"Stop the Race Toward More Risk in Defined Contribution Pension Plans"

Until 2008, there was little attention to or oversight of investment risk in defined contribution plans. Newspapers often featured stories of retirees facing disappointing pensions—especially after a market crash or a sharp drop in interest rates just before retirement. Since 2008, with the introduction of the duty of care (Article 52 of the Pension Act), much has improved. Lifecycle-based investing became the norm.

In recent years, however, we have seen pension providers repeatedly adjust and often increase the risk in their default lifecycle strategies. For example, while in 2011 many providers invested about 50% in equities during the accrual phase, today it’s often 80%, 90%, or even 95%.

Previously, the equity portion was entirely phased out approaching retirement, but now some lifecycles still hold 40% in equities right before retirement. Initially, interest rate risk was sometimes fully aligned with the annuity purchase rate three years before retirement. Now, some strategies still carry 30% of interest rate risk at retirement—even though a fixed annuity remains the default.

increasingly difficult. To still meet pension ambitions, higher returns must be pursued—only possible by taking on more risk.

Econometric models are used to determine the best risk-return balance in a lifecycle. These models usually show higher expected pensions when more equities are included. This optimization is pushed further and further.

This is reinforced by long-term scenario analysis. In De Nederlandsche Bank's (DNB) scenario sets, negative shocks tend to average out over the long run, so pension outcomes even in poor scenarios appear quite favorable.

There’s also the influence of asset managers, who often focus on adding asset classes, maximizing expected returns, and designing lifecycles as efficiently as possible—sometimes with little regard for pension goals or participant understanding.

Since 2019, there has been the uniform calculation method (urm). A calculation method that is the same for everyone certainly has advantages. But the strong simplification of reality may lead to even more offensive lifecycles.

The urm is often used by pension advisors. When selecting a pension provider, a urm calculation is used to determine which provider is expected to deliver the highest pension results. This provider then scores well in terms of investment policy, which is often of decisive importance in the selection of a pension provider.

Every provider therefore benefits from a favourable urm calculation. To achieve this, providers ‘optimise’ their lifecycle and increase the risk in their lifecycle to obtain favourable urm results.

Since last year, the URM method has also been mandatory when informing participants in a collective value transfer. If you switch from a pension provider with a risky lifecycle (and therefore a high expected pension payment) to a pension provider that has mainly focused on diversification and is conservative in terms of risk (and therefore shows a lower expected pension payment in the calculation), the participant gets the impression that the new pension provider has a bad product and that he is worse off. While in practice it is questionable whether that is really the case.

The uniform calculation method has brought us a lot, especially in communication with participants, but it is also a flattened method that should not be regarded as the 'holy grail'. Rigidly following this process can eventually lead to even more incentive for employers and their advisors to choose the pension provider with the best URM results (and possibly therefore the riskiest lifecycle).

If we look at the returns achieved in recent years, the life cycles are doing very well. From 2017 to 2021, an average net return of around 10.5% per year was achieved in the build-up phase.

Our concern is mainly in the years just before the retirement date. In the DNB scenario sets, the negative shocks often average out in the long term, which means that the pension results are still quite good even in bad scenarios. But practice can be erratic. The shocks resulting from Corona and the war in Ukraine have shown this. As long as the purchase of a fixed annuity is still the standard (and is therefore done by almost everyone), the equity and interest rate risk should be largely closed on the retirement date.

Our advice to pension providers is: take a critical look at the implementation of the lifecycles. Do not let the calculation models determine the policy alone, look at the participant and his pension needs. Ensure that the defaults are correct and only apply a continued investment strategy to participants who actually continue to invest after the retirement date.

Our advice to the AFM: reconsider the obligation to include URM calculations in information letters for collective value transfers. Although it is good to communicate openly and transparently, this way complex matters are oversimplified in a few numbers. No matter what explanation you add: the participant will ultimately only look at the numbers.

Our advice to employers: choose a pension provider based on multiple selection criteria. Not only based on the best URM calculation result. Also take a good look under the hood at the risk profile of the lifecycle.

Hopefully we will stop this race for more risk before it goes wrong and (again) distressing stories appear in the newspapers. We are all moving to a premium scheme and it would be a shame if confidence in premium schemes, and thus also confidence in the pension sector, were to be damaged before this transition.

Guyot van Meer is a partner and consultant at Highberg, an organizational consultancy firm specializing in, among other things, remuneration policy and pension issues.