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Architecture of Choice – Beyond Defaults

​​​​​​Architecture of Choice – Beyond Defaults

By Danie van Zyl, 18 April 2016 ​

Since the late eighties the South African retirement landscape has changed significantly with the shift from Defined Benefit (DB) to Defined Contribution (DC) Retirement funds.

Individual fund members now have to shoulder the burden of saving enough, investing appropriately and securing and managing their own retirement income. While some members thrive on all the flexibility and options available to them, many ordinary members find the range of choice bewildering. Instead of looking for help, these members often become apathetic towards retirement saving.

Trustees often respond to this problem by introducing default options, from levels of contributions and group life cover to investment choice. Although this is a welcome move in the right direction, these default options are often introduced separately to deal with a specific issue, with little or no thought to how these defaults form a holistic blue print to guide members to what is really needed, a secure income in retirement.

In a very real sense this can be compared to a team of engineers overseeing the construction of a bridge. Important design features are being decided while the bridge is being built, often in isolation to other design features. How high or wide should the bridge be, how much weight should it carry? They will figure it out as they are going along. Clearly not the best way of going about building a bridge!

Let us therefore take a step back and start at the beginning. You need to have a goal in mind before you set about achieving it. The problem is that few twenty year olds have any idea of how much they are going to need in retirement – even actuaries need to make a host of assumptions to approximate the amount needed. How can members save enough if they do not know what enough is? A generation ago when many of our parents belonged to a DB type fund, the fund rules set a retirement goal for members that was linked to their salary before retirement. Trustees of these DB funds could rely on actuarial and investment professionals to advise them on how to ensure that they meet this goal. This expert advice is not available to individual DC fund members, who have varied levels of financial literacy, leaving them to deal with very complex decisions on their own. Considering the many member surveys done over the last few years, it seems that many members would happily embrace the kind certainty that a DB fund provided.

South Africans are not unique in this regard; there have been recent discussions in the UK about a retirement fund structure that is a mix between a DB and DC fund. It would target a DB-type final salary-related pension, but would not necessarily provide any guarantees - hence the proposed name: a Defined Ambition Fund.

There has been a similar move in South Africa towards providing members with some sort of pension target by combining all the elements of fund design to work towards this goal. For example, 57% of funds in the 2015 Sanlam Benchmark Survey have taken the bold step of a having stated targeted pension for their members. Most Funds express this target in the form of a replacement ratio targeting a post retirement income of 70% to 75% of members’ final salary before retirement.

But many of these funds do not stop there; 67% of them have gone further and have aligned their default contribution rate with the targeted pension. These default contribution rates set a reference point which members can use to either aim for a higher or lower target for themselves.

In addition, three quarters of such funds (76%) believe that their members can achieve their stated target pension when invested in the default investment choice, mostly a lifestage solution, over their working lifetime. Lifestage solutions have evolved rapidly since their introduction during the nineties and 54% of the funds in the 2015 Sanlam Benchmark Survey now align the end phase in the lifestage solution with their members’ annuity options at retirement.

Once the trustees have set a target pension and aligned their default contribution rates and default investment choice to this target, they can then structure all their member communication and education initiatives around this target. A new employee induction programme is the ideal starting point to create awareness of the target pension. An annual benefit statement can be used to regularly measure a member’s progress towards this goal – whether in tabular format or more visually, using a traffic light for example. A green light would tell a member that he/she is on track, while a red light is a clear warning that the member is likely to miss the fund’s targeted pension. Member specific advice could be provided at this point, preferably in person.

Trustees can also incorporate some lessons learnt from behavioural finance to nudge those members that have opted out of the default options towards the defaults. This includes informing members with low contribution rates how much their peers are contributing or what their peer’s average projected replacement ratio is. Nobody wants to be worse off than their fellow workers.

DC fund trustees should look further than just default options in isolation. They should carefully consider how to structure their architecture of choice, starting with a targeted retirement income for members and then aligning all benefit options and fund communication to this target. This approach will help trustees to create a retirement blue print aimed at increasing the likelihood of members achieving their targeted income in retirement.