If you read nothing else, read this …
- DC schemes have been the poor relation in pensions with little time spent on them.
- They have been criticised for low levels of governance and poor investment structures.
- Investments have typically been 90% equities with little consideration for individual risk tolerance.
- More than 80% of DC members are in the default fund by failing to make an active decision about investments.
In the past, DC schemes have often been the poor relations of the pension world, but their prominent role from now on means they are having to shape up, says Padraig Floyd
If there was one thing DC (defined contribution) pension schemes did badly in the past, it was investment. Low-cost, low-return, yet volatile investments were at the core of what more than 80% of DC scheme members were invested in, which doesn’t bode well for a comfortable retirement.
New strategies such as target date funds and diversified growth are being touted as the way to go, but do they improve DC investments, or are they the emperor’s new clothes? How does an employer decide?
DC schemes have had something of a hard time in recent years. Volatility in the investment markets on several occasions since 2000 – most notably since 2008 – has exposed their weaknesses.
DC schemes have been the poor relation to DB (defined benefit), receiving little time from those charged with running them and attracting criticism for low levels of governance, uninspiring, even dangerously volatile investment structures and poor communication.
“A decade ago, DC was a quick-fix solution for companies and they would dump the young 20-somethings they didn’t want to put in their DB scheme into a DC scheme which was set up like a copy of an AVC (additional voluntary contribution) facility without any thought as to whether it was fit for purpose,” says Judith Donnelly, partner at Clyde & Co.
“Now DC is looking like the primary source of pension provision for the future, and generation X, now in their 30s and 40s – and, to a lesser extent, the generation coming up behind them – want decent pensions, and are in a better position than they were 10 years ago to bargain for them.”
The problems are well documented, but as it became clear that DC would be the repository for almost all future retirees, various groups – including the industry and the regulator – have sought to raise standards.
The close scrutiny of DC funds in recent years is, in part, due to the fact that the vast majority of members – 86%, according to the National Association of Pension Funds’ (NAPF) 2011 data – do not make an investment decision and find themselves in the default fund.
The typical asset allocation for a DC default fund has been anything up to 90% in equities (see box below). Although generally invested passively to keep down costs, such funds mimic the markets they are invested in, so there is no control of volatility and members can see their fund value fluctuate greatly – as good a reason as any for not investing in pensions.
To minimise the exposure to equity markets as the individual approaches retirement, lifestyle mechanisms are used to switch funds from equities to lower-risk assets such as government bonds and cash in the five years before retirement.
The latest NAPF survey figures show 80% of DC funds use a lifestyling approach but, ironically, this mechanism can be as detrimental as volatile markets to an individual’s fund.
Lifestyling operates automatically and takes no account of current market positions. This is a problem if lifestyling starts when there is an economic downturn and relatively cheap equities – cheap because their value has fallen – are sold at a low price and replaced with government bonds. These bonds will be relatively expensive because they are viewed as a safe haven by investors and so are in great demand, particularly in times of crisis.
Some schemes have tackled this issue by introducing a more dynamic lifestyle mechanism. The simplest approach is to simply extend the period of lifestyling from five years to 10 or more (even up to 15 years – see L’Oreal profile).
Using a longer timeframe makes it more likely that any switching will avoid the greatest excesses of the financial markets, but this remains a relatively crude approach, says John Foster, a benefits consultant at Towers Watson. “Organisations are looking at how suitable their defaults are in the light of market performance and turmoil and quite a few schemes are looking to review,” he says.
With The Pensions Regulator issuing principles last year on how a DC scheme should be run, employers and trustees must get to grips with their schemes. As auto-enrolment begins later this year, now is an excellent time to put your house in order and make changes if you choose to.
Age discrimination legislation makes it harder for employers to retire at a certain age. The default retirement age has been removed by statute and according to the recent Seldon case (in which a partner in a law firm failed in his bid to delay retirement), a default retirement age would be allowed in limited circumstances. If companies want older employees to retire, they will have to provide them with adequate – and that means better – pensions, says Donnelly.
“The concept of ‘extended morbidity’ is a factor,” she explains. “The increase in longevity doesn’t mean people are fit and healthy for longer. Old people may still be less fit to work than younger people, and companies will be forced to keep unwilling and unfit old people in employment if those people can’t afford to retire.”
Auto-enrolment means all employers will face pension costs. Some organisations will choose to differentiate themselves as an employer of choice with the pension they offer, and employees do value pensions even if they are often reluctant to join a scheme of their own accord.
The first consideration must therefore be the needs of the workforce and an employer offering lifelong careers will take a different view from one with a high annual turnover of casual workers.
The key point to determine, says Dean Wetton, a director of Dean Wetton Advisory, is the governance budget – what skills the employer has, how much time and money it wants to spend on managing the scheme, and how important it is to offer a good scheme to either retain staff or satisfy their views on paternalism.
“The answers to this will guide their choice of how much to outsource and the provider choice is then much easier once you know exactly what you need from them,” he says.
The actual procurement process is then no different than for any other service and should be evaluated on provider stability, transparency and level of costs, service levels, future-proofing, ability to exit, and conflicts of interest, says Wetton.
