By Andy Jung

Defined contribution (DC) plans, in today’s challenging environment, may not offer the level of comfort and security that most members expect. The events of recent years, and ongoing market volatility, are leading people to re-evaluate their perspectives on risk relative to return.

Risk in a DC context is quite simply the likelihood of failing to meet retirement objectives. One objective, for example, could be to retire on a pension that replaces 50 percent of an member’s salary at age 65. The possibilities are endless, but simple objectives add clarity to planning and decision making. Most members are likely to frame their objectives in terms of income desired at retirement, retirement age, or level of contributions.

Traditional measures of risk used widely for defined benefit plans, such as tracking error or value at risk, are not easily understood by the majority of members. They also vary significantly according to individual circumstances. In order to measure and communicate risk so that members regardless of financial education and different situations understand the risks that they face, defining the risks in the same terms as the members define their objectives is crucial.

The nature of DC is that investment risks are born solely by the member, so any losses will translate into lower pension, more working years, or having to save more.

Consider a member, who is five years from his planned retirement date and he has suffered a significant fall in the value of his DC fund. He may have to live on less when he reaches retirement, increase contribution to savings change the way he invests, or defer retirement date.

His colleague may suffer a similar fall in fund value. This gives her the same potential retirement deferral implications, but she is currently 10 years from retirement and therefore has more time and opportunity to either adjust her retirement income expectations, defer her planned retirement date, or increase her savings.

The requirement for these two members to change one or other of these inputs to stay on track is therefore a risk that other members may also be exposed to. The possible extent of this expected retirement deferral is referred to Retirement at Risk (RaR).

The measure for RaR is the minimum increase required in a member’s working life in order to recover from a 1-in-20 event (such as the recent credit crunch and debt crisis) over one year and maintain the same expected replacement ratio at the later retirement age. By retiring later, a member’s pension fund is expected to grow with more contributions and investment returns. Towers Watson’s research shows that, typically, members do not expect to delay their planned retirement by more than four to five years.

Whilst the absolute level of risk is a consideration, so too is its timing. Remember the first member described above, who is five years from his anticipated retirement date. Say he is exposed to six years of RaR; there is a 1-in-20 chance that he could be required to work at least six years longer than anticipated. These will more than double the rest of his remaining expected working life. The second member, on the other hand, with 10 years to respond to the same level of RaR, has much more flexibility to adjust her income expectations, retirement date or contributions. If she does not have flexibility in her choice of retirement date, she will need to reduce her exposure to this risk.

Thus, we may reach two conclusions from this measure: Firstly, when the term to the planned retirement date is long, the member may seek to correct deviations from the expected outcome with contributions, or hope that investments improve. Members closer to retirement, however, should consider reducing allocations to risky assets if they cannot tolerate the risk associated with the investment strategy.

Secondly, as the member’s term to retirement reduces, they have less ability to correct the impact of adverse market events through their contributions and instead may seek to defer their retirement in order to receive the same expected pension. A member’s ability to change their retirement age may be subject to employment constraints. Employers and trustees may wish to manage expectations of flexibility to defer retirement date.

In sum, those with DC plans should limit risk to what they can tolerate and recover from. The simple concept of RaR can prove a useful tool in their assessment of objectives and risk tolerance.

Andy Jung is a senior consultant at Towers Watson Korea