Defined Contribution Plans The Challenge of Achieving Benefit Adequacy

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by Ben Facer & Amy Reynolds

Within a period of three years, 54% of defined benefit (DB) plans have barred new entrants; the value of defined contribution (DC) assets has surpassed DB assets; and by next year, two-thirds of the 100 largest private employers will no longer offer DB benefits to employees.

As the worldwide trend of movement away from the unpredictable funding and expense requirements of DB plans toward the cash-oriented simplicity of DC structures plays out, the true aim of retirement plans – the provision of an adequate retirement benefit for retired employees – must be considered. Are countries with a longer history of DC retirement vehicles an effective indicator of what is to come for others? Remember, moving from a DB to a DC structure does not eliminate risk and responsibility. Rather, they are transferred from the plan sponsor to plan participants, who must now build an adequate retirement benefit, primarily through contributions and investment choices. Yet are these employees effectively prepared to take control? And what measures are governmental agencies and plan sponsors adopting to encourage them to prepare?

An adequate retirement income from all sources is thought to be 65% of pre-retirement income, after taking into account taxes (which may differ pre- and post-retirement). A DB plan readily exposes what the full-career benefit will be, usually defined as a multiple of pre-retirement income – something not as obvious in a DC structure, in which benefits are defined in terms of the contribution flow into the program, rather than the income distribution out at retirement.

Key components of building a retirement benefit include:

• Contributions. To build a retirement income of 60% to 65% of pre-retirement income, annual contributions of 15% to 18% over a full career would be required. The range is sensitive to investment performance, but rarely are company contributions this high in modern DC plans. Hence, a significant contribution from employees is needed.
• Investment earnings. Over a full working lifetime, modest increases in investment performance can yield considerable benefit increases, due to the compounding of returns.
• Length of contributions. All other things being equal, doubling the contribution period more than doubles the resulting benefit. Hence, commencing contributions early in one’s career can have a large impact on the ultimate benefit.

Increased reliance on DC structures typically results from one of three catalysts: legislative introduction of a compulsory savings plan; corporate reaction to balance sheet and financing risks; or market reaction to the (expected) reduction in previously generous social security benefits.

However, these catalysts rarely generate sufficient employee engagement to produce more than a basic retirement benefit. Our research of DC systems worldwide has identified key features that have enhanced member engagement, as illustrated in exhibit 1.

The progression of features on this graph will not necessarily occur in this order, and may, in part, be driven by the nature of the catalyst. When triggered by governmental action, features may be introduced simultaneously in an attempt to capitalize on a broader launch. For example, both the Japanese DC Law and the New Zealand KiwiSaver require auto enrolment.

• Features that force member participation are an excellent starting point to create an adequate DC system. But they rarely trigger the required 15% to 18% funding levels necessary to attain benefit adequacy.
• Informational features, such as basic communications and online information, will help employees understand the need for saving. But informational vehicles themselves won’t compel employees to take action.
• Enhancing information with basic tools, such as broader investment choices or a transactional website, encourages employees to take ownership of their savings. Yet the tools often do not quantify the level of savings required in simplistic, actionable terms.
• More advanced education, alternative investments and individual investment advice are the current “pinnacle” to strive for to fully engage employees. Where the education curve may be too steep to be tolerable, managed accounts have been introduced, as discussed further below.

The countries in which a DC system has been longstanding, such as Australia and the U.S., have generally been fairly slow to develop services that affect member engagement. Despite legislative initiatives in the U.S. to address the issue of educating employees, historical results have been disappointing. Geographies that are just now entering the DC market can build on the ideas and technologies of others, and hence are likely to have a faster progression along the evolutionary scale.

In exhibit 2, we comment on the relative position of each country in the evolution of DC plans, not on the appropriateness of what is being offered.

Some interesting observations include the following:

• DC plans have existed in the U.S. for nearly 30 years, yet they have only gained popularity as a retirement vehicle over the last five to seven years. Despite the availability of necessary tools, there is still a strong sense of employer paternalism.
• In contrast, the Australian model has evolved over a shorter time period, spurred by the near demise of DB plans and legislation requiring a 9% employer contribution. The Australian approach offers the greatest level of control to participants, although its success is largely driven by legislation.
• DC plans are emerging in China, although the high level of government-provided benefits limits the role for these plans. Here and in the Netherlands, limited plan design and investment vehicles will make it difficult for DC plans to function as much more than a supplement.
• The impact of DC plans in Germany and Japan has also been constrained by legislative restrictions. In Germany, the tax effectiveness of contributions to DC plans is limited to 4% of a capped salary. In Japan, member contributions are not permitted to DC plans, which severely limits the potential for member engagement.
• As has been typical of a new entry to the DC world, China has little in the way of investment choice. But with 60% of employers indicating that they expect to switch to DC plans by 2008, change is imminent. Germany, Japan and Brazil also currently offer only basic investment options, but are expected to advance quite quickly.

