Defined contribution (DC) pension schemes are still in their early stages in the UK workplace, particularly in terms of the number of employees who have retired with DC pots.
If you read nothing else, read this…
- Members of DC pension schemes face critical investment choices in the run-up to retirement.
- Employers can provide financial guidance to help employees make informed decisions.
- Employees can choose different investment approaches based on level of risk.
However, the numbers are set to rise. Some 400,000 people applied for an annuity in the past year, but experts say the numbers will leap by 17% a year for the rest of this decade.
This means far more people now face retirement with a high degree of uncertainty about the level of benefits they will receive, in contrast to final salary pension plans, in which the outcome is both known and guaranteed.
With DC, there are also critical decisions for members to make, notably whether to buy an annuity or take income drawdown, that do not arise in final salary schemes.
Helping employees through this minefield is not something that can be achieved easily. Most employers will gravitate towards financial guidance, supplying frameworks for staff to make informed decisions, without crossing the line into advice, where a specific course of action is recommended.
The internet lends itself well to the type of interactive decision-making trees that can help employees plan their options.
A lot depends on whether the pension scheme is trust-based or contract-based. Giving guidance is much easier in trust-based schemes, where governance and record-keeping are central, enabling segmented communication to members. For contract-based schemes, it is a very different story.
Philip Smith, head of DC and wealth at Buck Consultants, says: “The main problem is that most of these schemes are contract-based DC and employers have no right to see where their employees are invested. It is therefore difficult to target groups based on the underlying investments in their plans and what is going on in the scheme. Any communication must be generic; it cannot be done on a named basis.”
The key options of taking an annuity or choosing an income drawdown plan require different investment approaches. Members who plan to buy an annuity at retirement are well served by lifestyling, which de-risks their portfolio and switches it into bonds as retirement approaches.
But those who plan income drawdown, or simply aim to delay taking their pension, perhaps by continuing to work or living off their cash lump sum, will not want to lose the opportunity to grow their investment pot by switching into bonds, particularly as this is the time when the fund is at its largest and the impact of investment returns, compounding over several years, could be substantial.
To draw a comparison, consultants believe that, in a typical final salary scheme, where pensions are paid from a fund that is continually invested, 30% of the benefits are generated from pre-retirement investment, but 60% comes from post-retirement investment returns. The other 10% is simply the original contributions.
In income drawdown, staying in growth assets can make a huge difference as people continue to live longer. The average period of retirement is now about 18 years, but 10% of men will live a further 35 years, for example.
One argument supporting income drawdown is that over a typical 25-year retirement, modest inflation of 3% a year will destroy 50% of the value of a pension pot invested in cash.
Default fund design
One way consultants are starting to tackle these challenges is to engineer funds that suit every member throughout their career cycle, particularly as experts predict that average pension scheme assets in default funds will grow even more, from 70% to 83% in 10 years, according to Default fund design and governance in DC pensions, published by the National Association of Pensions Funds (NAPF) in September 2013. This underlines the importance of good default fund design.
Diversified growth funds, which invest in a range of assets that protect them from falling too far in bad times, meet that requirement. These funds are a good match for all member profiles, so should reduce the need for constant supervision.
Mel Duffield, the NAPF’s head of research and strategic policy, says: “Our research shows there is much more interest from trustees and employers in ensuring they have not just made the assumption that members will retire and buy an annuity, and there is also more concern that retirement outcomes may not be as expected.
“Diversified growth funds are increasingly used to reduce the volatility of member outcomes, straddling the glidepath and stripping out risk while delivering growth.”
Another disadvantage of a lifestyling investment strategy is that the very act of moving members into bonds as they approach retirement incurs switching costs.
Target date funds
Target date funds, in which the switching to reduce risk in the lead-up to retirement is achieved within the fund, are seen as a way to reduce switching costs. Duffield adds: “Both the National Employment Savings Trust [Nest] and the Pensions Trust took this churning into consideration and came to the conclusion that target date funds are more cost-effective.”
Multi-asset funds, which deliver equity-like returns with less downside, also help to overcome low tolerance to risk.
Rona Train, senior investment consultant at Hymans Robertson, says: “We are finding that more schemes are implementing some form of diversified growth fund in the latter stages of a lifestyle strategy to allow them to invest longer than they could if the growth phase was all in equities.
“At present, most members of DC schemes buy some form of annuity at retirement. But, over time, this is likely to change. This will be particularly the case for members who have built up significant historic DB benefits, which may allow them to meet the minimum income requirement without taking into account their DC assets.
“This means that a strategy which de-risks members to 75% in bonds and 25% in cash at retirement is unlikely to be appropriate and would argue for retaining a proportion of return-seeking assets, perhaps including diversified growth funds, at the point of retirement.”
Appropriate investment choice
Another concern for employers is whether pension scheme members who are not in the default fund are in an appropriate fund. Employees joining a scheme sometimes plump for a fund that, at the time, is flavour of the month, and then put the decision to the back of their mind while the fund goes on to do what fashionable funds typically do, which is to perform miserably in subsequent years.
Buck Consultants’ Smith says: “Our experience is that people forget what they have done in the past and don’t change the fund when economic conditions change and they then arrive at retirement without having done anything about it.”
In this respect, white-labelling funds can help because poorly performing managers can be terminated without having to consult the member.
Case study: Arriva drives lifestyle strategy
Passenger transport provider Arriva set up its group flexible retirement plan with Standard Life in March 2013. The scheme has 11,826 members, and is overseen by a governance committee.
The scheme’s default fund uses Standard Life’s lower-to-medium-risk lifestyle strategy, which aims to provide long-term growth whilst investing in a diversified portfolio of assets. This is the second lowest risk level of the five risk-rated lifestyle strategies Standard Life has developed, so employers can select the risk appetite that is most appropriate for their workforce.
Arriva company secretary Ken Carlaw says that a key decision was to define the lower- to medium-risk lifestyle strategy as the default strategy for members, who could then make an alternative choice if they felt they wanted to do so.
“We were conscious of the fact that, for many members, this might be their first experience of pensions and investments and so we wanted the default fund to offer a low-involvement, lower-risk experience to members which they could change if they wished.”
Carlaw says the lifestyle strategy investments may include equities, bonds, absolute-return funds and property, thus reducing the risk associated with being solely invested in any one asset class.
The lifestyle profile gradually moves a member’s investments into a combination of gilt fund and money market pension fund as the employee nears retirement.
“Switches on the lifestyle investments begin between 10 and five years before retirement, depending on the risk profile of the lifestyle fund the member chooses, with the lower-risk funds commencing lifestyling earlier.”
As well as the lifestyling strategies, there are 12 freestyle strategies and, if required, a member can access Standard Life’s full range of funds.
Lifestyle strategy: a very popular strategy in recent years that aims to reduce risk in a member’s pension pot by switching it progressively into a bond and cash fund over several years leading up to retirement. Strategic investment decisions are made by scheme fiduciaries and their advisers.
Target date funds: here a member actively identifies his or her desired retirement date and invests in a fund that de-risks its assets in the years leading up to that date. Decisions are made primarily by the fund manager.
Annuity: a stream of income usually guaranteed for life and purchased with a member’s pension pot at retirement. Annuity rates have tumbled in recent years because of increased life expectancy and the introduction of onerous capital adequacy regulations for banks and insurance companies. Most people who buy an annuity will just be getting back their own money until they are in their 80s.
Income drawdown: instead of taking an annuity, retirees can set up an arrangement with a financial adviser to keep their pension fund invested, and they can take income from it, within certain limits imposed by HM Revenue and Customs.