Pensions auto-enrolment legislation requires employers to offer their workforce a default investment fund, but it must be considered fit for purpose.
If you read nothing else, read this…
- Employers must offer staff a default fund under auto-enrolment legislation.
- But the funds are, arguably, not fit for purpose because of their legacy issues and restrictive asset allocation.
- Regulatory guidance on default fund governance should help default funds to evolve.
Pensions auto-enrolment has been dubbed one of the biggest behavioural economics-inspired studies in the world, and it is no surprise why.
Introduced in October 2012, the legislation requires employers to auto-enrol their employees into a workplace pension scheme, and, as part of their underlying investment fund portfolio, offer a default option for employees that do not, or prefer not to, make an active choice about where their pensions contributions are invested.
The legislation is clearly designed to address the apathy that the government has identified in employees when it comes to saving for their retirement.
The Department for Work and Pensions (DWP) expects the vast majority of employees to be auto-enrolled into their employer’s default pension fund, which explains why it requires organisations to ensure that their default option is fit for purpose on an ongoing basis.
In its Guidance for offering a default option for defined contribution automatic enrolment pension schemes report, published in May 2011, the DWP states: “The design, governance and communication of the default option will play an important role in securing good outcomes for members.”
But many pensions professionals and employers believe that default funds must evolve considerably to be fit for purpose and able to meet the DWP’s objectives, and that the fund’s legacy issues should be one of the first issues to overcome.
Simon Chinnery, head of UK DC at JP Morgan and chairman of the Defined Contribution Investment Forum (DCIF), says: “Looking back in time, not all defined contribution plans had a thing called a default. It’s a relatively recent phenomenon.
“Back in the day, there’d be risk-balanced funds, a balance of funds and a choice. The idea was, if there was choice, it was up to the employee: what did they feel like?
“The default fund is probably a legacy of an awful lot of funds that were okay at the time, because that’s all there was available, but I think that, given that the tipping point between defined benefit (DB) and DC will be about 2019, where assets in DC will overtake DB, it is appropriate that there is now a focus on what a default is.”
Pete Strudwick, pensions and performance partner at insurer LV=, says: “I hope that default funds are in their infancy still because while they do a job, I’m not sure they do it as well as they can.
Pots of money
“What default funds are [aimed at] doing at the moment is increasing employees’ pots of money, whereas what they should be doing is trying to target an income towards the end of employees’ working lives.”
But Mark Willmott, institutional business development director at Jupiter Asset Management, says it is a challenge to work out how to offer default funds that deliver an adequate and reliable retirement income for members. “It’s a key question that lots of people are wrestling with, and I’m not sure anyone has got the right answer yet,” he says.
Madeline Forrester, head of institutional sales at Axa Investment Managers and vice-chairman of the DCIF, says DC asset allocation is also a challenge, and can prevent default funds from being fit for purpose. She takes issue with the DC pensions industry’s daily dealing rules, which require DC funds to be priced daily, deterring investment into illiquid assets such as property, which cannot be priced daily.
“We have created a system that depends on daily liquidity for an investment that employees are making for 30 or 40 years, so what that means is that a significant amount of the investment options that are available to DB can’t be delivered to DC,” she says.
Forrester is particularly concerned about employees with accumulated income who are nearing retirement, but who have no plans to draw this down for at least 10 years. She says some bond-like investments, which also have a return element, are not available to employees.
This is why, as soon as their pot gets to a decent size, they end up, with a lifestyling strategy [an investment technique that allocates pension fund assets based on key life stages], with their money being put into bonds, which historically give low returns. The removal of daily liquidity constraints could enable members’ pensions pots to be put into higher-yielding, but still fixed income-like, investments such as infrastructure or property, Forrester says.
John Chilman, group reward and pensions director at transport operator FirstGroup, adds: “I think that’s a very important thing that hasn’t been harnessed yet. When you look at the added value that could be given if members were prepared to say, ‘I’m sticking with this [asset] for 20 years’, they could get an extra return [on their investment] in certain areas.”
But, understandably, many HR and benefits professionals are apprehensive about having input into potentially life-changing investment decisions on behalf of staff.
“There’s a ton of stuff that HR is facing right now, and quite rightly they’ve been throwing their arms up and saying, ‘well, we’re not the experts’,” says JP Morgan’s Chinnery. “It’s a pressure because under auto-enrolment, employers have to have a default, it’s got to be fit for purpose and they’ve got to have good governance.”
