The shift from defined benefit to defined contribution means a shift in risk pooling to individual risk bearing by individual participants. This means that adequacy on an individual level becomes the objective of retirement savings, but the question of how funds can provide retirement security for all plan participants is a more difficult one.
Michael Drew, Professor of Finance at Griffith University in Australia, says there needs to be a shift from the plan sponsor’s business imperatives to a real fiduciary focus.
In the paper Governance: The Sine Qua Non of Retirement Security, Drew and his co-author Adam Walk, question whether when plan sponsors say they are taking a fiduciary focus, they are prioritising values of the profession or doing what is best for investment clients, over the economics of the business or doing what is best for investment managers.
“Plans are concerned that the economics of the business are being prioritised over the interests of plan participants,” the authors say.
In defined contribution funds there is a real tension between a fiduciary focus and business imperatives, and that needs to be recalibrated. Drew questions whether those that say they have a fiduciary focus actually put it into practice.
“Do we really, hand on heart, live like that and put that into action? Simple questions like what does this mean for our 58 year old members, and not our peers,” Drew says.
In Australia, possibly the most established defined contribution market in the world, this tension is heightened because there is no requirement to ensure a certain level of retirement income for plan members.
Regulation in Australia is focused on inputs to wealth, such as the level of contributions and the investment risk, not on the outputs from wealth such as the replacement ratio or level of retirement income.
“In terms of defined contribution plan governance, there needs to be a shift from returns being the solution to being one of the inputs, not the outcome,” Drew says. “Delivering retirement income should be the headline objective of a defined contribution plan.”
Following the ‘north star’
In this context, that retirement income is the destination, and everything cascades from that “north star”, he says.
By following this north star, governance and investment decisions will be recalibrated.
“We wonder out loud if governance is below the line, for example focused on investments and returns,” Drew says. “If you reframe your beliefs as part of achieving an outcome, it leaves you with different beliefs. This is especially in the post-retirement phase where you can’t keep applying the idea that time is continuous.”
The authors say that defined contribution plan fiduciaries and the investment teams must take a more sophisticated approach to performance evaluation, consistent with the investment objectives set by plan fiduciaries.
“A replacement ratio of 70 per cent of final salary is an infinitely more useful objective for a plan participant than a return target of CPI+3 per cent per annum over rolling 10-year periods after fees and taxes.
“Once fiduciaries have set appropriate objectives, the entire governance framework and the investment complex should be directed toward this achievement. With the target properly set, the means needed to achieve it become clearer, as do the ongoing monitoring requirements.”
In a defined contribution context, Drew and Walk advocate the following investment beliefs as (nearly) universal:
- Retirement income is the true measure
Investors are heterogeneous
Timeframes are finite
Market returns (or beta) matter most
Dynamism is important.
“Whatever their progress, we would recommend to defined contribution plans, one overriding principle: coherence. For example, a plan that claims it is “outcomes focused” and yet only reports time-weighted returns to participants is subtly undermining its message or just using its “outcomes focus” as a slick marketing line. Claiming to be “best practice” will not suffice in the absence of both institutional commitment and tangible action – which is often costly – to evidence such a claim.”