“Part of this is obviously the investment default solution, including fund range, communication, and so on,” he adds, “but to be driven by those issues is to put the cart before the horse.”
It is, of course, perfectly possible to have no default option at all, as in the case of L’Oreal (see Employer profile), or a single fund as offered by mastertrusts such as Now:Pensions or The People’s Pension, but most schemes will choose to have a default, particularly for when many more previously unengaged employees are automatically enrolled.
Some employers and trustee boards are looking to different approaches for their default, such as a diversified growth fund (DGF). These actively managed funds give the fund manager some discretion as to how they manage the assets – and so the volatility – within the fund. If the manager is ahead of the targeted returns or doesn’t like the way the market is moving, he can sit in cash (or an alternative asset) and wait for a better opportunity.
Although there are a number of DGFs on the market, they are all quite different and it is important to get to the bottom of what each one offers to see if it works for your particular membership profile. But schemes are considering them, says Towers Watson’s Foster. “We are seeing an increasing number of clients building DGFs into the lifestyle approach as a core fund or even as a transitional fund [while they consider an investment strategy].”
But there is a cost, and this must be assessed rationally. Index trackers typically have an annual charge of less than 0.5% per annum and sometimes considerably less, whereas an actively managed fund will come in at considerably more than 0.5%.
“This can be a major move for some and they have to be sure the value is worth the additional cost,” says Foster.
Target date funds (TDFs) are another innovation that some are tipping to take off in the UK. A TDF is a fund designed to mature in the year the member intends to retire. Throughout the time a member is invested, the asset mix is adjusted for risk by the fund manager.
Some advocate TDFs because, like lifestyling, they take into account the specific time an employee is likely to retire. Some – particularly those offering TDFs – argue this is far superior to lifestyling because assets are managed dynamically, in response to the movement of markets.
All employers are different, but the process for making the right decision is relatively simple, says Nigel Aston, business development director at DCisions.
“The first task is to know the savers within the plan and understand the level of risk that is appropriate for them. The second is to decide which fund or funds gives the best return for that given level of risk.
“The third is to monitor the hell out of it. Don’t look at it every year or every couple of years or when you feel like it at the back-end of a DB trustee meeting, look at it monthly or quarterly, at least.”
DC investment: active and passive
Investment is the most difficult subject for pension scheme members to get their heads round, which is why default funds exist – typically a one-size-fits-all fund for those who fail to, or choose not to, make a conscious decision on where they will invest their fund.
In the past, most default funds have been heavily invested (up to 90% and more) in equity (generally the shares of large public companies on large, well-known stock exchanges) as opposed to fixed-income instruments such as government bonds (gilts in the UK, Treasuries in the US, for example) or corporate bonds (issued by companies such as Tesco or Marks and Spencer).
These are also typically run under passive management, which, rather than trying to pick which companies will be the winners and losers in any given market, avoids making forecasts in favour of mimicking the performance of that market.
For instance, a FTSE 100 fund would contain shares of each of the companies that make up the FTSE 100. Each holding will be in proportion to the size of that company within that particular group, or index, and be adjusted according to how the value of the company changes in the markets. Because of this, these funds are referred to as index trackers.
Active management relies not only on a fund manager being able to pick the right stocks that will outperform the average market performance (the index), but be able to time their purchases and sales to maximise the returns (or minimise any losses) for the fund and therefore for the client.
Passive management is considerably cheaper than active management, and is often selected within DC arrangements to keep costs down.
Trust versus contract-based and bundled versus unbundled
Not all pension schemes are the same. Their basic structure depends on the rules upon which each is based.
There are two primary types of pension fund – trust-based and contract-based – and the difference is the set of regulations within which they operate.
In the UK, trust law has a long history and many schemes have used trustees to govern their schemes. Trust law provides powers and protections for individuals to act as trustees in the best interests of their members.
These are often referred to as ‘occupational DC’. However, this term does not refer exclusively to trust-based arrangements, but, as the name suggests, a private pension plan put in place by an employer.
Contract-based schemes are provided to employers by insurance companies. They are so named because under schemes such as a group personal pension (GPP), group stakeholder or even group Sipp (self-invested personal pension), the contract is between the provider and the member, not the employer.
Contract- and trust-based schemes have often been delineated as bundled and unbundled, respectively. This was because insurance companies tended to bundle the various services – provision of the scheme, administration, investments and communication – into one, whereas trust-based schemes were more likely to use a best-of-breed approach and cherry-pick the elements they wanted to use. Although broadly accurate, it is somewhat misleading and is certainly undergoing change today.
Because contract-based schemes were bundled, they were generally cheaper for employers to implement and run. As a result, issues of governance and monitoring were left to the provider. However, increased focus on DC by The Pensions Regulator is likely to end the potential arbitrage between the two forms of scheme by employers simply wanting the cheapest, easiest deal. Any perceived difference in governance is likely to be eroded, with employers expected to play a full role in the future.
A further complication has arisen with the development of mastertrusts – trust-based, bundled pension offerings that have been the model in Australia and Scandinavia, are represented by Nest, Now:Pensions and The People’s Pension and others in the UK.
Read more articles from the Workplace Savings Quarterly