A model default fund would ensure all employees receive an adequate income in retirement, but what features will the fund strategy of the future need to secure this outcome?
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- The default fund strategy of the future should be flexible enough to address employees’ diverse retirement income needs.
- Asset allocation should be more diverse and include illiquid assets, such as property.
- But employers must focus on employees’ retirement income, rather than investment returns.
Flexibility should be at the heart of employers’ future default fund strategies , not least to cater for employees’ varied retirement dates.
Simon Chinnery, head of UK defined contribution (DC) practice at JP Morgan, says: “Employers are going to have these employees who, as they near retirement, decide that they want to, or need to, work a bit longer, but maybe not full time.”
Andy Dickson, investment director, UK institutional business at Standard Life Investments says employers can overcome this issue by offering staff more than one default fund, so the fund strategy of the future may include two or three funds from which employees can choose.
Dickson says there is no such thing as a perfect default because each employee has his or her own needs, but what employers can do is break their workforce down by cohort. This could be based on pay levels, he suggests.
Chris Curry, director of the Pensions Policy Institute, says: “I don’t think there is just one perfect default fund to look for, so what we’d like to see is a range of different default funds that are suitable for different groups [of employees] at different stages in their career, but also that the funds are good value for money.”
Curry says there is no reason why an employer cannot offer a good default fund plus sophisticated fund options for staff that want to take them. “What employers cannot do is force employees to have to take those options,” he says.
However many default funds employers offer, their future strategy must also be flexible in terms of asset allocation.
Mark Willmott, institutional business development director at Jupiter Asset Management, says his default fund of the future would be based on a well-balanced, diversified, multi-asset strategy that provides growth, can deliver a return on investment above inflation, and increases above average earnings.
“If it can do that, and in a cost-effective way, then I think that has to be a good starting place,” he says.
Pension professionals generally agree that default fund assets should include more illiquid assets, such as infrastructure and property.
Dickson says: “We’ve got a curious situation here in the UK, where all the DC arrangements have to operate on a daily price basis, and that puts a barrier in the way of diversification. A simple example would be property. Property, by its very nature, is not a liquid asset: it takes a while to sell a building and it can’t be valued on a daily basis.”
Pension providers that want their future default fund to be best in class in terms of asset diversification should try to move away from this daily pricing requirement, says Dickson, but DC pension providers must lead this change.
Employee investment choice
However, pensions professionals and employers are divided about how much freedom employees should be given to manage their investments.
Madeline Forrester, head of institutional sales at Axa Investment Managers, says: “We know retail investors are not great at calling the market: they tend to over-react to current market conditions.
“They are undoubtedly the experts in their own life goals, but that’s different from expecting them to make decisions about asset allocation.”
Nevertheless, Spencer Roach, total rewards manager at Cisco Systems, is striving to give his employees a degree of autonomy over their investment decisions.
“Having a default option is a really smart idea, but some employees do want to make decisions, and some will make bad decisions,” he says. “But if you said to employees, ‘we’re taking the decision away from you’, some would wonder why that freedom was being taken away.
“So, for me, it’s about giving staff the decisions, giving them that responsibility and building engagement and, of course, there’s still a sensible default fund there for employees who don’t want to decide, or want to take that balanced approach.”
Charles Pender, deputy chairman of Lloyd’s Superannuation Fund, also believes in allowing staff to make their own investment choices. “I think it’s very sad that 80 to 90% will go into the default fund, and that their employer might do it for them,” he says. “I think the onus is on the individual.
”The default fund is something we’ve got to have with auto-enrolment, but I think it would be a great success if we drove down the percentage [of staff] that were in default funds. That requires education. The key role for employers is on workplace education about pensions.”
Bespoke default strategy
But for now, Pender believes default funds should be less mechanistic and more bespoke for scheme members. “This is so it can be dynamic according to employees’ circumstances, rather than employers just putting contributions into a particular cocktail of indexed funds and then leaving them and not doing anything about them, which I’m afraid has been the old-fashioned way. A default fund needs to be more dynamic and more active.”
Pender would also like to see the introduction of debt instruments to default funds, to help manage the risks associated with more diversified asset classes.
“If employees are saying, ‘invest for me’, it ought to be much more like managing a defined benefit fund, where employers are actually balancing the risk, but being much more sophisticated about it,” he says. ”But so many things aren’t available, such as floors to cap the level that equities can go down [in value], for example.”
JP Morgan’s Chinnery adds: “It goes back to how we can get the best of the DB world into DC, and I think that is the challenge when there’s a cost focus. Extended asset classes and alternative asset classes cost more, and the point about the liquidity premium is that for giving up this liquidity, you should get a higher return, all things being equal over time.
“From a diversification point of view, it makes sense to have some exposure to less liquid asset classes, but they do come at more cost, so it’s about value for the employer, but also about the benefit to members about getting a better income replacement in retirement.”
Balanced retirement income
Pete Strudwick, pensions and performance partner at LV=, says the default fund strategy of the future must focus on a more balanced approach to retirement outcomes, rather than investment returns. “I think we can be smarter in the way we try to help employees reach a specific level of income,” he says.
John Chilman, group reward and pensions director at transport operator FirstGroup, says defaults also need to focus on a more balanced retirement income for scheme members. “Is an employer’s approach just to take risk, pile it high and grow the pot for the member because that’s the best outcome for the member?” he says. ”Or do we want to focus on some sort of income replacement? If the employer’s attitude is ‘fine, give staff lots of risk, they can afford it’, then tthey have got this massive dispersion of returns.”
This approach risks employees in the same pension scheme finding themselves with huge variations in the size of their pension pots at retirement, says Chilman.
Provider’s fund range
Spencer Roach, head of total reward at Cisco Systems, says that, ultimately, the default fund strategies of the future will be determined by pension providers’ fund ranges, which need to evolve to meet employers’ needs. “The reality is that employers’ start point is actually what’s available on the [pensions] platform,” he says. ”So, even if they start with big ideas, they have to deal with what’s there.
“Our provider has worked really closely with us, but by us just putting in a few parameters about the amount of diversity we wanted and the price, the range of funds [then available] gets quite small quite quickly. It really surprised me that we went from 300 funds to three so quickly. We wanted to move away from 100% equities to something more diverse and global.”
Roach says the default fund strategy of the future has to be simple to explain all the terms to employees, as well as being diversified in asset allocation and flexible.
Sarah Swift, a pensions partner at law firm Eversheds, says the fund should also be well governed, designed with an employer’s workforce in mind and reviewed continually, as well as explained to members properly.
Read the digital edition of our supplement, The future of default funds 2014, in full.