With the demise of Defined Benefit (DB) arrangements, what have we gained and what have we lost? Can we retain or get back some of the good features of DB funds?
Under a DB scheme, members’ benefits, not required contributions, are specified within the rules of the fund, typically using a formula approach. Under a Defined Contribution (DC) scheme, the level/s of contributions is/are specified in the fund’s rules, with the eventual benefits being uncertain.
It would be foolhardy to think that DB funds could make a comeback in Australia after many years of employers closing DB funds to new members or to future accruals. These closures have been done for many reasons, including:
- employers wanting to reduce or eliminate their exposure to DB funding risks
- changes to accounting rules that led to undesirable balance sheet and/or P&L effects for employer sponsors
- individual member preferences for bank account style DC accounts
- superannuation legislation (such as the introduction of the Superannuation Guarantee) and related requirements (such as DB funding prudential standards) predominantly being based on DC arrangements, with DB arrangements often treated as an afterthought, and
- changes in the packaging arrangements of employees’ remuneration.
Although there are very few open DB funds (UniSuper is the largest open DB fund in Australia), those open DB funds together with the DB funds that have been closed to new members will remain material in size for many years (DB assets currently exceed $150 billion) and will need to be well managed for their members and employer sponsors.
Advantages and disadvantages of DB funds
Most of the advantages of DB funds over DC funds result from the pooling of risks. The key advantages of DB funds include:
- greater ability of members to predict their future benefit
- member protection from the impact of poor investment experience (including protection from sequencing risk prior to retirement)
- benefits can be set based on retirement needs
- where pensions are provided, members can receive comfort from knowing their expected level of post-retirement income (protection from sequencing risk) and that their benefit will not be exhausted prior to their death (protection from longevity risk).
In the past, DB funds were often promoted as a tool for employers to attract and retain employees. Whilst the existence of a DB fund can differentiate an employer, their desire to do so via DB super has waned over the years.
Many of the disadvantages of DB funds reside with the employer sponsors, with those shortcomings including:
- volatile (and potentially large) funding requirements
- volatile (and potentially large) impact on the balance sheet and P&L of employers
- the treatment of DB arrangements being difficult in modern remuneration arrangements (for example, less flexibility and difficulty in placing a value on each member’s DB accruals)
- the perception that benefit structures can be too complex.
From the perspective of individual members, DB arrangements can have additional shortcomings, such as the inability to reap the rewards of strong investment performance and perceived inequity in benefits between individuals.
Whilst the majority of legislation has been made without concern for DB funds and their members, much of it has benefited DB fund members as well as DC fund members. For example, the introduction of the Superannuation Guarantee (SG) in 1992 has led to almost universal coverage as well as improved vesting of members’ superannuation benefits. Governance improvements have also benefited all super fund members. But the introduction of the SG and its focus on required contributions has also led to some less desirable outcomes. These predominantly stem from the resultant move from DB to DC arrangements under which members’ benefits have greater exposure to market volatility and less certainty regarding retirement outcomes. There can also be a greater focus on lump sums and no obvious way to deal with longevity.
Prior to the SG’s introduction, many employers were already providing good superannuation benefits, often well in excess of SG levels. Over the years, some of those employers have chosen to change such generous arrangements, for many reasons, but the DC focus of the SG legislation was often a contributing factor.
Which DB features could we introduce into non-DB arrangements?
Given it is highly unlikely that we would go back to offering DB arrangements, I believe we would benefit from incorporating some of the features of DB funds into our predominantly DC environment.
Firstly, although the benefits of most DC members are determined as lump sum amounts, we should move to present members’ benefits as income streams on benefit statements and websites. This should occur within lump sum DB funds as well. This has several benefits. Members can better appreciate whether or not their superannuation amounts are (or will be) adequate when they can compare an estimated post-retirement income with current income. Reporting lump sum amounts only can easily mislead people to believe that relatively modest lump sum savings are adequate when they are not. Also, the projection of future benefits as income streams can minimise member concern that arises with poor investment markets, putting into perspective, particularly for younger members, that market falls may not have a material impact on their ultimate benefit.
In a similar vein, stochastic modelling tools (like those typically used within the investment strategy modelling of DB funds) can be introduced. This would allow DC funds to provide their members with projections that enable them to better understand the range of potential benefit outcomes. Such tools could provide members of DC funds with more comprehensive information to assess the impact of possible investment strategies on their ultimate benefit rather than just relying on expected returns for each strategy.
For members of DC funds and members of lump sum DB funds that do not provide pensions or annuities on retirement, post-retirement solutions to assure individuals that their retirement savings will last for their lifetime need to be developed. Solutions would include a combination of advice and product. Financial advice can assist individuals to structure their arrangements appropriately. Product solutions will continue to develop as funds take advantage of many innovative ideas to protect members against outliving their savings. I hope that we will see the legislative change required to enable greater ability to cater for longevity risk.
In a DC fund, individual members bear all of the risk: market, longevity, sequencing, etc. In a DB fund, employer sponsors bear all or the majority of the risk. But is either arrangement optimal? I believe that we will one day see the introduction of arrangements under which pooling will be used to enable members to share the risks, like a DB fund, but without employer sponsors bearing so much of the risks. Like DB and DC funds, Defined Ambition arrangements (like Collective DC funds) have advantages and disadvantages but, over time, they may find a niche in Australia.
These enhancements can occur through a combination of targeted actions by super funds and legislative change. As they look to retain the significant amounts of money of baby boomers approaching retirement in coming years, funds see the need to better cater for members in retirement and post retirement solutions will grow. Funds also see the need to help members better consider the adequacy of their retirement savings and take appropriate actions.
Future legislative change, such as requiring all funds to show income equivalents on benefit statements and structuring tax and Age Pension rules to encourage or require members to take benefits in income form could also have a significant positive impact on our superannuation system.
I’m very optimistic that many of these enhancements will occur and that members and Australian society in general will benefit as a result.
Kevin O’Sullivan is Chief Executive Officer of UniSuper Management Pty Ltd.