I start from a belief that the contribution rate is one of, if not the, most meaningful pieces of information for a defined contribution (DC) saver. It reminds them how much pay they are giving up month in, month out, and how generous or otherwise their employer is. It is certainly more meaningful than an annual statement of the accumulated account balance.
However, the thought here is whether we could convey even more meaning through the contribution rate, perhaps via a set standard, akin to performance reporting following the global investment performance standards (GIPS).
The thought was triggered by a comparison between the Dutch and Canadian defined benefit (DB) markets. In essence the Dutch system is run on a solvency basis, so the accrued liabilities should be fully funded at all times in case the sponsor suddenly goes bankrupt. The liabilities are therefore discounted at a government bond rate – say 2.5 per cent for indicative purposes.
All safe and secure, but the contribution rate needs to do most of the heavy lifting as any mismatch between assets and liabilities is very risky and needs to be closed down quickly if things start to go wrong.
The Canadian system is run on a going-concern basis, where the sponsor is assumed to continue to make contributions, and discount rates tend to be around 5.5 – 6 per cent. Here the heavy lifting of future provision is split between the contribution rate and investment returns.
There is much that could be debated about the two systems, but let us instead lift this thought back into a DC context.
A DC saver could smooth their lifetime consumption needs the Dutch way or the Canadian way.
For the time being, let’s keep the pension the same in both cases. We could therefore offer a choice to our DC saver between a zero-risk pension outcome albeit at a contribution rate of, say, 45 per cent of pay a year (Dutch) and a contribution rate of, say, 20 per cent (Canadian) but with a higher level of risk associated with disappointing investment returns and sponsor failure (albeit hard to quantify).
While observers may have a strong belief in which is better, we have actually set these up to produce the same result. What differs is the risk.
And my question is, are we doing a good enough job in communicating risk to end savers in terms they can understand?
A new approach to explaining riskis
Now I admit, quoting a 45 per cent contribution rate in a DC context may not be the best way to go – in fact it could have the unintended consequence of lowering pension saving (“what’s the point!”). But a 45 per cent contribution rate buys you the DB gold standard: retire at 65 on a 67 per cent replacement ratio, likely inflation-indexed, and payable no matter how long you live. Perhaps we define the DC gold standard at a lower level.
In Australia the industry body, the Association of Superannuation Funds of Australia (ASFA), publishes income levels associated with a “moderate” or “comfortable” retirement.
We could re-label these as we liked – bronze and silver, say – but we could agree on a set of parameters that were consistent with a number of retirement outcomes – so moderate or bronze requires a (say) 15 per cent contribution rate, while a 20 per cent rate gets you silver.
I am not underestimating the difficulty of agreeing on the necessary parameters and assumptions (mortality, inflation, returns, age of retirement, etc) but that would only be necessary if the idea has any merit.
The framework could be developed further. Member engagement would now be centred on the contribution rate.
Imagine the following possible communications:
- “Investment markets have been weaker than expected, so we calculate that you will need to raise your contribution rate from the current 15 to 15.25 per cent to maintain your target of moderate or bronze outcome. Alternatively, you could raise the level of your investment risk and leave your contribution rate at 15 per cent – but this is highly likely to increase the future variability of your contribution rate. If you leave the investment risk at the current level and do not raise your contribution rate by 0.25 per cent now, we calculate that you will need to raise it by 1 per cent in five years’ time to stay on track.”
- “Investment markets have been stronger than expected, so we calculate that you have built a small buffer relative to your target of moderate or bronze outcome. We would advise that you take no action as the buffer is small, but the following options are available to you …” The options would include lowering the contribution rate, lowering investment risk (to lock in gains), raising investment risk (buffer) or raising the target outcome (with accompanying contribution rate or investment choices).
To recap: the point of this article is to consider one way to improve member engagement and better empower the end saver by offering choices in terms that are meaningful and understandable.
The underlying belief is that the contribution rate is very meaningful to the end saver. The idea proposed is that we should make more of the contribution rate and the associated risks it brings or addresses.
Tim Hodgson is head of the Thinking Ahead Institute