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DISCUSSION PAPER PI-0706

Its all Back to Front: Critical Issues in the Design of Defined Contribution Pension Plans

David Blake

A good defined contribution pension plan is one that is one that is designed from back to
front as a single, integrated financial product. The design process begins by determining
what size pension is required in retirement, and then working backwards from the projected
death date of the member to the planned retirement date, it estimates the fund size needed
by the retirement date to deliver this pension. Depending on the member’s attitude to risk
and desire to make a bequest, the pension can be paid either in the form of a life annuity or
using an income drawdown programme. Then working backwards again to the starting date
of the plan and taking into account both the length of the accumulation period and the plan
member’s attitude to risk and salary profile, the plan will determine the optimal (stochastic
lifestyling) investment strategy and the required net contributions. An allowance for
administration costs and plan provider profit is made to derive gross contributions. We find
little evidence that Personal Pension Plans, the main type of individual DC plan in the UK,
are well-designed and we discuss six critical design failures covering: charges, lapses,
investment strategy, investment performance, fund annuitisation and the incentives to those
delivering key components of the plan. We suggest a number of ways in which the design
can be improved.

Key words: pension plan, defined contribution, investment strategy, investment performance,
annuities, incentives