Provision for retirement is a global problem of ageing populations, unsustainable social security costs and a lack of adequate personal savings. Redesigning employer schemes could help address these challenges
The numbers involved in the global pension funding crisis are so vast that sometimes it helps to have a real example to bring home the problem. Nick Sherry, the former Australian deputy finance minister, has one. He says Japan sells more incontinence supplies for older people than it does for babies. “This is a global phenomenon,” says Mr Sherry. “Japan, China, Italy and Greece are more advanced in their ageing. Australia is ageing, as are the US and UK.”
Demographics and dependency
Mr Sherry says “longevity combined with the falling birth rate” is a major challenge, “leading to greater dependency, higher numbers of older people vis-à-vis lower numbers of younger workers”.
These trends are true for most of the developed world and there has been serious academic research to try to solve the problem and find better ways of helping people retire.
So far it is clear that governments can’t fill the void. A recent Citigroup report1 into the pension crisis estimates that the total value of unfunded or underfunded government pension liabilities for 20 OECD countries is a staggering $78trn.
And amid the move away from Defined Benefit (DB) schemes to Defined Contribution (DC) schemes, it also appears that it is no good relying on individuals to provide a secure lifelong income for themselves. A survey by Now: Pensions,2 the auto-enrolment pension provider in the UK, found that nearly one in four “definitely will” or “might” opt out of auto-enrolment when contributions rise to 8 per cent of qualifying earnings in 2019. In the US, even among those who do invest, nearly two-thirds do not accumulate enough in savings during their working lives to adequately fund retirement.3
“Serious financial analysis has been going on to find ways of making employer pension delivery more cost effective”
The role of employers
New ways to sustain income after retirement
Sustainable Income Plans take advantage of regulations that can turn asset liability management on its head
How do you get more for less? It is a challenge facing governments, employers and individuals who are all struggling to plug the retirement funding gap.
Kelly Coffing, Principal and Consulting Actuary at Milliman says of the firm’s Sustainable Income Plan (SIP): “For the same £10m contribution, an employer can provide up to 30 per cent more retirement income than they can with a DC scheme – without adding market risk or contribution volatility for themselves.”
In a DC scheme, the spend-down phase is inefficient because people do not know how long they will live. A SIP pools longevity risks, allowing the plan to provide lifelong benefits to all participants and basing funding on average life expectancy. In addition, participants in a DC scheme generally shift to more conservative asset allocations as they age, sacrificing returns in the process. By pooling longevity risk and maintaining a balanced portfolio over time, the SIP provides more retirement benefits per pound of contributions.
A new twist on an old design
In the US, Milliman was one of the first to take advantage of regulations published in September 2014 to “turn asset-liability management on its head… paving the way for true retirement innovation”. It launched its SIP this year.
While this may seem like a novel solution to the ageing problem, the idea has been around for decades.
“This design has been legal in the USA since 1953,” continues Ms Coffing. “However, in the original plan design, benefits moved up and down with market returns without any protection against volatility. Current retirees do not want that degree of uncertainty.
“It is only recently that we have been allowed to modify this 60-year-old plan design to smooth out the benefit ride that had been a hurdle to the success of these plans. Milliman has put a mechanism in place to hold back some of the upsides so that it can protect benefits when there are downsides. By embracing market volatility, the SIP can provide lifelong income to participants without exposing employers to market risk or contribution volatility.”
Which leaves us with employers. Clearly, not even the most benevolent employer wants to pay more, so a number of organisations have undertaken to find ways of making employer pension delivery more cost effective. A 2014 report by the National Institute on Retirement Security (NIRS) in the US entitled Still a Better Bang for the Buck4, found that “(DB) pension plans are a far more cost-efficient means of providing retirement income as compared to individual defined contribution accounts”.
Although this report looked at pensions in the US, the idea that more retirement income can be generated from the same contributions is something that has generated a lot of interest worldwide.
So where can savings be made to provide these higher pensions?
