A survey of pension trustees, managers and members by Aon Hewitt in July 2016, found that nearly two-thirds of respondents were considering reviewing their default investment solution in the light of the EU referendum result. Jenny Holt looks at the ongoing role of investment defaults within a pension scheme, and why a strong default investment solution is more important than ever.
Even without June’s referendum result, it is fair to say that the pensions industry has been going through seismic waves of change in recent years. Firstly, the advent of auto-enrolment, now well into its third year, means that a new generation of people find themselves in default investment solutions through their workplace pension. They have not actively chosen these solutions and rely on others to take action on their behalf if things change. More recently, pensions freedoms have opened up new options for members at retirement. Default solutions have been adapting to the new choice members have when taking their money.
So, briefly, two major areas of recent pensions change are already well into their respective journeys. Now, in this already shifting landscape, we are witnessing periods of market turbulence; the result of the EU referendum, the Chinese economy and oil price fluctuations. Where does this leave the progress that default solutions have made? What has changed and what has not?
The five key components
Let’s remind ourselves about the anatomy of a default investment solution as things stand today. Most such solutions offered by employers are based on one of two fundamental approaches, life styling profiles or target date funds, specifically designed to de-risk as investors approach their retirement. Whichever approach is taken, the ability to respond to change is key. It means, putting it simply, that future-proofing is baked into the structure, and allows the investment mix of default solutions to be updated and refined to reflect the fact that people can now access their money in a variety of different ways.
Look to the future
For a large organisation, future-proofing is particularly important; it instils confidence in pensions managers and employees alike, and it does not divert resources from the business of actually running the organisation at what is often a critical time. This is because if there is appropriate future-proofing built into a default solution, then the provider can take responsibility for keeping it up to date. So, if there is a market event or a change in regulations, or an EU referendum, then the solution should flex transparently, and repeatedly if necessary, to maintain its suitability without the company pensions team having to take any specific action. It might seem a bold statement in the circumstances, but dealing with the unusual is effectively ‘business as usual’. That said, employers still retain ultimate responsibility for putting in place a default for their scheme, so it needs to be the right default for their employees, both when they choose it and on an ongoing basis.
Keeping it flexible
Another key component is flexibility. When you choose a default investment solution, you are having to make an assumption about the average scheme member and while many people will conform to those average characteristics, there will be some in a scheme who are willing or able to take more risk, or who are a bit more knowledgeable and want to have a wider variety of options to choose from. Having a provider which offers a strong default solution and also flexible options beyond the default can be a real benefit to an employer, as it gives it the chance to offer the default, but then gives employees a chance to choose a
different risk level or other funds.
Diversification
Experience suggests that the majority of people are relatively risk averse, to the point where they would rather forgo gains to avoid large losses. This brings us to diversification, the third of our key components: investing in a broad range of different investment types, to reduce the likelihood of large swings in value. Pension providers want to smooth the journey so that if the markets change, as they did after the EU referendum, there is volatility management in place. All solutions will go up and down, that goes with the territory, but by minimising any falls it gives employees the confidence to stay invested. Over
the longer term, it also helps to provide more consistent outcomes for different generations of employees.
Performance
The fourth key component is performance, and after the amount paid into a pension, it is the next most important factor in determining an employee’s outcome. After all, people want to see that they are getting what they are paying for: strong, risk-adjusted returns.
Governance
Finally, governance. It is the fifth key component and it is woven through all the others. This means making sure formally that the scheme is being looked
after effectively and that it complies with the regulations around auto-enrolment. Many large organisations do not have the time to do the governance themselves, which is why it is so important that the provider does, and does it effectively.
The importance of communication
While these five key components taken together can help pension providers offer the best possible member outcomes, effective communication and engagement with employees is still vital, almost a sixth component, if you like. It can help members understand the role that investing plays in pension saving, how the default solution actually works and, ultimately, improve their outcomes. A range of different communication approaches over a period of time is likely to be most effective, not just in the six months before members come to retire. By applying the five key components, encouraging active decision making, and combining this with both active oversight and good investment management, great pensions providers can help members achieve their retirement goals, and pension managers sleep at night, even in the face of turbulent economic circumstances.