Charles Pender, deputy chairman of Lloyd’s Superannuation Fund, warns that this pressure may result in employers looking at the lowest-risk default option for their organisation, for which they will receive criticism.
LV=’s Strudwick agrees, saying: “I think the majority of HR professionals need external help to help them through this. The problem with that is that it’s costly, and is the advice given by the various consultancies out there the right sort of advice, or are they just going down the route of ‘this is the least risky option that I can get you to agree to’?
”Are they actually looking at what is right for the employer, and are they prepared to push an employer to recommend something that might seem slightly out of their comfort zone, but that they, as the professional, can genuinely back and say ‘yes, I’ll nail my colours to this mast and I think this is right’?”
Target date funds
FirstGroup’s Chilman also thinks some pension advisers may avoid recommending an investment that doesn’t give them an ongoing income stream. An example of this is target date funds, investment funds that de-risk as they approach a target date, which have not got a lot of traction in the UK, he says.
“They are highly adopted and seen as the safe harbour in the US, but they have actually got a lot of good things behind them and get away from the problems associated with traditional lifestyling,” he says.
But no single default fund will match all employees’ risk appetites, and it would be foolish for any employer to believe it could.
One size fits all
“Default strategies are based on a one-size-fits-all approach at the moment,” says Strudwick. “They are based on the average person and there is no average person out there, so they’re not fit for purpose for anyone. They will be close, but not close enough.”
Chilman adds: “I don’t think we should reach the conclusion that default funds are actually the right funds for anybody. They are appropriate for the amalgam. The work that needs to be done by HR and reward teams is actually finding out what their employees need.
“Employees need to have a pot that turns into a pension, but what are they going to do with it? There’s a very different situation between one of our bus drivers earning £20,000 who is planning to buy an annuity and an employee who would use their pensions pot for income drawdown. Managing that in the right way is very important.”
But Spencer Roach, total rewards manager at Cisco Systems, says employers should not fall into the trap of viewing default funds as the panacea for employees’ retirement savings needs.
“To me, the future is not about lots of employees having amazing default funds, but about them being informed investors,” he says. “We’re looking for something a lot more diverse with a better risk balance, but at the same time we will still be giving employees all the tools so they can make their own decisions, and we want them to continue making their own decisions.
“The default, to me, is a safety net. It would be a shame if the unintentional result of auto-enrolment is that staff stop making conscious investment decisions.”
Roach’s aspiration is ambitious at best, according to Chris Curry, director of the Pensions Policy Institute. “With auto-enrolment, employers are bringing pensions to a completely new group of employees who have no experience of investing or pensions, or even saving.
“So, over a period of time, to expect them to engage and understand enough to make their own investment decisions without a default is probably unrealistic. Most employees would rather not have to take a decision.”
Chilman believes most employees are incapable of making their own investment decisions. “When you look at the decisions that employees make in a DC environment, they make bad decisions,” he says.
“They buy at the top [of the stock market] and sell at the bottom. I look at my North American [pension] schemes that are much more established and there’s a much more engaged workforce there because these have been the [investment] models for 25 years.
“But we’ve had too many people in stable value funds [which offer guaranteed returns on retirement income], and we had to default them away from that to try to give them a decent prospect of having a good outcome.
“I’m in a business where the average reading age of my drivers is nine. I’m never going to make them financially sophisticated enough to make these decisions, so I have to give them a good default.”
Roach and Chilman’s different approaches to fund choice highlight the importance of the pensions industry recognising the differing needs of employers’ workforces, says Forrester. “We, as an industry, have got to get better at putting these at the heart of everything we do,” she says.
Sarah Swift, a partner in the pensions department at law firm Eversheds, believes the evolving governance of defaults will help to address their shortcomings, and ensure that the funds are fit for purpose.
“There is a wealth of guidance and governance from the DWP and The Pensions Regulator and the governance bar’s been raised, or it’s trying to be raised, and default funds must be going to a better place,” she says.
“Regulators are talking about continually reviewing insurers and having to review at least every three years whether the default fund is still fit for purpose, and making sure that it takes into account the members who are going to be in it.
“It’s difficult because I don’t know how to actually do that when members are so diverse. But people are thinking about it, and I think that if we can get to a position where default funds are better governed and doing the right thing, then that’s a good place to be.”
Read the digital edition of our supplement, The future of default funds 2014, in full.