SYDNEY: 10 May 2013 - Australia has been democratising access to the global investment markets via its compulsory defined contribution (DC) superannuation system for over 20 years. We have all become investors and owners of capital; like it or not. The aim has been to provide a level of dignity via financial security in retirement. But, are the challenges of low financial literacy, investor behaviour foibles and increased retiree risk aversion surmountable in a choice-based system? Is DC superannuation structurally capable of producing sustainable income streams in the face of the risks of increasing longevity, ongoing inflation and market volatility? Does DC super need to be re-intermediated to some degree and, if so, whose balance sheet could be used to absorb those risks?

The Australian superannuation system has had a ‘lump sum’ approach to retirement, as distinct from a ‘replacement rate’ or lifetime income stream approach. Defined contribution (DC) funds hold over 80 per cent of pension assets in Australia. Like in the United States, we are now realising the limitations of a DC retirement savings system insofar as it relates the provision of reliable retirement income for a population with increasing life expectancy.

DC systems work on the basis that you only get out what you put in, plus the net investment returns on those contributions, less tax. There is a tendency for DC schemes, particularly in a compulsory system, to lack a clear goal other than to build up a lump sum. In itself, a lump sum is not particularly useful in retirement. It must either produce an income to live off or be so large that it can merely be spent in pieces to fund a retirement of an indeterminate length.

Success in a DC scheme is also dependent on informed choices, rational behaviour and notions of consumer sovereignty. In the real world, information asymmetry, issues with financial literacy and innate behavioural biases often make it hard for the consumer to achieve any degree of ‘sovereignty’. The result is a system heavily reliant on (potentially conflicted) agents.

Another way of approaching the problem with DC funds is to say that they essentially flow from a conception of the retirement challenge as one of ‘wealth management’. In fact, for most people, retirement is about creating spendable income and managing some specific risks that are more acute in retirement: inflation, longevity risk and market risk. Because the DC model pushes risk and decision-making down to the individual level, in a compulsory system like Australia’s, there are cognitive and other inefficiencies involved. Take driving cars as an example. Because of what a car is, we all need to be trained and licensed to operate them. This is not so of pensions. Who thought it was a good idea to make an entire population become investment experts?

Not every DB scheme that ever existed has failed. That is, there are DB schemes that have been, and still are, run effectively to deliver the income that is required for their retired members. Any approach to guarantee a person against a specific risk (or the combination of longevity and inflation in this case) will have a cost. One way to ensure that the cost can be managed sustainably is to use a price mechanism around the cost of that guarantee

An alternative for the outcome of a DC system is to be able to use the skills that can manage a successful DB plan to deliver a guaranteed income for retirees. The superannuation promise could by partly re-intermediated so that it can retain its DC nature and yet deliver the required retirement income. This ‘re-intermediation’ would not be without risk, but it should be possible to have experts in the management of balance sheets, managing the balance sheet of the guaranteed income provider. The twist is that the benefit would be defined towards the end of the DC accumulation phase, rather than at the start. The UK market has demonstrated that the private sector is prepared to provide the capital to manage these sorts of risks.

Apart from their obvious social usefulness in accumulating retirement savings, DC pension schemes have other roles to play. The notion that pension funds are ‘universal owners’ is a particularly potent one. This is the idea that pension funds are always going to own a slice of the economy and so are, by definition, incapable of meaningfully exiting a particular industry or type of company. As a result, and given their long-term horizons, they have an interest in sustainable growth with limited externalities in the form of social and environmental costs.

Compulsory DC super is an effective piece of public policy because it forces people to save. But, it is a blunt tool. The arbitrary selection of 9 or 12 per cent of wages doesn’t necessarily lead to the right amount or shape of sustainable cash flows in retirement. Fund trustees need to do more to get members focused on the real game: targeting a replacement rate of income and a guaranteed floor of inflation-adjusted income in retirement. Trustees need to work towards a properly integrated retirement income solution that hedges the three key risks in retirement: inflation, deviation from expected outcomes due to market risk and longevity.