The DC effect

As a result, increased scrutiny of DC plans is imminent in many markets, while in others it has already arrived.

A key criticism of DC plans is that the participant controls the investment selection and may be ill-equipped to do so. Citing a study by the Employee Benefit Research Institute which found that nearly one-quarter of U.S. 401(k) plan participants aged 56 to 65 had more than 90% of their account balances in equities at the end of 2007, the report’s authors explain that poor asset allocation choices represent a major challenge for DC.

“Post-crisis, it is clear that the DC model needs to be strengthened,” says the report. “Many employees will choose to participate in DC plans at such a small level that the end result will be unsatisfactory regardless of market conditions. Worse, some may not participate at all. And as we have seen, many participants have inappropriate asset allocations. Should a large percentage of DC pension fund participants find themselves with inadequate retirement funding—as some U.K. experts project—there will be massive social consequences.”

This situation points to the return of a more paternalistic role for plan sponsors, which many are already embracing. U.K. plan sponsors that have both DB and DC plans are increasingly appointing one overseer for both, while changes to the U.S. Pension Protection Act have provided for 401(k) plans to add an auto-enrollment feature to increase participation.

Regulation
The report urges regulators to concentrate on both short- and long-term issues, including improved incentives to expand participation, increased access, better tools for evaluating risk, strengthened rules for enhanced disclosure and transparency, and renewed emphasis on investor education.

Regulatory efforts will also need to account for policy initiatives affecting global financial systems such as new rules governing derivatives and alternative investments, as well as systemic risk mitigation and asset valuation.

DC-related issues that require regulators’ attention include enhanced risk management and governance, along with questions of disclosure and conflicts of interest. Efforts to improve financial literacy will be needed and policymakers will need to take into account the potential downstream effects on pensions.

Fiduciary oversight
While government authorities charged with pension plan oversight have already increased their efforts, there is growing recognition that governance issues—affecting investment strategies, agreement on plan design, fiduciary requirements and risk-based controls—also merit further attention. The report’s authors suggest it may be time to consider new ways of understanding fiduciary responsibilities.

The crisis has also prompted questions about how to strengthen overall effectiveness of plan governance structures, and best practices suggest that a focus on plan design and participant education may be most effective.

“Recent events strongly suggest that DC plans may find it useful to leverage the accumulated experience of DB plans, particularly with regard to enhancing DC governance standards and processes,” says the report. “Moreover, as witnessed by the interdependence of pension funds’ performance in an increasingly globalized financial framework, the crisis also raises the question of whether it is time to consider globalized institutional approaches (for example, the type of pension pooling vehicles that are emerging in Europe) to manage DC plans.”

The authors suggest that the greatest insight from the crisis is never to underestimate the value of education, for both fiduciaries and all other stakeholders.

“Without up-to-the-moment education in skills and knowledge, fiduciaries will be unable to exercise the full duty of care assigned to them, including monitoring those to whom they delegate operational responsibilities. And without a focus on educating all plan stakeholders, pension plans’ fundamental objectives may slip from view, with calamitous consequences. In essence, all stakeholders share responsibility for keeping pension systems as healthy as possible.”

New DC plan models
The report cites a growing realization that shifting retirement choice (and risk) onto individuals does not make pension risk disappear. Instead, transferring the investment risk to individuals carries its own risk that governments, corporations and citizens will ultimately end up paying when pension savings prove inadequate to meet in-retirement needs.

As a result, increased expectations are being placed on the private pension market. For voluntary DC plan models to work well, members must be given a good reason to participate in the first place. The level of savings is a central issue, and investment options must strike a balance between offering sufficient choice without bewildering members and thereby discouraging participation.

Developing a more outcome-certain income stream for the draw-down phase has also become more challenging as guarantors for annuity products back away in many markets and retiring workers look for ways to draw an income while allowing assets to continue growing.

“If the recent financial crisis illustrated one thing, it is this: individuals cannot be relied upon to plan their optimal retirement funding alone. And, because DC represents the future in many markets, it is incumbent upon the financial services industry to work creatively and collaboratively with other stakeholders—including policymakers—to solve one of the most compelling social challenges of our time: ensuring sufficient funding to support a decent quality of life in retirement for an aging population.”