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DC comes of age

Foresight looks into the future of defined contribution (DC) pensions.

Long gone are the days when employees could sign up to a final salary scheme on joining a firm and stuff the details away in their bottom drawer – only to retrieve a shabby, ageing, dusty file at 65. Today’s plan is invariably DC, and in future, the name of the game will be not just pensions but workplace savings.

Such plans demand more engagement from both employers and employees to ensure good returns. Indeed, many employers could do more to improve the retirement prospects of their workers.

According to Mercer’s 2009 DC pension survey, less than a quarter (24 percent) of employers monitor the adequacy of members’ retirement benefits from their DC plans. Only 34 percent monitor the investment options selected by members. In future, following the Investment Governance Group consultation, governance of DC plans is likely to be more rigorous. Contract-based plans will be forced to have a governance policy on accountability, delegation, fund choices, default strategy and communications with members. The attitude from the Pensions Regulator could be comply or explain.

Employers and employees stand to gain by closely monitoring their plans. Andy Parker, Principal at Mercer, says that where plans have been running for a while and have sizeable chunks of money in them after even five years, “It might be worthwhile going back and renegotiating a more favourable management fee.”

In another few years people who have known no other provision than DC will be retiring. Will the predominant DC plan of the future be trust or contract-based? Fifty-one percent of the National Association of Pension Funds’ 2009 Survey respondents have trust-based schemes as their main DC arrangement.

However, use of contract-based plans has continued to grow: for the half of DC provision that is contract-based, 30 percent are group stakeholder plans, 18 percent are group personal pension plans and 2 percent are group self-invested personal pensions (SIPPs).

Some companies are diversifying their offerings. Andy says: “Some have a very focused DC pension for most employees, with a group SIPP for those who know what they are doing. Others have introduced a corporate SIPP for all employees.”

The message of the moment is flexibility. The age of the paternalistic employer insisting on employees joining the pension scheme is dead, especially with the government’s proposals for the National Employment Savings Trust (see this issue’s article on Personal accounts).

Students come out of university at age 22 or 23 with thousands of pounds of debts. They want to get on the housing ladder, get married and have children. The last thing they want to do is to lock up money for 30 years, so three- to five-year savings plans (albeit with less favourable tax advantages) with the possibility of transferring to a pension plan later will become more popular.

Third-generation DC will have a whole raft of alternatives, explains Andy. “There will not be just the firm’s pension plan on offer, but a retirement savings scheme which could include a pension, a cash account, an individual savings account (ISA), save-as-you-earn schemes and share incentive plans.” A corporate wrap account could give access to corporate ISAs, where contributions could be paid directly from payroll, share account and SIPPs.

“The new tax rules have disenfranchised higher earners from pensions, so different savings vehicles will also be devised for them”, adds Andy. More junior employees may also like their flexibility.

Contract-based options will see more target date funds, lifestyle and diversified growth fund choices. Total reward statements will become commonplace. There will be a portal for both employers and employees, with a link to HR and payroll.

“Technology will enable targeted communications and end the one-size-fits-all of the old days. You won’t be sending 25-year-olds communications on the retirement process. Similarly, you won’t be telling 64-year-olds about new high-risk equity growth funds”, says Andy.

Meanwhile, at retirement many employees will take the biggest single spending decision of their lives. Andy emphasises: “The wrong decision will stay with you for the rest of your life.” Not enough employers have adequate support for their employees at this stage. On joining the pension plan there may be a raft of communication – booklets, e-mails and dedicated websites – but too many are left to sink or swim and may end up floundering in acronyms and jargon, from open market options to unsecured pensions, as they approach retirement. Face-to-face support is vital to help individuals address their personal issues and concerns. To this end Mercer holds a number of educational pre-retirement seminars each year to help employees prepare for this life-changing event.

According to the Mercer 2009 DC Survey, less than 40 percent of employers offer members assistance when converting DC funds to a retirement income. Andy explains: “The plan sponsor, by not providing advice at this stage, loses all the kudos gained through operation of the plan.”

Both employers and employees must remember that retirement saving is a marathon, not a sprint, but regular pit stops for check-ups will help to ensure the ultimate prize of a happy retirement.

