Auto-enrolment requires employers to offer a default option to employees who prefer not to make active investment decisions for their pension scheme, so there is an increasing focus on default strategies.
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- Off-the-shelf default investment strategies are more common in contract-based defined contribution schemes.
- Off-the-shelf plans have less governance responsibilities for employers.
- Bespoke strategies give employers more flexibility in their investment management.
The structure of a default strategy is determined by various factors, such as whether a pension scheme is contract- or trust- based.
If it is contract-based, the strategy will usually be determined by the pension provider, whereas strategies for trust-based schemes are likely to be determined by the employer or pension trustees.
Tim Banks, managing director, pension strategies group, at AllianceBernstein, says: “Investment defaults, by their nature, are usually specific to the workplace pension scheme being offered, or have been constructed by the provider that is supplying the pension services, such as an insurer or a master trust.
“How customised a solution [an employer] gets depends on the governance model that the scheme uses.”
Pension providers typically offer employers a packaged, or off-the-shelf, default investment strategy, while employers with trust-based schemes are more likely to have a customised strategy. But there is some cross-over between the two approaches.
The two strategies have different attributes that may suit the different risk profiles of scheme members.
That is why Nigel Aston, managing director and head of UK DC at State Street Global Advisors, suggests employers determine the appropriate level of risk for their employee demographic.
“One of the ways that employers can customise and come up with a bespoke default fund is by truly understanding their membership,” he says. “The smaller the membership group and the more homogenous, the easier it will be for them to do that.”
A customised default strategy enables employers to white label their fund. This allows more flexibility than an off-the-shelf fund, especially if an employer wants to amend its investment strategy. A white-labelled fund allows employers or trustees to make changes without needing to alter employee communications extensively, such as the pension scheme booklet.
Phil Farrell, principal consultant at Quantum Advisory, says: “If, for instance, as a result of a governance review, an employer found that the particular equity fund that makes up a component part of a lifestyle strategy is no longer appropriate for whatever reason, whether it’s investment performance or investment risk, then [it] can remove that and it simplifies the communication side of things for employees, because it has been white-labelled.”
However, customised default funds will require greater governance responsibility for employers and trustees, because, unlike a pre-packaged solution, the strategy can be tailored and constructed to suit the workforce’s requirements.
Target date funds, which are investment funds that de-risk as an employee nears retirement, are becoming a popular choice in bespoke default strategies.
AllianceBernstein’s Banks says: “Where strategies are customisable, they are designed to work with the investment consultant in the traditional way, to really look at the risk capacity of employees in the scheme, and design the asset allocation against that, but also to pick the best fund managers and incorporate those within the target date funds.”
Nevertheless, pre-packaged pension default options still appeal to many employers. Farrell says: “They are pre-packaged, they are quick to implement and a lot of the communication materials are prepared by the provider.
“Another important thing for trustees or employers is that a lot of the governance responsibilities are assumed by that provider.”
For example, the component parts of a lifestyle strategy, the equity, bond and cash funds, are reviewed by a governance committee, which reduces some of the administrative burden, in terms of time and cost, from trustees and employers, says Farrell.
Also, off-the-shelf funds are typically based around passively managed funds, so fees should be lower.
But pre-packaged default fund strategies cannot take into account the specific needs of a workforce.
Pension providers and fund managers are currently focusing on the best way to de-risk an investment portfolio for employees nearing retirement.
State Street Global Advisors’ Aston says: “Typically, de-risking is achieved through lifestyling, whereby the employee moves from higher-risk to lower-risk asset classes in the last 10 to 15 years before retirement.
“The debate at the moment is: is that the right way to do it, or are target date funds the best way to do it? Regardless of which of those two constructs employers prefer, I would argue that if they want a bespoke [default fund], then target date funds are the way to go.”
Whichever approach employers choose, an effective communications strategy is key, to ensure employees are fully informed about the investment choices they make.
“There is no point having a great default fund if the employer doesn’t communicate it particularly well,” says Aston.
