Towards a new approach to retirement systems Part I - The new reality NOVEMBER 2017
THE NEW REALITY By Bruce Wolfe, CFA Managing Director and Executive Director of the BlackRock Retirement Institute Three key insights The Netherlands is one of the OECD countries that most urgently need to reform their system to maintain its sustainability. A simple matrix can help determine where countries are on their journey and what the most important areas of reform should be. When redesigning their pension systems, countries need to focus on finding the right balance between the three pillars, the appropriate level of individual responsibility, how to deal with longevity risk and ensure product design takes an integrated lifecycle approach. In this first part of a three-part series, we examine the evolving nature of pension systems around the world and identify key aspects of a new approach. We start with an analysis of what the new reality of increased longevity and higher dependency ratios means for defined contribution (DC) pension systems. Parts two and three will then delve into potential solutions at a global level and conclude with application to the Dutch pension system. Macro view Talk of the changing retirement and longevity landscape is plentiful, but most countries are still slow to act, often doing so only at a tactical level in response to immediate demographic or fiscal challenges. However, we expect change to become the norm as global aging gathers pace. Already for those countries further along the aging curve, we see a generalized move towards a higher retirement age be it age-specific or linked to changes in the overall population s longevity. Witness the modifications in Spain (linking pension benefits to changes in longevity) or the Netherlands (raising the retirement age from 65 to 67 by 2020) as recent examples. Where large private, employer-based (or second pillar) systems exist, we see a shift from defined benefit to defined contribution arrangement. This trend is probably most advanced in Australia, but is also increasingly evident in the UK and the US. Implicit in these changes is the shifting of more responsibility for funding older age programs from the government and employer to the individual. Less clear and consistent is the overall approach countries take towards providing sustainable pensions for an aging society. 2 TOWARDS A NEW APPROACH TO RETIREMENT SYSTEMS
Each country has its unique starting point from which to build a retirement system that can cope with the steady increase in longevity and dependency ratios. 1 However, common drivers will be the current and future proportion of older citizens and the generosity of current pension programs based on replacement ratios. 2 Figure One shows this relationship for several OECD countries. Although these data points are only a point in time and require deeper trend analysis, they do highlight those countries (in the upper right) that need to assess the sustainability of their current pension structure most urgently. FIGURE ONE Pension benefits and older population 120 India Turkey 100 Netherlands Austria Argentina Russia Spain Portugal Replacement ratio for avg. earner 80 60 40 Saudi Arabia Brazil China Italy Iceland France Denmark Sweden Australia Norway Belgium United States Korea Canada Ireland Chile Germany Switzerland UK Japan Mexico 20 0 0 5 10 15 20 25 30 Population % over 65 Source: OECD Pensions at a Glance, 2015; BlackRock Retirement Institute analysis. The analysis encompasses Pillar I and II payouts. Circle indicates countries where current levels of payouts is the least sustainable. 1 Dependency ratio is the share of those in their dependent years (<15 or 64+) to adults in their prime working years (15 64). 2 Replacement ratio is an individual s gross income after retirement compared to their gross income before retirement. PART I - THE NEW REALITY 3
A common framework Regardless of where countries are on the spectrum, each of them, will have to rethink what constitutes the right mix between public and private pensions in order to confront the fiscal and financial challenges posed by increasing life expectancy and a dwindling number of workers to fund those arrangements. As each country begins or continues this transformation, we believe a simple framework can help to inform the process. The first key factor is about change, and how fast are changes needed or expected. The second factor relates to how prepared is the population from its savings and investing culture to its technology infrastructure to assume greater ownership for their retirement savings. Figure Two is a simple depiction for this framework along with labels for each of the four environments. FIGURE TWO Defined Contribution Program Framework High rate of change Liberation Paternalism Engaged Outcomes A heavy nudge Flexible direction, hard goals Less prepared environment Governments feeling pressure to make changes to the pension system yet confronted with individuals unaccustomed to actively participating in the savings and dispersion of their retirement assets will need a system heavily reliant on decision-making guidance. Incrementalism Teach them to fish Environments with the luxury of time to make changes to their retirement system can focus their efforts on creating the educational and knowledge-building infrastructure in order to better equip people to assume control over their retirement decisions in step with the ownership transition. Deep financial markets with a history of engagement by individuals to plan and save for retirement can be designed with greater decisionmaking flexibility but timing pressure warrants programs with clear goals and outcomes. Deeper Foundation Behavior building The ideal situation whereby time constraints are not overwhelming and the market is fairly well equipped to embrace necessary changes creating an environment able to experiment, build lasting skills and minimize disruptions. More prepared environment Low rate of change Source: BlackRock Retirement Institute analysis 4 TOWARDS A NEW APPROACH TO RETIREMENT SYSTEMS
There is a range of permutations possible for each of these two dimensions, but as a starting point, here are some considerations to bear in mind. A country s desire to institute modifications to the retirement system, and the pace of those changes will be heavily influenced by: The magnitude of the tension displayed in Figure One between the shape of the population pyramid (x-axis) and the level of payout (y-axis). The less affordable, the more urgent the need for change The relative flexibility of its labor market and other measures to maintain the labor pool (from extending careers through more flexible arrangements, lifelong learning, increased female participation in the workforce to targeted, skills-based immigration) Political landscape, e.g., priorities, preferences Level of trust across and between the key players government, social partners, pension funds, financial service providers (including financial advisers) and the public On the flipside, how prepared is the government, financial services industry and population to embrace a retirement system more dependent on the individual s involvement? Again, the list of things to consider under this category are numerous but here are a few ideas to keep in mind: Prevalence of a savings and investing culture Depth and breadth of investment