Striving to create that perfect defined contribution plan

Defined contribution plans around the world are being tweaked and adjusted as regulators continue to search for the right mix of contributions, investment choices and income streams to give participants the security once provided by defined benefit plans.

Plan design improvements have been around as long as the plans themselves. But as a tidal wave of participants approaches retirement and DC plans take on a starring role or a key supporting one in a growing number of countries, those upgrades have taken on a greater urgency.

By 2016, the growth rate for DC assets around the world should be about 8.7% — more than double an anticipated 4.2% clip for defined benefit assets, according to estimates by Cerulli Associates, Boston. Total global DC assets under management will likely reach $13.7 trillion by the end of 2016, compared with an estimated $14.9 trillion for DB.

“DC will increasingly become the main source of retirement income worldwide,” said Fredrik Axsater, managing director and head of global defined contribution at State Street Global Advisors, Boston. “In one country after another, (governments) are carrying out a total review of their DC systems.”

The extent of participation or coverage, the rate of savings, the length of time investment returns on those savings are allowed to compound, and a sensible drawdown framework are all key to making DC plans work, said Don Ezra, New York-based co-chairman, global consulting, at Russell Investments.

In recent years, regulators have continued to tweak their national DC systems — raising minimum retirement ages, expanding investment options, adjusting tax concessions, mandating default options — even in markets seen as DC innovators, such as Chile and Australia.

That applies as well to the U.K. market, one of the largest pools of defined contribution assets in the world. “The U.K. DC market is going through enormous change,” with asset managers, consultants, employers and employees all looking at plans there with fresh eyes, said Nigel Aston, managing director and head of U.K. defined contribution at State Street Global Advisors, London.

Following reforms in 2008 that required all workers be automatically enrolled in a qualified retirement plan, the U.K. government called for the creation of a national DC plan available for all employers to use. The result, the National Employment Savings Trust, London, was modeled on best practices from around the world but continues to be tweaked in the areas of investments, guarantees and annuitization. As the plan has come into being — NEST took on its first participants in 2012 — it has become a plan design benchmark, particularly for low- and middle-income investors.

Auto enrollment, which began last fall in the U.K., is expected to add an estimated 5 million to 8 million new savers, pumping assets to a projected £829 billion ($1.26 trillion) over the next 10 years, according to data from London-based investment market research company Spence Johnson Ltd. DC retirement assets in the U.K. will surpass DB assets as early as 2019, closing the 40% / 60% split of 2010 in less than a decade, according to several sources.

All DC systems involve six or seven fundamental building blocks, including adequate individual contributions, tax incentives, good systems for disclosure and education, and some control of egress, noted Donald Kanak, Hong Kong-based chairman of Eastspring Investments. Those are the areas that could see continued changes “around the edges,” he said.

Market veterans say for the most part the right mix of those building blocks has remained elusive.

For example, contribution levels remain too low, noted Paul Kelly, London-based director of benefit consulting at Towers Watson & Co. “In Europe, with the exception of the Netherlands and possibly Denmark, it's typically below 10%. That's not enough,” he said.

For some experts, Chile's DC system — launched in 1981 and hailed as a model for pension programs around the world since then — comes close.

Chile meets most of the Paris-based Organization for Economic Cooperation and Development's latest recommendations and guidelines for best practices in DC design, said Pablo Antolin-Nicolas, principal economist in the OECD's private pension unit. “It's not perfect, but quite good,” he said.

That nation's compulsory individual account DC system is set up to supplement benefits received from Chile's first-pillar public system, a government-funded, non-contributory pension subsidy, with lower-income retirees receiving more of a safety net if they haven't saved enough in their DC portfolios. Furthermore, incentives such as matching contributions are available to younger workers to encourage savings.

However, even Chile's system leaves male participants with retirement incomes of 64% of their pre-retirement incomes — the figure is just 50% for women in Chile — both less than the 69% average for all people in OECD countries, according to OECD data. Furthermore, only about 60% of the country's labor force is covered, even after recent government initiatives to expand the DC program to include self-employed individuals.

