If you read nothing else, read this…
• Employers and pension trustees have been seeking ways to limit the level of risk in default funds.
• Poorly performing investments will reduce the size of pension pots, with repercussions for employers and staff
• Ascertaining risk for scheme members is fraught with difficulties.
• The vast majority of employees do not want to make investment decisions.
• Risk profiling tools have limited value.
How much risk do employers and pension scheme members want to take with investments? Padraig Floyd reports
With the demise of defined benefit (DB) pension schemes in recent years, employers are looking to improve the pensions they offer to their workers.
Defined contribution (DC) schemes have traditionally offered poorer security because, unlike DB arrangements, the investment risk is placed squarely on the shoulders of the member.
There are a number of problems with this. The first is that the retiring employee may have a relatively small pot to provide their retirement income. That has attendant risks for the employer, not least in terms of reputation.
Another crucial element for employers is that if staff have small retirement funds, they will be less willing to retire, especially now that there is no default retirement age.
As such, that may not be a problem. Many employers want to maintain a link with senior staff because their knowledge and experience are major assets. But there will be situations where that is not the case and if organisations cannot manage their succession planning, this will be a considerable drain on resources.
There is anecdotal evidence that investment is fairly high up the list of concerns for employers, particularly the more paternalistic ones, says Paul Todd, head of investment policy at Nest (National Employment Savings Trust).
“Employers are doing things directly to their workforce through auto-enrolment and there is nervousness about making the wrong decision, bad outcomes or culpability in the future,” he says. “They want to do the right thing, but they are not sure what the right thing looks like yet.”
The Department for Work and Pensions has provided guidance on best practice for selecting a default fund but, says Todd, do employers know what their membership looks like?
Employers have been changing their approach to default options because 90% of members fail to choose an investment strategy, and the defaults that are still in place in many schemes are considered unsuitable for an unengaged audience. They tend to be have high exposures to equities (shares) and so are subject to the peaks and troughs of the market. They also tend to be invested passively, replicating the market they are invested in rather than having just high-performing company shares. This reduces cost, but does nothing to protect member funds.
Employers and trustee boards have therefore been looking at ways to limit the level of risk to which their default investment structures expose members’ funds. For more on the different types of structure being used and the difference between active and passive management, see last month’s cover story.
Some want to do more and there is a discussion between employers, the advisory industry and the pensions minister as to how employers might share risk with members without shouldering the burden associated with DB pensions.
This debate, about what is being called “defined ambition” or “defined aspiration”, is in its early stages, but could result in structures that will support employers in the future by offering risk-shared pensions. Before that is possible, some are looking at alternative methods of reducing risk.
The concept of ascertaining risk for your pension scheme membership is fraught with difficulty. The typical approach is to communicate members’ options to them, which includes investment strategy. At the most basic level, this will say how many funds there are to choose from and may give an indication of the level of risk contained within them.
This is a difficult enough concept to convey to an engaged workforce, but the vast majority of scheme members will fail to engage or make any active choices in their pension plans. This will be compounded by auto-enrolment, which starts in October for the UK’s largest employers. As it is designed as a catch-all for any employees who do not already have a pension scheme, auto-enrolment relies on a lack of engagement to ensure large numbers of staff do not choose to opt out.
So there is a hard choice for employers: to build a strong default fund that can offer the best compromise for all members, or try to offer a degree more tailoring.
Tailoring should not be difficult because DC pensions are based on individual savings pots. Currently, employers spend a lot of money trying to get people to make active investment decisions, but some are uncomfortable with that. Of course, there is the risk that they may make a poor investment decision and suffer serious detriment. This may result in them not wishing to retire at a notional normal retirement age.
Sue the employer
There is also a greater chance that they are going to sue the employer if they feel they have not been well looked after. We live in a litigious society and once the PPI (payment protection insurance) mis-selling saga has died away, the ambulance-chasers will be looking for a new revenue stream. The low levels of governance DC funds have had for two decades, combined with highly volatile markets, means there will be plenty of scope to bring actions against employers and trustee groups.
Neil Smith, partner in the pensions groups at CMS Cameron McKenna, agrees that the volatile markets of the past decade could result in retirees in the coming years being less than satisfied with their retirement funds and possibly seeking redress from the trustees, employer or both. But members have different views of risk, which must be catered for, says Smith.
“Even in an investment bank, where most employees are highly sophisticated on investment matters and are naturally risk takers, there are those in the membership with different levels and you therefore need a wide range of investment vehicles.”
Offering a more tailored option might be dangerous because neither trustees nor employers are qualified to give advice and sophisticated risk profiling would have to be repeated to account for any changing attitudes to risk. This is fraught with difficulty, because the reason people end up in the default option is that they do not engage with communications.
“Schemes could make allocations based on age, salary level and status,” says Smith, “but it is very difficult. Although it might be a reasonable decision and the regulator might agree it, you would have to expect to leave yourself open to more claims.”
