A key benefit of the scenario approach taken by the World Economic Forum in assessing the impact of an ageing population is that governments, companies and individuals get to “road test” whether current plan designs make viable future pension systems. So, of the three scenarios put forward (“The winners and the rest,” “We are in this together,” and “You are on your own”), are we already on the path to one of these approaches?

In many countries, the harsh realities of funding a traditionally generous social security system for an ageing population are hitting home. We are starting to see these munificent systems diminish – the average pension promise in 16 countries studied by the OECD has fallen by 22 percent since 1990 (OECD 2007, as noted in its report, Pensions at a Glance ). Many countries are also increasing the age at which social security pensions commence. This is hardly indicative of the scenario “We are in this together.”

Rather, many countries are attempting to encourage private provision of pensions through systems of tax relief – certainly a positive step toward adequate retirement incomes. However, the well-off – or possibly the growing middle class - are more able to afford private provision, especially because social security contributions are not necessarily diminishing. Hence, a significant funding burden remains for the poor, which hampers their ability to bridge any social security gap. Further, the well-off are also able to gain more from tax relief due to the progressive nature of many tax systems – in other words, again, the rich get richer. This sounds like we are already headed for “The winners and the rest.”

This is not the only approach being taken, of course. Systems of compulsory contributions exist (for example, Australia, Singapore) or “opt-out” systems (for example, KiwiSaver, UK Personal Accounts), which certainly have an element of “We are in this together.” However, even these systems combined with relief from progressive tax means that the more well-off benefit the most.

Although we are a long way from the final scenario outcome, it seems that, if combined with sustained economic growth, “The winners and the rest” scenario is the outcome to watch.

Thus, current ideas and initiatives that are generally accepted as best practices will continue to add value: good governance, member choice and education, flexibility at retirement and drawdown options, and carefully thought-out lifestyling.

But what if ... ?

But what if the world were to progress along the lines of the other two scenarios examined by the World Economic Forum? Let’s first have a look at what these scenarios may mean for pension provision:

So will the current trends in pension provision meet the needs of these scenarios? If not, what actions must be planned in order to be ready if these scenarios do become reality? Let’s look at each in turn.

We are in this together

A number of pension systems around the world in the current day reflect elements of this scenario. Primarily driven by the prominence of trade union bodies, collective pension funds are commonplace in countries such as Australia, Italy and the Netherlands. Many of these collective funds are defined contribution (DC) in nature, and this approach is likely to become more common as employers bite the bullet to finally withdraw themselves from collective defined benefit (DB) plans, instead establishing individual DC plans or participating in collective DC plans arranged on a multi-employer basis.

When managed prudently and professionally, collective plans can certainly help to improve benefit adequacy. For example, multi-employer DC plans in Australia have been instrumental in driving down member fees and in adding features to the plan that help employees customize and improve their savings. However, the current pension environment demonstrates that - unless we have conviction, strong incentives or significantly improved education - member apathy or lack of knowledge is likely to mean that a DC plan may be insufficient to provide an adequate retirement income, because employees simply are not contributing enough to DC plans.

As awareness of what constitutes an adequate retirement income grows, as well as of how this adequacy may be achieved, perhaps this can be built into the benefit design of collective plans, which then may thrive under this scenario. Examples of possible plan enhancements include:

The final point may appear somewhat strange now, but in the future, it would make more sense. The employer would be required to contribute at a fixed rate and at a reasonable level, and members would contribute the balance of the cost. A collective vehicle would be an ideal structure for such a plan, for several reasons:

A number of barriers would need to be overcome with such a structure. For example, to what extent should future generations bear the cost (or benefit) of current economic circumstances? Contribution rates may need to vary considerably in order to allow for speedy recovery of deficit or distribution of surplus, such that the current generation bears most of the current risks. There may need to be limits and restrictions set upon the salary link to ensure that groups with moderate and steady salary increases do not subsidize the benefits of the high risers.

