Global lessons in DC plan design

As this global shift to DC plans continues, the potential consequences of financial illiteracy on the overall well-being of everyday citizens has become a pressing concern for governments everywhere. Many have begun to take active steps to address the problem. In 2009, Canada established a federal Task Force on Financial Literacy. Its 2011 report, Canadians and Their Money: Building a brighter financial future, makes several recommendations for improving the level of financial knowledge of Canadians across all demographics. The difficulty, however, is that improvements to financial literacy will take generations to achieve, and although initiatives to improve financial literacy hold hope for the future, plan sponsors still need to deal with the present.

The three autos
The time and/or inclination challenge is observed in DC plans globally, and a key buzzword used to capture it is inertia. DC plan members display inertia in numerous ways, the most common being that they often remain invested in the portfolio they selected or were defaulted into when they entered the DC plan and continue to contribute at the rate they first chose when they entered it. This has led to a focus on the three “autos.”

Auto-enrollment: Instead of members being left to decide whether or not to enrol in a plan, they are automatically enrolled and then have the right to opt out. This is the new approach introduced in the U.K. starting in 2012, to address the concern with members never joining a plan. (By law in the U.K., occupational pension plans could not be compulsory.)

Auto-escalation: The member joins the plan and starts contributing to it at a low rate. As time goes on, the contribution rate automatically increases. This approach is particularly helpful in getting members into the plan at a manageable contribution rate and then slowly increasing that rate over time until it reaches a level more likely to generate a reasonable income in retirement.

Auto-investing: The key example has been the use of target date funds (TDFs) or lifecycle funds as the preferred default option for DC plan investments. With these funds, which follow lifecycle investment principles, younger members are invested in more aggressive, higher-risk portfolios, but, as they age, the riskiness of their investments is automatically reduced.

Canada’s lessons
How would Canadian plan sponsors implement these auto features?

Auto-enrollment is far less of an issue in Canadian DC plans that have either a compulsory membership or a base employer-paid contribution. However, auto-enrollment is a feature being considered for pooled registered pension plans for Canadians who currently do not have access to a DC plan, to address a concern that many Canadians do not save for retirement simply because a plan is not made available to them.

A variation on auto-enrollment that could have applicability in Canada is in plans where members automatically (or on a compulsory basis) join a DC plan but generally contribute at the lowest level. One way to address the level of retirement provision would be to consider enrolling members at a higher contribution rate and then allowing them to elect to “step down” to a lower contribution rate if they wish.

Auto-escalation is a concept that could also be used in Canada. But it may have less applicability than in the U.S. or the U.K., where, in general, DC contribution rates are lower. In Canada, contribution rates are often higher than in the U.K. and the U.S. (although, in many cases, higher contribution rates would still be more desirable), and the overall limits on tax-sheltered contributions are a further constraint, so the effectiveness of auto-escalating contributions is more limited.

Auto-investing is a familiar concept in Canada. TDFs and lifecycle funds are being increasingly added to Canadian DC plans and used prospectively as the default investment option for members who do not provide investment instructions. A greater challenge is how to switch current inert members to auto-investing funds. The desire to move these members toward auto-investments will be a continued focus in Canada over the next few years.

Foundation phase
There are other developments taking place elsewhere. An interesting one has been with the design of TDFs/lifecycle funds in the U.K., where a “foundation phase” has been introduced, most notably by the National Employment Savings Trust (NEST). (See the diagram on NEST’s approach to target date/lifecycle design, below.)

The principle behind the foundation phase is that in the early years of accumulation it is more important to get members to learn strong savings habits. Hence, in order to avoid members opting out of the plan, or switching their investments to cash, the foundation phase focuses on minimizing the chance of a new member becoming disgruntled with his or her investments by reducing the likelihood of negative investment returns. The theory is also interesting since, in the early years, members have very few assets, so having a lower expected return in the earlier years has a very limited impact on long-term expected outcomes.

Although the foundation phase approach is a foreign concept to North Americans, at a workshop at Mercer’s Global Investment Forum in Washington, D.C., in June, participants were asked, Should a foundation phase be incorporated into North American target date design? Forty-nine percent of the participants responded yes. So the foundation phase of a target date/lifecycle is a concept that may gain traction over time—and one that Canadians can learn from.

Crossing generations
One issue that is beginning to be addressed is the realization that our workforces today are multi-generational. We have plans and companies with baby boomer and generation X, Y and Z members and employees. There is a growing realization that these different generations have very different savings and retirement needs. In fact, for much of today’s multi-generational workforce, the notion of pension as a one-size-fits-all solution is losing its relevance, calling for a broader approach to workplace savings.

When talking to younger employees in a number of countries, consultants hear comments such as the following:

• “My top priority is to get started in the housing market.”
• “Right now I need to pay off my debts.”
• “No way am I going to tie up my savings until retirement—that’s a lifetime away!”
• “I’ll be moving around—I don’t see the point of building up lots of little pots of money.”
• “What happens if I need my savings back for an emergency?”

From a retirement adequacy perspective, one may not believe that these concerns are key to address. However, for generations that are living in the present, a broader concept of workplace savings cannot only answer some of the financial challenges they face but may also play a role in recruiting and retaining the sort of engaged workforce that companies must rely upon for long-term competitiveness.

The market that has most addressed this issue has been the U.K., ironically, since there have been younger employees pushing back on the move to auto-enrollment. But even in U.K. these discussions are certainly not mainstream. Clearly, though, there are concerns that some will not use cash/short-term savings wisely (they will spend rather than save), with longer-term implications on the ability to retire. But in an increasingly competitive marketplace, where recruiting and retaining young talent is a key prize, broader workplace solutions may warrant further discussion.

As the global DC market continues to grow, innovative ideas, approaches and solutions to tackle the challenges facing DC plans will continue to emerge, and DC plan sponsors and members will continue to benefit from them. Global DC markets can provide an interesting perspective and offer novel approaches to addressing common problems.

Neil Lloyd is a partner with Mercer. neil.lloyd@mercer.com

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