With UK defined contribution (DC) assets expected to reach GBP 829 billion by 20221, many plan sponsors are reassessing how best to position scheme design to deliver more successful retirement outcomes. J.P. Morgan's UK Defined Contribution team evaluates three critical factors that determine whether or not DC members will be able to achieve their retirement income needs - saving, investing and spending.
While simply offering a DC scheme may have seemed like enough in the past, a growing amount of research is highlighting the important role plan sponsors can play in helping members make the most of these offerings. For example, sponsors can introduce strategies to help members save more and provide default funds with optimised risk/return profiles that maximise pre-retirement asset accumulation potential. They can also help members define their retirement income needs to help smooth the transition to retirement. Deciding how to approach each of these key areas starts by setting realistic measures of what the scheme is designed to accomplish. This goal can then be used to inform overall scheme construction to help increase the number of members positioned to cross the retirement finish line with a more secure level of retirement income.
The UK pensions and retirement market is in the midst of a hugely transformative change, as assets continue to shift rapidly from defined benefit (DB) schemes to DC schemes. DC assets are expected to exceed DB assets by 20202. This remarkable transition carries tremendous ramifications for companies offering DC schemes and participating members alike.
As DC schemes become the main retirement savings vehicle for a growing number of workers, many sponsors may find themselves reviewing their offerings in context of this new, changed landscape. In our conversations with scheme sponsors, advisers and other providers, we find that many begin DC discussions by weighing up which type of investment offering might make the most sense for their members. This is a crucial decision, of course, but it is only one factor in delivering a successful solution. We believe a stronger starting point is the more encompassing, fundamental question:
What does the company hope to achieve for members with its DC offering?
Articulating this goal can help introduce an outcome-focused approach to help companies make smarter, more holistic DC choices that strengthen not only investment selection but also overall scheme design as well.
The DC structure represents a unique partnership between companies and their employees. Sponsors can offer an industry- leading DC solution, but members must also do their part.
A scheme's success rate largely hinges on the interaction of three critical components that ultimately remain under member control: how much the member saves, how the funds are invested and when and how assets are withdrawn. Companies, however, have a very real ability to place a greater number of members on a prudent DC path by influencing constructive behaviours through strategic scheme construction. To accomplish this successfully though, they must first develop a clear vision of what they want that path to be and where it should lead.
The article that follows examines current industry trends and key points to consider in each of these three key areas. Assessing plan design from this broader perspective can help significantly enhance overall scheme effectiveness. Indeed, these opportunities make it an incredibly exciting time to be part of the UK DC market. Working together, companies, legislators, advisers, consultants, administrators and providers can apply this type of outcome-based thinking, to help develop and implement strategies that increase the odds that as many members as possible, cross the retirement finish line, safely and securely.
A major retirement market shift
DC assets continue to grow at a remarkable pace, and this trend is expected to gain even more momentum and is due to two key factors. Firstly, DB plans are now largely closed to new members and many are closed to future accruals. Many employees may find that the transition from a world of DB certainty to "you-are-on-your- own" DC is unpalatable. Evidence to date shows that the majority want their scheme sponsor to "do-it-for-them". Secondly, the number of DC members is forecast to more than double in the next decade, from six million today to 16 million by 20203 and many of these people have most likely never saved for retirement before. Both of these drivers mean that the design of the default offering is critical and how scheme sponsors navigate the opportunities and challenges presented by this will shape the potential retirement outcomes of members for many years to come.
Key points to consider
- What is the goal of the DC offering?
- How does the scheme sponsor view its role in helping to determine successful member outcomes?
- Does scheme design align well with overall corporate strategy?
- How do decisions around the intricate balance of cost, implementation ease and good governance improve or hinder member outcomes?
Saving: Are members saving enough?
On a positive note, the UK has introduced automatic enrolment legislation that will get more employees saving for retirement, though questions still remain about minimum contribution rate levels, which start at 2% and escalate up to 8%. This is far below the average DB contribution of 21%4. Hence, most DC members are likely to end up with smaller retirement nest eggs to draw on compared to a DB option. Complicating this issue is the fact that behavioural research indicates most people tend to tune out once they have been automatically enrolled in a scheme.
Although it may seem that members are saving at a healthy rate with consistent increases, averages still remain notably lower than comparable DB contributions.