Portions of Chile's DC design have been imported by a number of other countries, including Mexico and Colombia. In Eastern Europe, nations such as Hungary, Poland and Latvia also have copied certain aspects of the Chilean model. However, in many of these systems, serious faults have emerged.

For example, following the 2008-"09 financial crisis, earlier pension reforms were reversed in countries such as Argentina, Poland and Hungary to cover budget shortfalls. While governments technically borrowed from their respective country's pension pot, the move likely will result in higher taxes or lower benefits to future retirees, sources said.

“Chile didn't do any of that,” said Mr. Antolin-Nicolas, who warned that DC plans that allow governments to tap pension savings for other purposes risk leaving participants “disenfranchised.”

Sometimes, participants themselves dip into their retirement savings.

In Asia, where combined contributions by employees and employers in countries such as Singapore and Malaysia top 20%, the ability of participants to tap savings for pre-retirement investments in property or to pay for higher education has raised questions about the adequacy of even those hefty savings rates.

Those pre-retirement expenditures, and the relative prevalence in Asia of lump-sum payouts to DC participants upon retirement, are issues regulators in the region will have to grapple with as they look to ensure their participants have an adequate stream of income in retirement, noted Michael Dommermuth, Hong Kong-based president and head of Asia with Manulife Asset Management.

“It's a struggle to find DC implementation with the right level of contribution, the right governance structure and the right design efficiency for employees,” noted Towers Watson's Mr. Kelly.

One positive in the quest for the holy grail of defined contribution-powered retirement security is a common set of challenges, some observers said. “There are subtle nuances, but overall people with DC savings are largely financially unskilled, suffer from the same behavioral biases and face the same challenges in saving for retirement, so the objectives of DC savings plans should be consistent globally,” said Will Allport, London-based vice president and DC business development manager, U.K. and Ireland, with Pacific Investment Management Co.

That doesn't preclude some important regional differences.

For example, getting the mix right in Asia is especially urgent, with the demographic complexion of countries in the region such as China, Korea, Taiwan and Singapore set to gray at an unprecedented clip in the coming two decades.

Those countries' populations are aging at two to three times the pace experienced in the West, so “time is of the essence” in bolstering retirement programs, noted Mr. Kanak.

The high proportion of working age people in Asia that helped power the “Asian miracle” of spectacular economic growth in recent decades will peak in the coming 10 years, and policymakers will want to make needed reforms while their economic situations remain favorable, added Rafal Chomik, senior research fellow with the Sydney-based Centre for Research Excellence in Population Ageing, at the University of New South Wales.

As those policymakers push to extend retirement coverage and make their systems sustainable, defined contribution — whether compulsory or voluntary supplemental plans — will inevitably become a bigger part of the picture, Mr. Chomik predicted.

Between 2002 and 2005, supplementary corporate DC schemes were introduced in China, Japan and South Korea.

The takeup in those defined benefit-dominated markets has been modest thus far, but market veterans say regulatory moves by governments in those countries — including the adoption of accounting standards that have brought pension-related liabilities onto corporate balance sheets — could add some momentum in coming years.

China's corporate “enterprise annuity” system, a voluntary program launched in 2005, had 445.2 billion yuan ($72 billion) in combined assets as of Dec. 31, 2012, with many observers describing the retirement savings vehicle's growth as tepid.

Amid a growing host of insurance and bank products, enterprise annuities are the only DC plan in China offering tax incentives to promote retirement savings, but those incentives haven't been sufficient to give the system real momentum, noted Jessica Chen, a Shanghai-based principal of Mercer's retirement, risk and finance business in China.

Over the past five years, the issue of saving for retirement has become a dinner-table topic for more and more Chinese, and government officials are eager to promote those savings, Ms. Chen said. Still, the large number of regulatory agencies in China with a stake in that issue makes it difficult to anticipate decisive moves to promote enterprise annuities anytime soon, she added.