Malcolm Delahaye, a director of Supertrust UK, believes the multi-employer master trust model gives employers much better governance for offering more tailored investment options. He is a champion of a tailored approach and Supertrust offers Managed DC, which helps staff to select an investment strategy without needing excessive communication or documentation (see box, page 18).
“There is no substitute for systems which allow employees to understand what is feasible, what downside risks they can stand and for professional governance and risk management systems to manage assets dynamically on their behalf,” says Delahaye.
But Laith Khalaf, a pensions analyst at Hargreaves Lansdown, is dismissive of risk profiling within DC.
“Using age and salary data as a proxy for risk is pretty close to useless,” he says. “It is like asking someone what their favourite flavour of crisps is.
“Risk profiling tools are a little like psychometric tests: at the end of the day, you are a medium-risk investor.”
Khalaf says there is no automated system that can satisfactorily manage a member’s risk in that way and he advocates a “common sense approach” to being invested for a long time by taking a balanced or mixed asset funds route and engaging with members directly.
“If you have an adviser, that is great, but it is better to encourage members to think about the risk themselves,” he says.
Risk profiling of any kind is not an option for Morten Nilsson, chief executive of Now Pensions. “Our analysis is that most people end up in the default options, so you need an option that has an appropriate default strategy,” he says.
Nor does Nilsson advocate detailed engagement. “You can spend too much time trying to educate people when they are only going to be guided into something that actually makes sense,” he says.
But some would argue that a broader root-and-branch review of DC pensions is required, rather than just reviewing the default option.
Lee Hollingworth, head of DC at Hymans Robertson, says: “DC is not set up to deliver value for members at present. The evidence suggests that many DC schemes have been set up without any real thought as to the outcome or impact of their design, particularly from an investment point of view.”
Rather than risk profiling, Hollingworth recommends a new approach to defaults that goes beyond the single catch-all fund.
“A one-size-fits-all default fund is inadequate,” he says. “Multiple default funds, based on different earnings bands and retirement income replacement rates, are a far better solution.
“Low earners, who are likely to receive a higher share of their retirement income from the state, are almost certain to have different requirements and risk attitudes to high earners in the same scheme. To put them in the same default fund just doesn’t make sense if you are trying to reach retirement replacement income targets for each group.”
Make a call
Employers who want to reduce the level of risk within their employees’ pension funds have to make a call as to how they are going to do it.
“There is a very important discussion about governance around default strategies as many members will be accidental investors,” says Jonathan Lipkin, associate director, pensions and research at the Investment Management Association. “Millions will be enrolled in a pension with no experience of finance beyond bank accounts or mortgages.”
He suggests employers be guided by The Pensions Regulator’s six principles to help them build a governance framework, but additional support may be required.
Far more worrying are other risks that are all too often forgotten in the maelstrom surrounding employer responsibilities.
“Ultimately, there are two critical risks in DC,” says Lipkin. “The first is that the member does not contribute enough and the second is not taking risk commensurate with their investment horizon: reckless conservatism in investment or an inadequate glidepath in not taking account of the time to annuitisation.”
Individual risk tolerance
If there is one thing that doesn’t change, it is human nature. When times are tough, we pull in our horns, tighten our belts and batten down the hatches. Or so say many investment advisers: that risk tolerance is directly correlated to the volatility of the financial markets. However, there is increasing evidence that this view, although orthodox, is wrong.
This is because risk questionnaires that do not screen for an investor’s perception of risk have been widely used by investment advisers when determining their clients’ attitude to risk. This is what individual DC scheme members are being asked to do today, often without any recourse to such a tool.
Evidence shows that financial risk tolerance is not only largely consistent over time, but is not a learned disposition. It is part of an individual’s DNA, says Paul Resnik, co-founder and director of Finametrica, a risk-profiling specialist that works with advisory companies in the personal finance market.
“Risk tolerance changes little through the life of an investor and is only nominally prone to being influenced by emotional factors at times of market stress,” says Resnik.
This is not bad news for advisers, it is fantastic news, he says. If tolerance does not move, the adviser is better placed to advise clients on their planning strategies and manage their perception of risk, which is likely to be challenged by poorly performing markets.
Resnik believes more accurate risk tolerance measurement will better satisfy client, adviser and regulator that any advice suits the requirements of the client in the future.
Although this applies to the individual advised market, some feel there is an application for such technology in helping employers and trustee bodies to determine the structure of their defaults.
The role of individual risk profiling
Supertrust UK offers a Managed DC service that uses a member’s age and salary details to determine a default risk profile.
Using a simple online dashboard, the member can change the parameters governing their minimum retirement income, how much income they would actually like to have, how much they want to contribute and the age at which they want to retire. The system then produces a figure showing how likely they are to achieve that.
By focusing on the variables that the individual understands rather than those they do not, such as getting to grips with risk profiles and selecting funds, the employee can reach a strategy they are satisfied with.
Once this has been done, the investment managers adjust the asset allocation within that individual’s fund in line with the targets decided upon.
Read more features on workplace savings
Read more articles from the Workplace Savings Quarterly