Who gets the most from defined contribution pensions? (Or, DC pensions; another generational battleground?)
We’ve recently undertaken a survey of DC pensions provided by FTSE 100 employers. You can read more about that here. One of the findings of the survey was that ‘matching’ contribution designs remain very popular - they are used by over half those surveyed.
A ‘matching’ design works very simply – the more an employee pays in, the more the employer will contribute. We shouldn’t ignore that a matching design won’t cost as much as the maximum contribution rate, because not every employee will contribute at the maximum level and many will leave employer money on the table. Therefore, a matching design may appear more generous than it really is.
Who gets most value from DC?
So who are the people that do maximise the value from matching designs? When you pull plan data apart, you find that such employees tend to be older and/ or better paid, meaning that matching designs generally operate in an age-related manner – older people (we’ll call them baby boomers) get higher contributions than younger people (we’ll call them millennials), and so a matching design often means an age-related design, albeit unintentionally.
It’s worth noting that defined benefit plans work in a similar manner – accrual for baby boomers is more expensive than it is for their younger colleagues, and so matching DC contributions mimic DB accrual cost structures.
All of which seems reasonable from a pensions-centric perspective. The DC pension contribution budget is spent on people who like and value pension and the resulting ‘accrual’ is along the same lines as a defined benefit plan.
(A side note: this ‘gearing’ effect is unique to pensions. If my employer allows me to buy holiday, I won’t typically get more than I buy. Similarly if I want to increase my life cover from say three times salary to six times salary, it would be unusual to find an employer offering fund it up to nine times salary. Pensions seem to be a special case. Why?)
Let’s look at pensions from a different perspective – what goes in rather than what comes out. As the only readily comparable aspect, what goes in is how most employees think about DC.
Matching designs could be perceived as certain populations of a workforce ‘cross-subsidising’ others, be it millennials cross-subsidising baby boomers or lower paid employees cross-subsidising higher paid employees.
Contributions are being directed to employees for whom they make little or no difference
A £100 pension contribution is far more valuable to a 24-year old millennial than it is to a 64-year old baby boomer. The ‘miracle’ of compound interest will see the 24-year old benefit from (at least) four decades of growth. In contrast, the 64-year old may have mere months before cashing in – that £100 will make no meaningful difference whatsoever to the 64-year old’s retirement plans.
In some matching designs therefore, contributions are being directed to employees for whom they make little or no difference, but who value them. At the same time the employees to whom they would be most valuable either do not value them or cannot afford them.
Outcomes are not always being materially improved and only a small element of the workforce really appreciates what they are getting.
Is this what an employer would set out to achieve? Why are we doing DC like this?
Dyed in the wool pension "superfan" who wishes everyone financial confidence and freedom
8yA matching structure sends a positive message of "we are in this together" from the employer and they have their place so the key issue is design. If you set up a matching structure then you should look to enrol near or at the top but allow the opt-down route for people that find that % level uncomfortable. What that gives the employer is data to start to evaluate who the opt-downs are and then you can start to understand why this is the case - is it because they are lower paid and need more immediate gratification on their spend. Although inertia exists we should never rely on it as disengagement is the silent killer for governance and risk management. The fundamental issue we always face in this industry is we think about redesigning the game rather than explaining the rules clearly.
Telling the world about the BNY approach to DC / Co-host of the VFM pensions podcast
8yI think you mean why are we doing DC at all?, rather than ...like this. Matching contributions are simply solved by changing the position of the default level to the maximum, employees who dislike it can always drop it down, but employers don't like the risk of inertia and making better contributions to DC. As to the wonders of compound interest - we'll see! Hasn't been working too well in real terms recently, if you are 22 now your financial investments have huge headwinds (unwinding QE, climate change for instance) and your employment prospects are nothing like your parents' (driverless cars, globalisation, machine learning and automation...) and not forgetting the repayment of personal and national debt. If individuals taking more from an employer is the measure of value, you might be ignoring the increased certainty an older person has that they'll get anything back from the deal at all. Maybe we shouldn't see all savings types as equal? Government disincentivising employers to have an honest conversation with younger people around the pensions pay-off are argued as behavioural biases around money now. If economic equalisation was enforced (eg same bump in my net pay if I opt out of pension) I suspect you'd find that was hands down the winner. Is DC just for us consultants?