South Korea's government, meanwhile, made it mandatory for companies there to offer employees either a DB plan or a DC plan starting in 2005. Companies have opted 3-to-1 for defined benefit, in part because their DB liabilities of one month salary for every year of employment were little different from the prior severance pay system, said Austin Kweon, the CEO of Aon Hewitt Korea in Seoul.

However, with new accounting rules adding volatility to corporate balance sheets in Korea and unusually low interest rates making it more difficult for companies to cover their defined benefit-related liabilities, defined contribution is “definitely going to be more popular in the future,” predicted Mr. Kweon.

Likewise, just more than a decade since Japanese regulators put a corporate defined contribution plan framework in place, the amount of retirement assets in those plans came to $66.2 billion as of March 31, 2012, the most recent data available, or roughly 8% of combined corporate defined benefit and defined contribution assets of $800 billion, said Junichiro Goto, a Tokyo-based director and head of DC promotion with AllianceBernstein Japan Ltd.

However, the Japanese government that came to power last November is moving to announce steps next month to promote defined contribution plans, at which time they could possibly address concerns about low annual contribution limits of ¥306,000 ($3,088) for companies that also offer a DB plan, Mr. Goto said.

In addition, a new system of individual savings accounts will be launched next year allowing investments on a tax-exempt basis of roughly $10,000 per year, in pursuit of a government goal to persuade Japanese savers to move some of their roughly ¥15 trillion ($151 billion) in low-yield bank deposits to more productive uses, he said.

Manulife's Mr. Dommermuth said such a goal should be a much broader priority in the region. Research this year by Manulife shows the window of opportunity that large working-age populations gave Asia to construct adequate pension systems has largely closed for fast-aging countries such as Japan, Korea, Singapore, Taiwan and Hong Kong. On the positive side, those countries have all built up considerable financial wealth, and persuading citizens there to shift some of the roughly 50% of that wealth currently parked in low-yielding bank deposits into riskier, but higher returning, stocks and bonds will be a key to ensuring adequate retirement income there, he said.

The window of opportunity to strengthen defined contribution plans remains open for countries with younger demographic profiles, including Malaysia, the Philippines and Indonesia, he said.

Over the past two years, Malaysia and the Philippines launched new supplementary defined contribution systems to make it possible for a broader range of their citizens to save for retirement.

While Malaysia's Employees Provident Fund has succeeded in accumulating $171 billion in individual retirement accounts for Malaysian workers, EPF data show the system's compulsory contributions of 11% from employees and 12% from employers help the average participant replace only one-third of his or her income in retirement. Meanwhile, EPF data show retirees using up their lump-sum payouts upon retirement within three to five years.

The addition of “another pillar” in July 2012 — Malaysia's Private Retirement Scheme — to supplement those EPF savings and expand coverage to self-employed individuals was a matter of some import, said Steven Ong, CEO of the Private Pension Administrator, which oversees the program.

With the additional handicap of low returns on Malaysian bonds and bank deposits, “how can you retire happily ever after” on one-third of pre-retirement income, asked Mr. Ong. With tax incentives provided to workers and employers alike, the PRS hopes to help workers saving over a 40-year career to raise replacement rates closer to roughly two-thirds of income, he said.

Although just off the ground, Mr. Ong said the hope is that the PRS can become a significant pillar of Malaysia's retirement system within 10 years.

A year and a half ago, meanwhile, the Philippines launched its Personal Equity and Retirement Account program in an effort to extend the country's retirement savings net far beyond the less than 30% of the workforce covered by the nation's defined benefit-structured central retirement pillars.

In an interview, Cyd N. Tuano-Amador, assistant governor, monetary policy subsector for the central bank of the Philippines, said the program was designed to be flexible enough to cover the millions of Filipinos working overseas in the Asia-Pacific region, with special incentives to get those workers to begin saving.

For example, while the maximum annual contribution covered by exemptions from taxes on investment income under PERA is $2,415 for Filipinos working within the country, the maximum for Filipinos working overseas is $4,830. n