The changing nature of default funds makes it more important than ever for employers to educate staff about their pension choices.
Quantum Advisory’s Farrell says: “The advent of auto-enrolment has changed the purpose of default funds from encouraging people to join, because auto-enrolment means they don’t have any choice, to one where it’s a question of detainment and keeping people within the scheme.
“It’s a question of education, making people understand what investment risk is, and how it can work for them. It doesn’t necessarily have to be a negative thing.”
Research by State Street Global Advisors, published in July 2013, shows that employees’ attitudes towards default funds are far from negative.
The survey found that almost half (49%) of respondents in the default option of their defined contribution (DC) pension scheme chose to be there, nearly a quarter (24%) believe their default fund offers secure savings, and 26% chose it because it was recommended to them by their pension provider or employer.
Case study: Towry creates default fund to help staff spread investment risk
The organisation has mirrored the risk profile-based investment approach that it offers to private clients when looking at retirement planning for its own staff. The strategy is a mix of different asset classes.
The lifestyle investment strategy Towry created is a blend of a growth-based and a managed approach, a bond fund and a cash fund.
Of its 700 employees, about 93% are in the default fund, the Towry investment strategy.
Richard Higginson, head of reward at Towry, says that when the organisation switched pension providers in 2009, from Axa Wealth to Zurich Life UK, it looked closely at what default funds were on offer from different providers and, rather than choosing a standard fund, it decided to create its own using multiple funds to ensure an optimum blend of risk for staff.
Higginson says: “It’s a strategy with which our wealth advisers are very familiar because they are explaining it to our clients. For the rest of our employees, we explain it to them, but rather than just talking about making pots of money, we discuss their attitude to risk and [the importance of] trying to spread risk by having a default fund that invests in lots of different things, rather than putting all their eggs in one basket.”
How employers chose the default investment fund
Pension provider’s default option 36%
Adviser chose it 31%
Employer chose it 27%
Don’t know 4%
Sample: All respondents responsible for pensions (253)
Proportion of scheme members that invest in their organisation’s default investment option
Less than 25% of members 1%
25-49% of members 2%
50-75% of members 9%
76-90% of members 34%
More than 90% of members 37%
Don’t know 17%
Sample: All respondents responsible for pensions and have auto-enrolled staff (85)
Source: Employee Benefits/Capita Pensions Research 2013
Viewpoint: Simon Chinnery: Plenty of guidance on good governance
Evidence points to the majority of savers wanting someone to take responsibility for their investment decisions, so figures of 70-85% of scheme members opting for the default strategy are the norm. The millions of new savers entering DC for the first time as a result of auto-enrolment is likely to lead to this percentage increasing.
This places a strong duty of care on employer sponsors or trustees to select an appropriate default and to show, as the Department for Work and Pensions (DWP) calls for, ”an alignment of interests between those running the scheme and the members”.
Fortunately, there is plenty of guidance from the DWP and The Pensions Regulator on applying good governance to the default.
Our members’ aim is to promote investment excellence in DC in the UK. We believe that DC savers deserve the best possible investment service, and we are concerned to promote the widest range of investment techniques and approaches.
Whether a default plan is bespoke or off-the-shelf, we encourage employers and trustees to put themselves in the shoes of their members and create what is most appropriate for their workforce.
Guidance will encourage regular reviews, but this is not just about investment performance, but about having a clear scheme objective. This will help frame the view on the appropriate trade-off between risk, return and volatility within asset allocation, both in the growth and de-risking phases.
We support the National Association of Pension Funds’ recent work, Default fund design and governance in DC pensions, which focused on discussions with its members that have recently reviewed and overhauled their default fund design.
Key features are: the balance between cost and value, the importance of active governance and good, simple communication, and growing diversification and innovation in de-risking.
We were heartened to see so much thought and vision applied to such a critical part of the DC scheme.
Simon Chinnery is chairman of the Defined Contribution Investment Forum