“When you have a large number of people pooled together it is much easier to predict life expectancy and fund accordingly”
More bang for your buck
For a start, it is about pooling retirement risks. Individuals do not know how long they will live so they have to deal by themselves with the possibility that their retirement could last much longer than the average (which will be the case for half of retirees). But an employer with tens of thousands of employees only has to cater for the average life expectancy. This alone can cut costs by 10 per cent.
“When you have a large number of people pooled together it is much easier to predict life expectancy and fund accordingly,” says Kelly Coffing, Principal and Consulting Actuary at Milliman, which has created the Milliman Sustainable Income PlanTM.
Another saving comes from asset allocation. Instead of shifting down to lower risk investments as you approach retirement in order to ensure that income is relatively guaranteed (the case for individuals), these large pooled schemes can remain “ageless”. This, according to the NIRS, provides a further 11 per cent in cost savings.
The other major cost saving comes from pooling funds, resulting in lower fees and higher returns. The NIRS estimates that this method generates a further 27 per cent in cost savings.
All of which points to the value of large employer plans over an individual approach. “In order to provide the same value of retirement benefit, the contribution to a DC scheme such as a 401(k) (the individual money purchase plans available in the US) would need to be 30 per cent higher than in a traditional DB plan,” adds Ms Coffing. “The National Institute on Retirement Security puts this number as high as 48 per cent.”
A different approach
However, there is one drawback of the NIRS findings: they are based on DB schemes, which have become unsustainable for many employers because they have to shoulder all the risk and plug the yawning pension deficits that most schemes now face.
This is why a different approach is needed to make the “more bang for your buck” more palatable (and affordable) to employers. Plans such as the Milliman SIP can offer similar savings to those identified by the NIRS for traditional DB schemes, but without requiring plan sponsors to shoulder the market risk.
“A different investment approach allows returns to be maximised because there is no risk of jeopardising plan funding”
Ms Coffing says that unlike traditional DB plans, liabilities and assets move together with a SIP. That keeps such a plan funded in all market conditions. “This enables a different investment approach, allowing returns to be maximised because there is no risk of jeopardising plan funding,” she adds.
Maximising investment returns is not the only way these newer types of schemes boost retirement incomes. One of the major issues for retirees in the UK, for example, has been the recently abolished requirement to buy an annuity. With interest rates at a historic low, this has meant pension incomes have suffered too.
With a SIP model, retirement funds continue to be invested (and therefore grow) even after retirement, but some of the upside is held back so that when markets fall - which they inevitably do from time to time - these “reserves” can be used to smooth out the retirement income of scheme members. In this respect, they offer an important element of a traditional DB scheme: a secure stream of income in retirement.
At the same time, a SIP approach overcomes two of the most significant risks of DC schemes: the risk of lost investment growth as individuals approach retirement and the risk of a poor retirement income.
“Redesigning retirement plans to provide better retirement incomes can help firms to manage their workforce better”
Although these plans are a very new type of solution to the pension funding problem, they are already generating a great deal of interest.
Skills gaps and talent problems
In the US, Milliman has found that large unions are particularly interested in these new pension plans because they provide better benefits for plan members. Meanwhile, private sector employers are now also showing interest, but for a different reason: workplace productivity and motivation.
“Corporate sponsors who moved to DC plans are finding that employees are not saving enough to retire,” explains Ms Coffing. “This is leading to increasing numbers of older workers, who may be disengaged, finding they are stuck in the workforce because they don’t have sufficient funds to retire.
“At the same time, younger workers are likely to become increasingly frustrated as their route to the top is blocked by older workers (the ones without sufficient pension income).
“Redesigning retirement plans to provide better retirement incomes can therefore help firms to manage their workforce better – and for the same cost and with the same risks – enabling mature workers to retire and also providing an attractive benefit to millennials who are more concerned about security.”
This content was produced by FT², the advertising department of the Financial Times, in collaboration with Milliman.