Counter to expectations, the evolution of DC plans through the plan features does not guarantee success. Fostering adequate retirement savings among the majority of the population ultimately requires some degree of compulsory contributions. Some late entrants into the DC arena are learning from their predecessors and moving quickly to compulsory savings, such as Israel, which is introducing compulsory employer and employee contributions to DC plans beginning 2008. South Africa is also considering mandatory DC provision.

In countries where voluntary DC systems still prevail, attempts have been made to encourage participation through “matching” contributions, such as one-for-one, or lower, employer contributions. Yet experience reveals that employees interpret this threshold as an endorsed target and often elect to make contributions at or below the match level. Alternatively, the relatively new but fast-growing practice of an “auto-enrolment” or “opt-out” design eliminates the participant from the decision making by automatically initiating contributions, unless the participant takes action.

In the U.S., auto enrolment is now encouraged by law, and may well become the norm. The New Zealand KiwiSaver system also adopts auto enrolment, as do plans in the Netherlands and Japan.

The U.K. government is planning to introduce a quasicompulsory system for retirement savings beginning in 2012, known as “personal accounts,” incorporating auto enrolment, employer matching contributions, and tax subsidy. The government intends to encourage adoption of auto enrolment by occupational plans in advance of the implementation of personal accounts.

Auto enrolment is an effective tool, but still leaves a portion of the workforce exposed to the extent that default savings rates are less than adequate. “Auto increase,” in which a portion of salary increases are automatically redirected to a DC plan, plays on the idea that this “new money” will not be missed. This strategy is encouraged in the U.S., and it will be interesting to see if it becomes more widespread.

While the use of automation and mandatory employee contributions is encouraging, individuals still do not manage their contribution levels to ensure an adequate retirement income results. This is where the advanced features prevalent in countries such as the U.S. and Australia, and to a lesser extent the U.K., may be of great interest to others.

Advanced features typically start with the expansion of investment options. The Netherlands, the U.S. and the U.K. all offer, in addition to the basic risk-based options, a number of “select your own” investment options. These will include many brand name investment managers, offering both risk-based and single-asset-class options.

In recent years, “lifestyle” or “lifecycle” funds have become popular, offering diversification with more aggressive asset allocation during an individual’s younger years, and tapering to a more secure allocation as one approaches retirement. Many plans even offer individuals the option of choosing the point of retirement (for investment purposes), and the period in which the asset allocation tapers off. Australia has taken these options a step further, also offering a range of alternative asset classes, such as emerging markets, hedge funds and specific infrastructure funds, and even direct investment in specific listed securities on the Australian Stock Exchange.

But with these additional choices comes enhanced education about the plan and general finances, such as that offered in Australia, the U.K., the U.S. and Japan, with the objective of elevating the financial acumen of the workforce.

The U.S. has an interesting alternative, or complement, to providing advice. In response to a low take-up rate for individual advice, “managed accounts” have developed. For participants who choose this option, information is provided to the individual’s advisor around personal preferences and other savings, and the investment manager will set, rebalance and alter the individual’s asset allocation over time to suit specific needs, without the member having to take action unless circumstances change.

Despite the varying regulatory environments in which DC plans operate around the globe, the evolution of these programs is surprisingly consistent. While the need to save is universal, the process of leading the working public to actively participate in DC programs is arduous. The ultimate objective of universal worker engagement remains elusive.

There is much to be learned from the experiences of others with regard to education, investment options, linked financial products, personal advice and other features. Clearly, these plans are evolving, with the optimal design yet to be developed. Looking beyond the legislative environments at the basic structures of these programs can provide insight into key features and practices – only some of which have been addressed here. Other key considerations include plan governance structures and how a plan sponsor might develop communication and education strategies for building member engagement.

For multinationals that are looking to DC retirement plans as a key benefit component, the country trends described above should aid in decision making.

Specifically, companies should do the following:

• Review their existing plan against current local best practice;
• Within local regulatory frameworks, adopt aspects from more advanced countries that have positive outcomes, ahead of local trends; and
• Update their plans when necessary to keep pace with changing trends and employee needs.

Ben Facer is an actuarial consultant in Mercer’s international business in London. He has extensive actuarial and superannuation experience and advises corporations on a range of issues, including pension fund financial management, employee benefits program design and international employee mobility. He can be reached at or 44 20 7178 3542.

Amy Reynolds is a defined contribution consultant in Mercer’s retirement business in the U.S. She consults with organizations regarding their defined contribution design, compliance and administrative issues, and can be reached at or 804 344 2639.