LONDON - U.K. companies pondering switching to defined contribution plans should look before they leap.
Reigate-based Watson Wyatt Worldwide estimates the typical British defined contribution plan is 30% more costly than a defined benefit plan designed to provide equivalent benefits.
Not only are these plans less efficient at providing benefits, but they expose employees to market and interest rate volatility, particularly in the years immediately preceding retirement.
To a large extent, increasingly popular lifestyle funds - which link asset mixes to participants' ages, gradually switching to bonds and cash in the years leading to retirement - address these issues.
The big question, some experts worry, is what happens if retirees are left with inadequate pension benefits. Unlike U.S. companies, which are more inclined to let former employees fend for themselves, British employers by and large still retain a paternalistic attitude.
If there's a shortfall in retiree pension benefits, many believe the employer will end up on the hook for augmenting the pension check, even though defined contribution plans theoretically shift the risk to the employee. According to a survey by the Confederation of British Industry, 53% of those companies with defined contribution schemes would top up benefits - if the money were available - when investment returns were poor.
Aggravating the potential shortfall is that many employers are seeking to cut their pension contributions when changing to defined contribution plans. A survey by the U.K.'s National Association of Pension Funds, cited by London's Incomes Data Services Ltd., shows total contribution levels of 15.4% for final-salary plans, nearly twice the average 8.2% rate for defined contribution plans.
Nevertheless, a big shift to defined contribution plans is expected. Big names such as Barclays PLC, Lloyds PLC, Philips Electronics U.K. Ltd., and W.H. Smith Group PLC recently have adopted defined contribution plans, while others, such as Glaxo Wellcome PLC and Zeneca Group PLC, have opted for hybrid vehicles.
The NAPF survey also revealed only 6% of companies rely solely on defined contribution plans now. But pension experts believe more than a quarter of companies will rely solely on money purchase schemes within 10 years' time, while nearly half expect to use a combination of defined contribution and defined benefit plans.
Some money managers are betting heavily on the trend. Julius Pursaill, a director of Mercury Asset Management PLC, London, the U.K.'s market leader, estimates that within 10 years' time, half of U.K. pension assets will be in defined contribution plans - up from only 10% to 12% now.
Others, including Fleming Investment Management Ltd., Morgan Grenfell Asset Management Ltd., Prudential Portfolio Managers Ltd. and the United States' Fidelity Investments, have been ardently marketing defined contribution products to British funds.
But little has been done to quantify the dangers inherent in adopting defined contribution plans in the fledgling U.K. defined contribution - or money purchase - market, until recently.
Roger Urwin, head of Watson Wyatt's European asset consulting practice, recently told his firm's Global Asset Study conference that inefficiencies of running defined contribution plans stem principally from two areas: the lower levels of equity investment generally found in these plans, and the need to purchase annuities upon retirement.
While the typical British pension fund is 78% invested in equities, defined contribution plans have an average of 73% in stocks, which historically provide the best returns of any asset class.
U.K. pension funds' typically high equity weighting have made them among the most efficient in the world, about 13% more cost competitive than the global average, Mr. Urwin said.
In comparison, the average U.S. defined benefit and defined contribution plans have the same equity level of 57%, according to Watson Wyatt. Australian defined benefit plans are 56% weighted in stocks vs. 50% weighted for defined contributions plans, while Canadian defined benefit plans have an average 43% equity weighting, compared with 40% in defined contribution plans.
But the variability of benefits in defined contribution plans also might affect plan design, and the level of equity investment.
A 100% U.K. equity fund invested from 1974 to 1996 would have seen a spread of 50% between the top and bottom benefits given to retirees. In comparison, a lifestyle fund that switches equities to bonds and cash over a five-year period before retirement would have reduced the spread in top and bottom benefits by half.
But there are dangers of projecting past returns into the future, especially given the strong-performing equity markets of recent years. Stochastic modeling techniques, which project forward results based on a series of simulations and using different investment strategies, reveal other significant risks.
An analysis conducted by Watson Wyatt for Edinburgh-based Guinness PLC showed a 30-year-old employee who participates in a money purchase scheme for 30 years would have a 90% chance of earning a pension between 15% and 70% of final salary, based on a 100% investment in U.K. stocks with an expected real return of 5.5% a year.
If the account were invested 50% in U.K. equities, and 50% in index-linked gilts (with an expected real return of 4% a year), "there was a 90% chance that the pension would be between 20% and 40% of final salary," said Chris Lewin, head of group pensions for Guinness.
But a lower equity level does not provide much additional protection from downside risk, Watson Wyatt's Global Asset Study revealed. For employees approaching retirement, this can be critical. For example, a 59-year-old employee with a target benefit of 10,000 pounds a year could lose 1,800 pounds in benefits in a 100% equity strategy assuming retirement at 60.
Lifestyle funds can address this threat. A fund that shifts the bulk of a participant's account to bonds and cash over a 10-year period could almost guarantee no loss in principal, Mr. Urwin said.
Changing interest rates also pose a risk to participants as they approach retirement age. As interest rates decline, annuity costs soar. Robert Fairburn, a director at Mercury Asset Management, termed the first half of this decade, when interest rates roughly halved in Britain, as "the unknown crash of the '90s."
Lifestyle funds that shift participants' accounts into 15-year gilts that approximate annuity rates avoid the dilemma.
Interest in lifestyle funds has soared. The selection of investment options taken by Mercury clients has shifted from 45% self-directed, 52% balanced and 3% lifestyle options in 1993 to 3% self-directed, 21% balanced and 76% lifestyle options this year.
In the long run, the costs of purchasing annuities at retirement also might be reduced. Now, only personal pension plans - akin to individual retirement accounts - can buy a flexible annuity, allowing the individual to pick a more opportune time to convert the account to an annuity.
Eventually, this will be an option with defined contribution plans as well, Mr. Urwin said, but it requires a great deal of sophistication to leave the account invested in stocks.
Another option is for the employer to underwrite the annuity terms, thus taking on some of the risk.
In addition, the employer could base annuities more on equity returns than bond returns, he said. "There are wonderful opportunities here for future design of DC plans," he said.