer examination of these specific countries:

• DC plans have existed in earnest in the US for nearly 30 years. Yet their position as a primary retirement vehicle is relatively new, gaining in popularity over the last five to seven years. While many of the tools necessary for an effective plan have existed for some time, there is still a strong sense of employer paternalism and “entitlement” to an employer-funded benefit among employees. 
   
• In contrast, the Australian model has evolved over a shorter time period, spurred by the near demise of DB plans and legislation requiring a 9 percent employer contribution. The Australian approach offers the greatest level of control to participants, although its success is largely driven by legislation.
   
• Legislation is also driving the emergence of DC plans in China, although the high level of government-provided benefits limits the role for these plans. Here and in the Netherlands, limited plan design and investment vehicles will make it difficult for DC plans to function as much more than a supplement.
   
• The impact of DC plans in Germany and Japan has also been constrained by legislative restrictions. In Germany, the tax effectiveness of contributions to DC plans is limited to 4 percent of salary, with salary further capped at the Social Security ceiling. While employers may be willing to make tax-ineffective contributions for executives, these limits significantly affect benefits for the broader population. In Japan, member contributions are not permitted to DC plans, severely limiting the potential for member engagement.
   
• As has been typical of a new entry to the DC world, China has little in the way of investment choice. But with 60 percent of employers indicating that they expect to switch to DC plans by 2008, we wouldn’t expect this to last for too long. Germany, Japan and Brazil also currently offer only basic investment options and websites, but are also expected to advance quite quickly.

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So what can be learned from the experiences of the countries above?

Counter to expectations, the evolution of DC plans through the plan features, as shown above, does not guarantee success. Attaining success with a DC plan, where success is defined as achieving a level of member engagement sufficient to provide an adequate retirement benefit for the majority of the population, seems to require some degree of compulsory contributions.  Systems that began using a voluntary approach have gravitated over time to a minimum or default contribution level, or in some cases, to a mandatory rate. 

Australia is probably the earliest example of a compulsory savings initiative, with the introduction of the 3 percent Award contributions in 1987 for employees covered by collective bargaining agreements. This was followed in 1992 by the Superannuation Guarantee for all employees, with employer contributions starting at 3 percent or 5 percent, depending upon the size of the company, and gradually increasing to 9 percent for all. While there has been continuing discussion within the government and the superannuation industry, compulsory employee contributions have not yet been introduced. The Superannuation Guarantee has gone a long way toward providing a basic level of retirement income for all employees; however, on its own, it cannot provide a truly adequate level of retirement income.

Some late entrants into the DC arena are learning from their predecessors and moving quickly to compulsory savings. We mentioned earlier that Israel is introducing compulsory employer and employee contributions to DC plans beginning 2008. South Africa is also considering mandatory DC provision.

In countries with voluntary DC systems, an attempt has been made in some instances to eliminate the need for compulsory savings by encouraging participation through “matching” contributions, such as one-for-one, or lower, employer contributions. Initially perceived as a key driver of the savings level, experience reveals that employees will often make contributions barely sufficient to obtain the employer match, and sometimes not even that. It seems that this design is inadequate to lift member engagement to a level where making additional voluntary contributions is seriously considered.

The relatively new but fast growing practice of an “auto-enrolment” or “opt-out” design eliminates the participant from the decision-making by automatically initiating contributions unless the participant takes action. In the US, auto-enrolment is now encouraged by law, and may well become the norm. The New Zealand “Kiwi Saver” system also adopts auto-enrolment, as do plans in the Netherlands and Japan.

Further, the UK government is planning to introduce a quasi-compulsory system for retirement savings beginning in 2012, referred to as “Personal Accounts.” This system will require a 4 percent employee and a 3 percent employer contribution, with the government contributing a further 1 percent. Auto-enrolment will be a feature of Personal Accounts, and the government intends to encourage adoption of auto-enrolment by occupational plans in advance of the implementation of Personal Accounts.