and insurance products Level and expectation of intergenerational solidarity Whether or not there is an expectation of risk-sharing that needs to be partially retained Importance of integrating wider societal/ ESG concerns into design Level of integration of pension and savings / investing infrastructure Building a framework and then understanding where a country s current pension system and population reside on the framework helps to set the stage to design and develop solutions where the balance of responsibility for retirement rests more with the individual. For example, the United States would fall under the Deeper Foundation Behavioral Building category. The US has not been under pressure to transform its retirement and pension system rapidly, but rather had the luxury of making the transition to a defined contribution system over the last 40 years. Likewise, although the U.S. social security system projects a funding shortfall for the mid-2030s, there is still time to make gradual adjustments. Moreover, the US financial services market is highly developed and regulated, with an extensive set of investment and insurance products and services for the retail market. Individuals have been educated and nudged into becoming retirement savers and investors, especially with the adoption of the Pension Protection Act in 2006. As with any strategic evaluation, no framework is perfect. This one is no different, but could help to shape and prioritize the types of questions and issues requiring careful examination. PART I - THE NEW REALITY 5
Building a new retirement system Positioning a country on the framework is an important, albeit first step in this process and sets the stage for the design phase. What are the elements to consider when actually creating or adjusting the pension system? Looking around the world at the state of the more progressive DC pension systems offers some insights and direction. Figure Three highlights four key characteristics to consider in the actual design phase. Most countries organize their pension system into three pillars 3 with the ultimate objective of providing individuals with a certain level of retirement funding as deemed appropriate by policymakers. For many countries the metric and goal is a 70-80% replacement ratio. Ideally, public policies, tax incentives, regulation, etc. are designed in a reinforcing and integrated way, leading towards that desired outcome. Historically, Pillar I was the dominant contributor to funding retirement in most countries but now the mix is shifting towards a greater balance across all three pillars. Whatever the right mix is will be country-specific, but with one constant, common factor: individuals having greater responsibility in the decision-making process. How active should individuals be in this process will, again, vary. On the one hand, this is their retirement and personal preferences should inform decisions about savings contribution rates, investment allocations and the like. On the other hand, most people may not be properly educated on retirement matters, be unwilling to decide or hold hidden biases in their thought processes that might not guide them towards optimal decisions the rational vs. irrational mind. Finding the appropriate balance is hard, but policymakers can now look at examples across the spectrum from mandatory solutions (Australia, Chile) to strictly voluntary (Japan). FIGURE THREE Defined Contribution Design Characteristics Contributors Accountability 0 PILLAR I MANDATORY SELF-RELIANCE PILLAR II PILLAR III Longevity risk Integration INVESTMENTS INSURANCE INDIVIDUAL PHASES INTEGRATED LIFECYCLE Source: BlackRock Retirement Institute analysis. 3 Pillar I is primarily public transfers; Pillar II and III are private pensions and savings programs. 6 TOWARDS A NEW APPROACH TO RETIREMENT SYSTEMS
At a product level, two fundamental issues are worth considering: Longevity risk is the most obvious one. It can be addressed with investment and / or insurance products. Both types of solutions have inherent pros and cons for the end-user. Depending on many of the environmental factors previously discussed, the optimal solution(s) can cover the gamut from pure investment, to pure insurance to a mixture of the two. The second issue, and a more nuanced aspect to the product solution, is how these are designed or not for a person s entire lifetime. Most defined contribution retirement systems cleave the lifecycle between the accumulation or savings phase and the decumulation or retirement spending phase. Often they offer fixed benefits that do not align with a 20 or even 30-year time horizon. In sum, longer, healthier lives create new possibilities. But to realize the miracle inherent in those extra years a miracle maybe unimaginable a generation or two ago countries will have to make fundamental changes in their approach to retirement. ABOUT BlackRock Retirement Institute The BlackRock Retirement Institute (BRI) is BlackRock s global thought leadership platform on retirement and longevity established to enable our clients and broader community to make better decisions toward a financially secure and dignified retirement. Lifespans have shot up over the last several decades but the way the world thinks and acts to address this new reality has yet to catch up. We at BlackRock recognize this emerging revolution its challenges, its opportunities and through BRI we join our voice with the voices of other experts to create and amplify some of the best thinking on retirement and longevity. As the world s largest asset manager 4 with two-thirds of the funds we manage related to retirement BlackRock understands that our firm has a special responsibility to assist people all over the globe to live out their later years with dignity and security. An essential component of that is helping governments, institutions and individuals understand and take action in response to this new phase in mankind s history that s what BRI is here to do. 4 Based on $5.97 trillion assets under management as of 9/30/17. PART I - THE NEW REALITY 7
Want to know more? BRI@blackrock.com 877-992-5532 (1-877-99-BLKDC) This material is provided for educational purposes only and should not be construed as research. The information on this website is not a complete analysis of the global retirement landscape. The opinions expressed herein are as of September 20th, 2017and are subject to change at any time due to changes in the market, the economic or regulatory environment or for other reasons. The material does not constitute investment, legal, tax or other advice and is not to be relied on in making an investment or other decision. Note: The opinions expressed in the third-party articles or content do not necessarily reflect the views of BlackRock. BlackRock makes no representation as to the completeness or accuracy of any third-party statement. No part of this material may be reproduced, stored in any retrieval system or transmitted in any form or by any means, electronic, mechanical, recording or otherwise, without the prior written consent of BlackRock. This publication is not intended for distribution to, or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation. 2017 BlackRock, Inc. All Rights Reserved. Prepared by BlackRock Investments, LLC, member FINRA. Not FDIC Insured May Lose Value No Bank Guarantee Lit. No. RETSYSTEM-PTI-1117 171760T-A-1117