People want certainty – including when it comes to pensions. And particularly amidst the growing turbulence in the financial markets. Pension administrators are responding to this need by offering investment funds with guaranteed returns. In my view, it is better to remove the uncertainty through smart investment solutions and clear communication. Why? Let me explain.
A study conducted by Motivaction (2010) entitled ‘Higher pension versus 100% certainty’ shows that:
In other words, insight into the effects of guarantees prompts people to make different choices. In this article I want to point out the potential disadvantages of guaranteed returns and how these can be avoided through smart investments and clear communication. Smart investments offer more certainty at the same costs, or the same certainty at lower costs. In short: what are the disadvantages of guarantees and how can we do things better?
Guarantees are costly
There are costs involved in guaranteed returns. These costs are deducted from the invested contributions or the return on the guaranteed fund’s investments. The ultimate effect is more certainty and a lower pension capital. But how much capital are you prepared to surrender for extra certainty? The average current rates offer a guaranteed return of 3% in exchange for 1.75% of the contribution.
The current pension ambitions, including indexation, require an investment return of 6.5%. So a guarantee of 3% falls short of that ambition. Clearly, many concessions need to be made to achieve the desired certainty. Guarantees, therefore, are costly.
Guarantees take no account of investment and interest rate risk
The level of the pension payout depends on both the size of the pension capital upon retirement as well as the interest rate applicable at that time.
Guaranteed funds aim to generate a certain pension capital, but not a certain pension payout. Due to fluctuating interest rates, an employee has no certainty about the pension that can be purchased with the guaranteed capital. As a result, guarantees often fail to yield the certainty that the employee expects.
Guarantees are an obstacle to achieving a better pension
Guaranteed returns are applicable on the retirement date and only with the current administrator. Members who exit the scheme early, e.g. due to a pension value transfer, run the risk of losing their guarantee – even though they have paid for that guarantee. A pension value transfer can thus result in a sizeable loss. So you are more or less condemned to staying with your current administrator. The upshot is that switching to an administrator with a better product at lower costs is more difficult than it should be.
Guarantees make employees less interested and involved in their pension
The effect of guaranteed returns is that employees are not concerned about their pension: “my pension is guaranteed anyway, isn’t it?” This makes employees passive towards their pension affairs, which can lead to unpleasant surprises when they reach retirement age when it is too late to set things right.
How can we do better?
How can we improve the way we deal with pension risks and uncertainties? How do new administrators of defined contribution schemes control these risks? Let’s look at the solutions offered by BeFrank, a new and fresh player in the market for group pensions.
Controlling investment and interest rate risks
BeFrank invests pension contributions according to the life cycle principle. By taking a little more risk in the initial period, the employee has a chance of generating a good investment return. The asset mix can then be gradually adjusted and a steadily larger amount can be invested in pension stabilisation funds in order to gradually reduce the investment and interest rate risks.
Stabilisation funds gain in value when interest rates fall and vice versa. Thanks to the falling interest rates in the past year, the pension stabilisation funds yielded a return of around 10%. This largely neutralised the adverse impact of the falling market interest rates on the pension payouts. Despite the low interest rates, retirees were thus still able to buy roughly the same pension.
Due to this life cycle investing approach, both equity prices and interest rates have steadily less effect on the pension payout as the retirement date draws nearer.
Individual choice between return and risk
As noted, there is a trade-off between return and risk. Article 52 (duty of care) of the Pension Act stipulates that there must be a correct balance between risk and return. However, everyone will give a different answer to the question “how much pension capital are you prepared to surrender for extra certainty?” BeFrank therefore offers every employee a choice of three life cycles. By completing a risk profile, the employee gains insight into his personal preference while the innovative pension planner gives advance insight into the effect of the various options. If the employee wants to switch from the neutral profile to the defensive profile, the planner intuitively shows that the expected pension payout will be slightly lower and that the level of certainty will increase.
In this way, every employee can make his own risk-return decision, in the secure knowledge that the investment risk will be carefully managed, no matter what option they choose.
Employees who have chosen the self-select investing and want to temporarily rule out all investment risk can also choose to put their money in a BeFrank interest-bearing account. BeFrank pays a reasonable rate of interest on the balance in the account, which can be used at any time to purchase investments.
The BeFrank life cycles, including pension stabilisation, can remove the most important objections to an investment-based pension. The investment risks and interest rate risk are gradually reduced. This creates more certainty about the pension at low costs. And thanks to clear communication, employees gain insight into their pension.
Moreover, by making choices tailored to their personal preferences, employees can control their own pension. Guaranteed returns are usually a more expensive alternative and often provide less certainty than is widely thought.
Folkert Pama, BeFrank CEO