Why it's time to change how we think of DC

Vanguard's Steve Charlton says DC schemes should not focus on asset accumulation

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Vanguard's Steve Charlton says we need to take a different view on DC

What is the ultimate purpose of a defined contribution (DC) pension plan? Today, DC plans in the UK, and in other parts of the world, are focused on asset accumulation.

Plans are managed, and default funds are designed, to consider maximising the overall pot of money at retirement to be the principal goal of the plan.

We need to re-think this in my view. Rather than focusing on asset accumulation, the goal should be redefined as accumulating sufficient future income - providing a given level of income starting at retirement age and through to end of life.

This should allow for any shape a member might wish: cash withdrawal; annuity; or drawdown.

Of course, this theory sounds like a traditional defined benefit (DB) approach, perhaps looked at from the finishing point rather than the starting point.

As DB sponsors have become more attuned to the changing value of their liabilities, they have adopted a liability-driven approach to investing.

This tends to lead to portfolios with reduced equity holdings (because they're not correlated as well with the liability) and increased fixed income assets (which have a much stronger correlation). In the UK, pension scheme equity allocations have fallen from 65% to 50% between 2003 and 2013, according to Towers Watson's Global Pensions Asset Study 2014.

Does this mean that DC plans should be run more like DB plans? The short answer is no and there are several reasons why.

The sole objective of a DC plan is not necessarily an inflation-adjusted income at retirement. Most DC plan members will have at least two goals - to receive a regular income, which can be provided with a large degree of certainty, and to have assets to pay for unexpected spending needs.

Alongside this, many households have a natural desire for bequests. These goals suggest that plan members require a mix of regular income with some asset growth into and throughout retirement. The liability approach of DB schemes could help achieve some of these DC objectives, but it is not the sole solution.

I believe we need to take a different view of a DC scheme's ultimate purpose. We should stop viewing it as asset accumulation and start to think of it as meeting future income needs.

But, for this to work, we need to get plan members thinking in terms of future income rather than the size of their pension pot. We need to translate the DB concept of income provision to the DC world.

It's difficult for most people to equate an ambitious £100,000 of pension savings with an annuity income in the region of £3,000 to £3,500. What seems like a large cash sum becomes a meagre annual payment.

The coming changes in UK pension legislation should be a catalyst for developing new investment approaches and retirement solutions to meet the multiple goals of DC plan members.

The challenge for us in the pensions industry is to respond with easy-to-understand products that will engage members and provide a comfortable retirement.

Steven Charlton is DC proposition manager at Vanguard Asset Management

 

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