What can we learn from the US pension market? Kylie Harrison reports

The US experience of defined contribution (DC) schemes is richer and more mature than ours. Possibly as a result, the average American pension pot is much larger.

Despite different social security systems, legislation and the imminent arrival of personal accounts, there are some trends predicted to cross the Atlantic.

Target date funds

Default investment funds in the UK have traditionally moved from equities into bonds and cash around five to 10 years before retirement. Despite this quite narrow, pre-determined approach, an average 94pc of DC members accept the default option where one is available, begging the question: how can it be appropriate for the majority of employees?

Over the past few years, the US has tried to address this by investing a huge amount of innovation and investment into target date funds. These follow a simple formula: simply determine the year in which you want to retire and find the 'target date' mutual fund that matches it.

"It has quite high levels of diversification," explains Fidelity head of DC business development Julian Webb. "It is invested in all global markets and has a larger number of underlying stocks than traditional equity."

Ideally, the fund routinely rebalances to offer assets that ensure growth combined with progressively less risk as the retirement date approaches. Axa corporate benefits marketing development director Mark Rowlands believes this will soon be the norm in the UK, adding: "It has been going for the last couple of years in the US, but has really taken off with 50pc of new cash going into these new funds."

Draw down funds US default funds also use another strategy. Instead of buying an annuity, people roll their assets over into a programme that still actively invests their funds beyond the age of retirement, but allows them to draw down from that pot of money as required. Employees can say to the provider 'I would like my pot of money to last 15 years' and draw it down in equal installments; they could have half capital and then draw down the rest of it; or draw down 3-4pc on an annual basis.

Financial education

While target date funds and draw-down programmes offer a more tailored and sophisticated approach, many US employees are still not taking advantage of them. To counter this, the US has spent years trying to improve communication and ease of access to its schemes. Rowlands says: "Everyone wants to be talked to as an individual. You get better engagement levels and that helps the employer get better return on investment."

According to Webb, the US has also succeeded in making 80pc of DC participation, transaction and communication self-service via the internet, while in the UK it is probably the reverse.

"In the US you can access your DC plan, DB plan and your own private investments on a single site. It is easier to go on the internet rather than phone three or four organisations. That is something we need to adopt."

Despite the huge amount of time and money that the US invested in communication techniques and technology, employees were still not saving. Webb says: "While DC has been around a lot longer in the US, what they have now recognised is ultimately there is only so much you can do to influence take up rates and contribution levels that members pay into their DC plans."

Rowlands agrees. "Financial education has been around a long time in the States and what they have worked out is that on its own it is virtually worthless; you have got to connect it to changing peopleÕs behaviour."

Automation

The US is now following an approach that we are beginning to see the first signs of over here. Instead of advising people to join their pension scheme, they are simply signed up with the possibility of opting out.

Rowlands believes this is the way forward, a view backed up by behavioural economist Shlomo Benartzi's report Save More Tomorrow. Benartzi has shown that even if people do sign up for the default fund, they hardly ever review their choices and never switch because of fear of regretting their decision.

"Understanding consumer behaviour is the biggest thing the US can teach us. You can then design solutions based on well researched, well-understood obstacles to saving," says Rowlands.

In addition to auto-enrolment, the US is also making use of automatic increase and automatic investment. However, Rowlands points out that in some ways these American trends are not new.

"Defined benefit schemes weren't the greatest success everyone thought they were because they were defined benefit, I have come to the conclusion the reason they were so successful is that they automated all decision making for the employee.

"DC put more and more decisions on the individual, so let's take those decisions away again but do it in a more affordable DC scheme."

Safe harbour

Automation has its risks. If an employee arrives at retirement and suddenly realises he hasn't got as much in his pension pot as he anticipated, he could blame his employer for putting him in the wrong default fund. In the US, with their culture of lawsuits and blame, they have protected against this with safe harbour.

"Safe harbour has got some merit as it gives employers some comfort. If we want them to be really engaged with pensions I think it would be a really good step forward," says Rowlands. He is uncertain, however, whether it will be taken forward in the UK, adding: "We are already massively regulated and I don't know if the government has the appetite to do more."

What not to follow

The sheer size of the American economy means it often leads the way in financial matters, but Webb advises caution about impersonating everything that happens there. According to Webb, global equity funds in the UK used to be weighted more to the UK on a ratio of 70-30, then 50-50 was more of a likely strategy. Now he believes we are seeing a trend for 40-60 overseas.

"That is very positive. In the US even today there is still significant weighting on company stocks. It has been promoted by employers who allow members to access company stocks at a discounted price but they need to achieve diversification."

Key differences

Employees in the UK and US also start their retirement planning from very different vantage points. Rowlands says: "We can learn a lot from the US but some things we are better than them at. In the US they don't annuitise, they live off their fund and can run out of money. Annuities are a good product. What other product can give you a guaranteed income for life?"

Another key difference is personal accounts, which are due to be launched in 2012 and will drive take up rates in the UK. "It is not a one-way street. We are helping them too," says Rowlands.