Extreme as it may be, this is a concept that employer and employee groups could start to consider; it has the benefits of risk reduction for the employer, much like the recent move from DB to DC plans, and it also has a more certain outcome for employees, akin to a pension insurance contract. And here is an example of this approach: In 2005 Don Fuerst, a retirement consultant, actuary and client manager in Mercer’s retirement, risk and finance consulting business, outlined another approach to sharing risk, the Retirement Shares Plan. See also our 2006 article on the subject.

There are other aspects of “We are in this together” that we are already seeing. Opt-out systems were mentioned earlier, but also a trend toward automation – auto-enrolment, escalation of contributions, lifecycle funds, etc. These features will generally have a greater impact on younger, lower-income workers, and hence serve to help this group to improve their retirement savings.

You are on your own

In effect, this scenario is a more extreme version of the current path of pensions – with significantly less reliance upon social security support and greater responsibility for individual pension provision. Under such a scenario, the current pension structures are unlikely to succeed for two key reasons: 1) employees currently have insufficient financial knowledge to successfully manage both the accumulation and the decumulation phase, in which the accumulated pension assets are converted into a sustainable pension income, and 2) structures for the decumulation phase need to be more flexible to allow for choice and planning.

Taking financial education first, the move from DB to DC plans has increased the need for financial education, and markets are beginning to respond. In the UK, both the financial regulator and a publicly funded pensions association now offer free financial education workshops in the workplace to individuals and employers. The aim of these workshops is to introduce basic financial knowledge: understanding of basic financial concepts - budgeting, debt management, etc – that may be used as the backbone for financial decision making. However, there remains the need for more detailed financial education, particularly about investment markets, before individuals will be able to make wise investment decisions.

Such education will become even more important in this scenario, not only because individuals are taking greater control, but also because this control will be handed to them in a period of economic slowdown and financial crisis.

Flexible options in the decumulation phase are also imperative under this scenario. Lump sums, spend-down vehicles, and annuities all have their place in pension systems around the world. However, no single economy has successfully combined all three. Some systems require most or all of the accumulated benefit to be paid as a pension or an annuity, while others offer lump sums without a sufficiently deep market to use such lump sums in the purchase of annuities, or to invest and spend down. A successful market driven by individual responsibility will require elements of all three: lump sums in order to meet immediate financial needs (removing debt, meeting medical expenses, etc), the security of annuities, and the flexibility of spend-down vehicles for estate planning and for those wishing to take greater financial and longevity risks.

Where permitted by local regulations, employers may be in a position to drive this flexibility now, via the introduction of options through their existing corporate plans or through demanding such features when choosing providers. An employer making this effort to assist its employees to take control is likely to see that favor returned through a more engaged and loyal workforce.

Present planning for future gains

The range of features discussed above – collective thinking, financial education, flexibility in decumulation – are important considerations should the pensions world progress down the roads of “We are in this together” or “You are on your own.”

But what if the world does not progress in those directions? Collective member-risk DB plans may not be created, or a reversal of the downward trend in social security coverage may reduce the need for financial education in pension plans or for highly evolved spend-down products.

However, collective thinking in the planning of future pension policies may help to develop systems that produce more equitable and adequate benefits. And financial education linked to pension plans may help to improve knowledge of mortgages, credit cards and budgeting in retirement. That doesn’t seem to be such a waste of effort, whichever way the world goes.

Maybe we can have the best of both worlds – or was that three?

Additional reading:

Gullible’s Travels, Part III: Capturing the aging workforce to stay competitive 

The world's population is aging at an unprecedented rate. This article examines the effects of an aging workforce and explores how businesses can achieve competitive advantage by keeping older employees in the workforce longer and leveraging their skills. (17th edition: 2008 Perspective)

Finally, a defined benefit plan without volatility!

Here we take a look at a recent innovative plan design - the Retirement Shares Plan - that might be ideal for plan sponsors who want to maintain a defined benefit plan for their employees, but reduce their exposure to investment, interest rate, and mortality risks. (Sixth edition: 2006 Perspective)