KPMG LLP (UK)

Investment for Defined Contribution Schemes

DC Market developments As more companies provide a DC pension scheme for new employees, and as significant money has flowed into these schemes, the market has grown exponentially over the past few years. This market growth has led to significant innovations in all areas of DC including service delivery, administration, communication and investment choice. On the investment side, more products have become available and cost efficient for DC pensions, and the capabilities of administrators to tailor and blend together bespoke strategies has increased dramatically. In particular, alternative investments are being made available and some of the new developments in the DB space such as Diversified Growth Funds have also found an application in DC funds. DC pensions delivery There is an increasing trend in the UK pensions market to move from trust-based DC schemes that sit within a trustee framework to contract-based plans where members have personal control over their plan benefits, investment choices and options at retirement. Cost efficiency and bundling of services (investment and administration) are key drivers for change in the market. Modern DC plans exploiting the best of what is available in the market can generate material savings for the corporate sponsor. hese T savings can either be used to enhance employee support programmes or to introduce wider benefits. At the same time, governance is becoming more important in both trust-based and contract-based DC arrangements. Both types of arrangements can create a good framework for oversight of general plan administration and complete flexibility over investment options.

Over the last few years there have been many developments in DC product design that allow for the less costly provision of more efficient DC investment options. We highlight some of the changes and illustrate our latest thinking.
Background Today most employers have a DC pension scheme in place, often alongside a legacy DB scheme. While historically the focus of pension fund trustees and corporate HR and finance managers was on effectively managing the DB strategy, we now see an increased focus on the cost-efficient provision of state of the art DC pension arrangements. A large number of DC pension investment arrangements were set up with simplicity in mind. his usually included an off-theT shelf lifestyle option consisting of a passive equity fund and a limited range of equity and bond funds.

Evaluating DC investment
Same expected replacement ratio

Growth asset = Diversified growth fund Frequency Growth asset = passive equity Note: Sample replacement ratio analysis, for illustration only

0%

25%

50%

75% Replacement ratio

100%

125%

150%

2010 KPMG LLP , a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

The Replacement Ratio When reviewing the effectiveness or success of a DC investment strategy, the most common measure used is the replacement ratio. This is the ratio of the expected pension to the final salary. For example, a replacement ratio of 30% means the pension is expected to be 30% of a members final salary. The expected levels of replacement ratios depend on a number of factors, most notably the contributions paid, the investment strategy utilised and the time to retirement. When modelling replacement ratios, it is important to look at the expected value as well as the spread of possible outcomes. This spread is an indicator of risk, with a wide spread indicating a larger possibility of lower replacement ratios. In our experience, changes to the investment strategy that aim to maintain an expected return but diversify the asset base can materially reduce the dispersion of expected replacement ratios. hanging the de-risking or switching periods will also C impact the spread of expected replacement ratios, but this has less effect than the investment strategy itself. DC investment structure Research has shown that without significant education and communication, a large majority of members do not make an active investment choice in a DC scheme. We therefore believe it is extremely important to have an appropriate default fund option. This default should be a lifestyle fund that switches the member out of growth assets over a predetermined period before retirement.

It is best practice to encourage choice and investor education through offering more than one lifestyle option. Different lifestyle strategies can then be delivered based on a simplified self-selection process reflecting a cautious, moderate or aggressive risk appetite. For more active members that prefer to self select their investment options, we see a trend towards a concentrated core range of funds consisting of a range of different asset classes and investment strategies. DC Lifestyling Growth portfolios There have been significant developments in respect of the structure and composition of the growth / accumulation investments that comprise the early part of a lifestyle strategy. The wider variety of fund options now available and affordable for DC schemes allows a more broad-based growth portfolio to be constructed. This can help achieve a similar expected return and replacement ratio as for a passive equity strategy, but with significantly lower expected risk, i.e. a lower expected spread of replacement ratios. Technical improvements at DC administrators and providers mean that a selection of individual funds can now be blended together and white-labelled as a bespoke new fund, such as the XYZ Pension Scheme Cautious Growth Fund . These blended funds make member communication significantly easier and can be used in lifestyle strategies. There are additional governance benefits, as it is easier to replace component funds within a blended and white-labelled bespoke fund without complex member record keeping.

Lifestyle structure
100% Cash fund 80% Cautious Growth Fund can include: 60% Passive UK Equities Passive Global Equities 40% Corporate Bonds Property Diversified Growth Fund 20% Matching fund

0% 25+

20

15 Years to retirement

10

2010 KPMG LLP , a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

Switching periods and de-risking Developments at DC administrators have also led to greater flexibility when it comes to switching (or de-risking) out of growth assets into bond assets within a lifestyle strategy. In the past this switch typically happened over 5 years before the expected retirement age. Switching periods have become more flexible, allowing longer switching periods that can be used for a cautious lifestyle approach. In addition there have been developments towards accelerated and other non-linear switching mechanics. When switching out of risky assets as part of a lifestyle strategy, the choice of appropriate destination investment vehicle is important. here have been developments in matching funds T that aim to have a low risk and provide a reasonable match for annuity prices.

KPMG View There has been tremendous development in the DC pensions sector over the last couple of years. he growth of the DC T market has accelerated product development and innovation to a new level. We believe that there is an opportunity to review DC pension arrangements to make them more efficient. We see most innovations in designing state of the art lifestyle strategies. DC pensions can be effectively delivered through a trustbased or a contract-based structure depending on client circumstances. Most benefits detailed in this note are accessible through both structures.

There has been tremendous development in the DC pensions sector over the last couple of years. The growth of the DC market has accelerated product development and innovation to a new level. We believe that there is an opportunity to review DC pension arrangements to make them more efficient.

To discuss this further, please contact: Alex Koriath T: 020 7694 1902 E: alexander.koriath@kpmg.co.uk www.kpmg.co.uk

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. 2010 KPMG LLP , a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved. Printed in the United Kingdom The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. KPMG LLP (UK)s Design Services I RRD-237960 I December 2010.