We have established 16 good practice principles in modelling defined contribution pension plans. These principles cover the following issues: model specification and calibration; modelling quantifiable uncertainty; modelling member choices; modelling member characteristics, such as occupation and gender; modelling plan charges; modelling longevity risk; modelling the post-retirement period; integrating the pre- and post-retirement periods; modelling additional sources of income, such as the state pension and equity release; modelling extraneous factors, such as unemployment risk, activity rates, taxes and entitlements; scenario analysis and stress testing; periodic updating of the model and changing assumptions; and overall fitness for purpose. For the complete white paper on PensionMetrics Methodology, see: www.pensions-institute.org/workingpapers/wp1302.pdf
Principle 1: The underlying assumptions in the model should be plausible, transparent and internally consistent.
Principle 2: The model’s calibrations should be appropriately audited or challenged, and the model’s projections should be subject to backtesting.
Principle 3: The model must be stochastic and be capable of dealing with quantifiable uncertainty.
Principle 4: A suitable risk metric should be specified for each output variable of interest, especially one dealing with downside risk. Examples would be the 5% value-at-risk and the 90% prediction interval. These risk metrics should be illustrated graphically using appropriate charts.
Principle 5: The quantitative consequences of different sets of member choices and actions should be clearly spelled out to help the member make an informed set of decisions.
Principle 6: The model should take account of key member characteristics, such as occupation, gender, and existing assets and liabilities.
Principle 7: The model should illustrate the consequences of the member’s attitude to risk for the plan’s asset allocation decision. It should also show the consequences of changing the asset allocation, contribution rate and planned retirement date, thereby enabling the member to iterate towards the preferred combination of these key decision variables.
Principle 8: The model should take into account the full set of plan charges.
Principle 9: The model should take account of longevity risk and projected increases in life expectancy over the member’s lifetime.
Principle 10: The model should project both at-retirement pension outcomes and post-retirement outcomes. The risks associated with the following strategies should be clearly illustrated:
Principle 12: The model should consider other sources of retirement income outside the member’s own pension plan. These include the state pension and home equity release. A well-designed DC model will also help with lifetime financial planning.
Principle 13: The model should reflect reality as much as possible and allow for such extraneous factors as unemployment risk, activity rates, taxes and welfare entitlements.
Principle 14: Scenario analysis and stress testing are important. For any given scenario, one should also:
Principle 15: The model will need to be updated periodically and the assumptions changed. Such modifications should be carefully documented and explained in order to make sure the model retains its credibility with users.
Principle 16: The model should be fit for purpose.
Applying these principles will often have uncomfortable implications for plan members. They will often show that if members want to have a particular standard of living in retirement, then they will be making insufficient contributions to their pension plan, following a recklessly conservative investment strategy, planning to retire too early, or some combination of these. Practitioners have told us that revealing this reality to members might put them off contributing to a pension in the first place. We would argue that it is much better to be realistic about the future than to hide your head in the sand. In addition, there might be pressure to change the assumptions if the outcomes are not liked. This should be resisted, unless there are compelling reasons for doing so.