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Industry Voices

Commentary: DC plan customization to drive next wave of innovation

"We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next 10." Bill Gates, in "The Road Ahead."

The defined contribution world is poised for change. It will take time — $20 trillion systems aren't transformed overnight — but don't let that fool you into underestimating just how big the change will be.

It helps to have a global perspective. While each market is driven by local factors and most of the conversations are local, there are global themes that underlie the changes. A clearer picture emerges when we look through a global lens.

One theme across most major markets is an increased focus on lifetime income provision. DC is meant to provide income that supports participants throughout retirement. But in its early days, DC was all about the accumulation of assets. That's understandable: the payout phase was not a high priority when the system was largely a supplement to defined benefit plans and retirement was many years away. Today, it's a more mature system and the primary source of retirement security for tens of millions of workers. So it's not enough to grow a pot of assets; those assets need to be converted into a stream of income.

So lifetime income is one global theme. And it is likely to be an area of increasing emphasis everywhere there is a DC system that is moving from middle age to maturity.

And lifetime income provision is an area that cries out for innovation.

What makes managing the payout phase difficult is that some individuals live longer than the average. And some individuals live a lot longer than the average. So this is really a problem of insuring against an unexpectedly long life. But how to do it? Various solutions have been suggested, but none has become the dominant approach.

The investment industry is generally very effective in creating products that respond to demand. That's the key question here, though: Demand for what? Most individuals approach retirement with just a general sense of what they believe to be possible, and a loosely defined set of preferences. This is not an optimization challenge; it's about understanding and creating clarity around what retirees really need when it comes to lifetime income and longevity insurance and then crafting a solution.

Another question related to lifetime income — and also begging for innovative thinking — is reporting. If the system really is focused on delivering income, not just on accumulating assets, then shouldn't reporting reflect that focus? After all, what gets measured … well, you know the rest.

So lifetime income is a big area of change, and it's only going to become more evident throughout the system over time.

New developments

This evolution of DC can be thought of as being a move from version 1.0 to version 2.0. Of course, the system won't stop there; there's always a next version, a new area of development. For DC, we believe another wave of innovation is going to come through customization.

DC assets don't exist in isolation, so better answers can be found when we take into account the whole of a participant's balance sheet. So we expect version 3.0 of DC to be characterized by hypercustomization: fitting the solution to the exact circumstances of the saver. That's not really just DC any more, of course, it's more comprehensive than that. Again, this will call for innovation, and it could be a huge opportunity for those who can find solutions that resonate with savers.

These changes are taking place against the backdrop of a shake-up in the nature of the institutions through which DC services are provided. This change has been most obvious to date in Australia, where industry funds and master trusts already have largely displaced single-employer funds.

Master trusts also have grown rapidly in the U.K. since the introduction of auto enrollment in 2012.

And talk of open multiple employer plans is now widespread in the U.S., as a way to extend coverage among private-sector workers who lack access to workplace-based retirement vehicles. These, like the U.K. and Australian master trusts, involve roles and responsibilities that traditionally fell to employers being taken on instead by a platform provider. Open MEPs are now in a strange regulatory limbo, and I'll make no specific predictions about where that's going to end up. But a greatly increased role for a master-trust-like platform of some sort in the U.S. is certainly possible, and arguably probable, in the next few years.

As platforms take on a greater role around the world, supplementing and in some cases replacing employer-run DC plans, this will change the dynamics of the whole system. Platforms must compete with one another in a way that employer-based DC plans do not. They have a greater incentive to be proactive in improving the solutions they offer, in customizing, and in how they engage with plan participants. In short, to innovate.

Finally, let's reel it back in to the present. There are plenty of areas where innovation within DC is needed in the short term, too: improving coverage; ensuring contribution levels are adequate; further developing the choice architecture; and managing leakage from the system.

An area that's especially ripe for innovative thinking now is the question of sustainability in DC. There's a noticeable shift occurring in attitudes, with the financial importance of this area being increasingly recognized. That shift has big implications for fiduciaries. Not only do fiduciaries need to ensure they do not sacrifice financial benefit with their actions, they also need to ensure they do not create negative financial impact by failing to consider sustainability issues. It does not make the fiduciary role any easier, but sustainability is becoming hard to ignore. A handful of organizations globally are leading the way in this area; again, the global lens is helpful in getting the full picture.

With all these issues in play, the need for innovative thinking in DC is as pressing as ever. The DC ship might turn slowly, but it is turning; the origins of the changes outlined here go back, in some cases, many years. The increasingly prominent role of DC has brought with it new responsibilities and new expectations, new challenges and new opportunities.

Bob Collie is head of research in the Thinking Ahead Group, an independent research team at Willis Towers Watson PLC, and executive to the Thinking Ahead Institute, based in Reigate, England. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.