The only way members can ensure they will be able to retire when and how they want, is to save enough - and current savings patterns may mean that many risk falling short.
Key points to consider
- What are the demographic and saving patterns of the scheme?
- How can sponsors help minimise the number of members who opt out and encourage members to contribute more than legislative guidelines?
- Are there specific strategies that have proven to be successful at increasing member engagement?
- How might inertia and other behavioural insights be used to help members secure more retirement income?
Investing: What is the most prudent default fund option?
The vast majority of members - roughly 85% - are currently invested in default funds, typically balanced or lifestyle funds. This high percentage is good news given that most members lack the knowledge, time or inclination to manage their own retirement assets in an effective manner. Though the most appropriate default fund option will largely depend on the specific scheme's goals and member needs, we believe target date funds in particular offer compelling benefits for members and sponsors by offering significantly improved risk/return profiles and enhanced outcome potential.
Target date funds typically provide broader asset class diversification and active professional management to adapt to changing market cycles, with reduced equity and risk exposure, relative to the average lifestyle fund, while pursuing attractive outcome-oriented returns.
This focus on improving risk/return tradeoff offers a more controlled performance range with less potential downside exposure - offering a steadier path to more successful expected retirement outcomes.
Key points to consider
- How reliant will members be on their DC scheme assets in retirement (greater reliance usually translates to a greater need for less risk exposure)?
- How is the default fund expected to perform in a range of market conditions, as well as across full market cycles?
- Does the default fund achieve an appropriate risk/return profile for members?
- How much downside risk is embedded in the default fund, particularly in the years leading up to retirement when members may not have time to recoup extreme losses?
Spending: What happens at retirement when withdrawals begin?
The goal of helping members reach sufficient retirement funding is firmly linked to sound corporate governance and workforce management. Sponsors need to define a target replacement income for the plan as a whole. This helps determine the amount required to secure at least a minimum level of income replacement. In essence, this is the member's "retirement finish line," and we believe a prudent scheme goal is to strive to maximise the number achieving this asset level at the point of retirement.
Today, members generally draw most of their retirement income from DB scheme assets, but DC schemes are largely expected to replace this source in the future.
Currently, 95% of members purchase an annuity when they withdraw scheme assets (many before they retire), but rapidly changing legislation and product innovation, as well as relatively low annuity rates, are driving the need for expanded future choice.
Key points to consider
- When do DC scheme members typically withdraw their assets after retirement and how might this change as DB benefits decline?
- How many members may need to push back their retirement dates if their DC assets fall short?
- What are the corporate implications of a workforce that cannot afford to retire?
- What are realistic retirement replacement income options based on best-and worst-case balance outcomes?
Securing stronger member outcomes through scheme design
J.P. Morgan can help sponsors and their advisers evaluate how the answers to these key points can be used to increase overall DC scheme effectiveness. Our team of DC specialists can provide actionable insights into how to:
- Set a realistic, measurable DC goal. Without a clear vision of what the scheme seeks to accomplish, sponsors risk offering a DC option that fails to unlock the full potential of a well-designed retirement platform. At best, this may expose members to greater outcome uncertainty and, at worst, might even result in unintended consequences that could prove detrimental to success.
- Develop practical strategies that address real-world member behaviours. Sponsors can increase positive saving, investing and spending patterns by applying industry best practices tailored to their specific scheme demographics. Companies have access to a wide range of member data that can help uncover areas of scheme strength, as well as identify opportunities for improvement.
- Provide investments that help members make the most of their retirement assets. DC investing may soon represent members' best chance to maintain their standards of living in retirement. The fact remains, however, that markets will not always work in their favour, as evidenced by the past decade's heightened equity volatility and current low annuity rates. Investments with too much embedded risk can be disastrous when markets sour, especially in the critical years before retirement, but playing it too safe can be equally problematic, providing members with too little return over the long term. Default funds and other investment options can address these realities by applying risk efficiently through broader diversification and professional managemen to help better navigate changing market conditions and capture improved long-term return potential
By applying an outcome-focused approach to scheme design, sponsors can potentially reduce some of the uncertainty that can often surround the DC framework and help members achieve a more secure retirement.
- Source: Spence Johnson, 2013
- Source: Oliver Wyman, 2012
- Source: Pensions Policy Institute, 2012
- Source: ONS Pensions Trends Paper 2012 Edition