How best to define a good outcome is a question which has stumped the DC industry for decades. Making DC good is optional for employers; it’s a discretionary spend. However, “good DC” doesn’t need to be expensive, complicated, or exclusive to big schemes or paternal organisations. It can be done within a trust, contract or master trust. It just needs to target and govern against the right outcome.
The clue is in the name: defined contribution. We know what we’re putting in, but not what members are getting out. Various measures have been used to benchmark a “good outcome”, such as a simple two-thirds of final salary (like in DB) or the Pensions Commission’s salary-related replacement ratios.1 But it’s important to recognise that utility and other fixed costs mean 50% of final salary, for example, might work for higher earners but not for lower earners.
More recently, the Pension and Lifetime Savings Association (PLSA) launched its Retirement Living Standards (RLS).2 These give people a rough idea of the income they need in retirement to fund lifestyles described as “comfortable”, “moderate” or “minimum”, based on things like whether they like to drink excellent wine, cheap wine or brew their own under the radiator. It’s not perfect; one person’s Chateauneuf-du-Pape is another’s plonk. But the RLS is a simple way for people to get a sense of the pension they need to be aiming for in actual pounds and pence — and we were proud to support the PLSA in their work.
Taking the RLS as the target outcome, the questions then become how to get your members to that income and what to do if you’re off track.
How to target the income your members need
Defining the target outcome should always be the first stage in setting an investment strategy. For example, a 25-year-old on national average earnings working to 68 with an 11% contribution rate needs around inflation plus 2.5% every year until retirement. If the contribution rate is lower, more investment return is required and vice versa, as the graph shows.3
You can build a lifestyle strategy around this target return, with more risk in earlier years and less risk as members come in to land, to reach a suitable at-retirement position.
Constructing the investment strategy this way, and then monitoring investment performance, helps ensure the pension scheme is governed against an aim of providing a good income in retirement for members, linked to the actual real-world cost of buying things in retirement. That’s powerful.
What to do if blown off track
Of course, not everyone contributes as much as they should, and some people start later in life as other priorities can dominate at a younger age. As well as targeting the right outcomes, it’s crucial to monitor the position as it develops to see if your members are on track or not.
Mercer’s interactive Retirement Readiness Index (RRI) is a tool which looks at an entire scheme’s membership to see whether members are on track for a good retirement outcome. It provides interventions that can improve the situation, such as more contributions, better investments or working for longer.
For example, a 50-year-old contributing 11% needs to have a pot of approximately £110,000 saved up to retire at age 68 to support a “moderate” lifestyle. With only £50,000 at that stage, they might be 20% below the target income, but not all is lost.4
Simple targeted communications can help get your members back on track. For example, messages that encourage members to put in another 5% for the remainder of their career could make meaningful inroads in closing the gap, boosting their income by around £140 a month after tax.4
We firmly believe putting members at the core of everything we do is the right way to do DC. We’re passionate and work tirelessly to ensure the members who have entrusted us with their pensions savings are looked after.
This does not contain investment advice relating to your particular circumstances. No investment decision should be made based on this information without first obtaining appropriate professional advice and considering your circumstances. Mercer provides recommendations based on the particular client's circumstances, investment objectives and needs. As such, investment results will vary and actual results may differ materially. Past performance does not guarantee future results
All information is correct as at April 2021.
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