Auto-enrolment is an effective tool but still leaves a portion of the workforce exposed. Younger individuals may set their contribution rate at a low level to ensure that cash is readily available for “more important” items, such as cars, property, or general spending. But the individual often may not increase his or her savings as these alternatives become less important.  “Auto increase” is a strategy whereby a portion of salary increases are automatically redirected to a defined contribution plan as an increase in contribution rate, the idea being that this is  “new money” that will not be missed. This strategy is encouraged in the US, and it will be interesting to see if this strategy becomes more widespread.

While the use of automation and mandatory employee contributions is encouraging, and certainly allows for the accumulation of a basic benefit, there still remains no real encouragement for individuals to appreciate what additional contributions might be required to provide an adequate retirement income, and how these contributions should be managed in both the accumulation and draw-down phases. This is where the advanced features that are becoming commonplace in countries such as the US and Australia, and to a lesser extent the UK, may be of great interest to others.

Enhancing features for greater participation

Advanced features typically start with the expansion of investment options. The Netherlands, the US and the UK all offer, in addition to the basic risk-based options, a number of “select your own” investment options. These will include many brand name investment managers, offering both risk-based and single-asset class options. Experience has shown, however, that offering more vehicles does not assure greater diversification of participant accounts. In recent years, “lifestyle” or “lifecycle” funds have become popular, offering diversification with more aggressive asset allocation during an individual’s younger years, and tapering to a more secure allocation as one approaches retirement. Many plans even offer individuals the option to choose the point of retirement (for investment purposes), and the period in which the asset allocation tapers off. Australia has taken these options a step further, also offering a range of alternative asset classes, such as emerging markets, hedge funds and specific infrastructure funds, and even direct investment in specific listed securities on the Australian Stock Exchange. These options are within reach of any individual, all within the plan.

But with these additional choices comes enhanced education. More advanced plans in countries such as Australia, the UK, the US and Japan, now include not only education about the specifics of the plan and its investment options, but also broader education on basic financial matters, such as budgeting and debt management as well as creating an entire savings picture in making contribution and investment decisions. The plan sponsor decision to rely on a DC approach seems to include a desire to elevate the financial acumen of the workforce.

Success in this effort is elusive, as plans are challenged to offer the technology to allow access to total wealth in line with the broader financial education that espouses that approach. In many cases, plans are restricted by legislation to adopt this approach, required to keep concessionally taxed pension savings separate from other forms of saving. But this is not to say it cannot be done. Many large plans in Australia now offer links and discounts to banking products, health insurance products and other financial services to their members, including access to individual financial advice.

In some parts of the world, there is discussion around allowing individuals to use a limited amount of their pension savings as a deposit on their family home – the Swiss and Singaporean systems allow this already. And at the draw-down phase, plans in Australia are now considering the possibility of allowing access to savings, within the regulatory draw-down limits, via automated cash machines.

The US has an interesting alternative, or complement, to providing advice. In response to a low take-up rate for individual advice and a lack of consideration of it over time, “Managed Accounts” have developed. If the Managed Account investment option is chosen, information is provided to the individual’s advisor around personal preferences and other savings, and the investment manager will set, rebalance and alter the individual’s asset allocation over time to suit specific needs, without the member having to take action unless circumstances change.

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A mandate: Educating and engaging the workforce

Despite the varying regulatory environments in which DC plans operate around the globe, the evolution of these programs is surprisingly consistent. While the need to save is universal, the process of leading the working public to actively participate in DC programs is arduous. The ultimate objective of universal worker engagement remains elusive. 

We believe there is much to be learned from the experiences of others with regard to education, investment options, linked financial products, personal advice and other features. Clearly, these plans are evolving, with the optimal design yet to be developed.  Looking beyond the legislative environments at the basic structures of these programs can provide insight into key features and practices – only some of which have been addressed here. In future editions of Global Retirement Perspective, we will review other key considerations, including plan governance structures and how a plan sponsor might develop communication and education strategies for building member engagement.

For multinationals that are looking to DC retirement plans as a key benefit component, the country trends described above should aid in decision making. 

Specifically, companies should:

• Review their existing plan against current local best practice
   
• Within local regulatory frameworks, adopt aspects from more advanced countries that have positive outcomes, ahead of local trends
   
• Update their plans when necessary to keep pace with changing trends and employee needs

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