Measuring the pensions climate

As we approach the decade when the first generation of lifelong DC members will retire, employers should consider the long-term impact of DC pension provision on their businesses.

Increasingly, they may find it more difficult to predict when their workers will retire.

People’s ultimate pensions will vary depending on a number of factors, including the size of the pension pot and market conditions at the time of retirement. Some, particularly highflyers, might retire early if their pension pot is large, and HR may not be prepared for the loss of key people. Equally, should the pension underperform, people will not be able to afford to retire.

Steve Charlton, Principal at Mercer, says: “To manage the uncertain timing of retirements and the impact on their businesses, employers should begin to form a better picture of the adequacy of the benefits in their pension scheme.

“Keeping an eye on how well their employees are preparing for retirement will also provide a good idea of when they are likely to retire. And there is an opportunity to step in and provide guidance if needed.”

With this in mind, Mercer has developed a new tool – the DC Barometer – which shows changes in annuity and investment markets, as well as contribution levels, and can influence the expected retirement age and income of DC pension plan members.

For example, comparing stock market conditions and annuity price movements at the end of December 2009 and the end of December 2008, Mercer’s DC Barometer shows that a sample scheme member considering retirement will now have to work around 15 months less in order to retire on the same expected income.

Steve explains: “At the worst point in March 2009, members would have found themselves working until age 67, instead of 65, to achieve the same level of income.” This example is based on a member in his/her 50s, with combined annual employee and employer contributions of 12 percent of salary and an existing pension pot of £200,000 at December 2008.

Steve concludes: “If it is this difficult for a member to plan the best date for their retirement, this difficulty is only magnified for employers considering succession, recruitment and replacement – not to mention the prospect of an ageing workforce”,
he adds.

Optimising schemes with Mercer’s DC MOT

As DC schemes become the main source of retirement savings for the majority of employees, it’s time for plan sponsors and trustees to do all they can to optimise those schemes. In response to this, Mercer has developed the DC MOT™ – the Mercer Optimiser Tool for DC schemes – a means of putting existing DC arrangements through a rigorous, best practice-based process to determine whether the optimal scheme is in place to meet members’ objectives.

The DC MOT consists of a 10-point checklist illustrating a range of diagnostics. It begins with a focus on strategic objectives; then progresses through member profiling; contribution and investment strategies (can they achieve benefit adequacy?); default arrangements that adapt investment strategies to different circumstances (rather than to a one-size-fits-all approach); the challenge of self-selected choices (ensuring that members have an adequate range of fund choices and review them in a timely fashion); and the return potential of alternative fund choices (to provide a more consistent return than that of equities).

The DC MOT then focuses on active monitoring of the scheme’s investment options; the effectiveness of its member communications; and, finally, whether the governance structure supports the trustees’ objectives. Relying on the strategic framework of the DC MOT, sponsors and trustees can better assure employees that an optimal DC scheme is in place to support retirement success.

Time to make an informed choice

The number of people who crystallise their benefits early significantly increased before the change in the minimum retirement age.

“We experienced a 16 percent increase in the volume of retirement quotes, compared with this time last year. It’s a direct response to the increase in the minimum retirement age from 50 to 55”, says Jill Robinson, Head of Client Service Delivery in Mercer’s Outsourcing business.

Before 6 April 2010, anyone with a personal or occupational pension was able to draw their benefits at 50 and take their tax-free cash. Now, people between 50 and 55 will need to wait for up to five years before they can do the same (except, of course, those with a protected retirement age or through special circumstances such as ill health).

Meanwhile, the potential removal of the default retirement age (see panel) may give employees more control over how long they work. The default retirement age has traditionally set the timescale for discussion between employer and staff. Jill warns companies against leaving it too late.

Experience shows that planning tends to be last minute and, as she says, “an employee turning 52 next year may not have realised that he or she may have missed the opportunity to retire early”.

Managing different generations in the workplace will become increasingly important. Jill adds that expectations of retirement are changing: “People need to be financially aware but also understand the implications for their wellbeing. Companies should do everything to help prepare employees – it’s a duty of care.”

For more information on DC pensions and retirement solutions, including Mercer’s DC Barometer and the DC MOT tool, visit our DC minisite or contact your local consultant. In addition, more information on Mercer’s Pre-retirement Seminar can be found here.