Paris, 7 June 2010
Imagine working 40 years beside a colleague and contributing the same amount to the same defined contribution (DC) plan every month, but he receives 100% of his final salary in retirement while you receive less than 40%. The difference: you retired three years later.
Welcome to the future of defined contribution payouts as depicted in a newly-released Working Paper, "Assessing Default Investment Strategies in Defined Contribution Pension Plans". The report is produced by the OECD and sponsored by Allianz Global Investors, a leading global investment management firm. According to the report, future retirees can expect dramatic fluctuations in fortunes between members of a cohort unless they adopt investment strategies that reduce the impact of market shocks. Similar strategies should also become the default for individuals who make no active investment choice.
Allianz Global Investors supported the OECD with underlying research and expertise to produce the report, including a background paper conducted by risklab, an analytical-focused subsidiary of Allianz Global Investors.
“As defined contribution plans become the primary retirement savings vehicle for individuals, there is increasing demand for research focused on creating sustainable retirement income from these plans”, said Brigitte Miksa, Head of Allianz Global Investors’ International Pensions Group. “This report provides critical insight for policymakers and the financial industry as they look to ensure the financial security of all individuals throughout their retirement.”
There is a strong push to make participation in DC plans mandatory or, as in the United States, to enroll workers automatically. However, with many plan participants lacking the knowledge or ability to choose from the variety of investment strategies available to them, the default investment or preset option is an important consideration for policymakers. The better the design, the greater the possibility that individuals will enjoy financial security in retirement without being reduced to old-age poverty or requiring future support from governments due to market downturns.
“As a result of the financial crisis, the OECD last year called for carefully designed regulations to limit investment risks in default options and help avoid situations where older workers and retirees are exposed to major losses of retirement income,” says Juan Yermo, Head of the OECD Private Pensions Unit, and co-author of the OECD report.
The current report also reveals that the success of an investment strategy in ensuring a secure retirement can depend on the type of the benefit payout. “We found that life-cycle strategies do best when benefits are paid as life annuities and are less valuable when benefits are paid according to a predefined logic that might use up a part of the capital,” says Pablo Antolin, a lead author of the OECD report. “On the other hand, dynamic strategies work better with predefined withdrawals, though a mixture of life-cycle and dynamic strategies may be required when benefits are to be paid through a combination of predefined withdrawals and deferred life annuities bought at the time of retirement.”
The Working Paper conveys the following:
The OECD concludes that regulators may find life-cycle strategies easier to explain to the public and therefore more suitable as default investment strategies. However, it acknowledges that sophisticated investors may prefer dynamic investment strategies, especially, as argued in the Allianz Global Investor study, since they can protect the retiree even better in case of equity shocks short before retirement. “What emerges from our results is that it’s better to give up on some of the upside potential to limit extreme losses on the downside,” says Pablo Antolin. “Policymakers should provide guidance on the specific glide-path of default investment strategies, taking into account the design of the payout phase and the role of the DC plan in the overall pension system.”
Download the full text of the Working Paper (PDF)
Download the background paper by risklab Assessing Investment Strategies for Defined Contribution Pension Plans under various Payout Options