The old adage ‘If it ain’t broke, don’t fix it’ often informs business decisions. But in the pensions arena, it is more often ignored for another: ‘If it’s broken, don’t fix it, we’ll just carry on regardless’.
This is not an attitude that can be laid solely at the door of the government, either – for example, means-tested benefits, S2P, stakeholder pensions, personal accounts, I could go on. No, industry is equally good at pulling the wool over its own eyes and slipping into denial when the problem is just too hard to contemplate – or one that everyone wants fixed, but nobody is sure who is going to pay for it, perhaps.
It can hardly have escaped your notice – we’ve been covering it for years – that defined contribution (DC) is the great hope of employers seeking to escape (to paraphrase Dick Cheney) the unknowable unknowns of defined benefit (DB).
The other thing you will have noticed is the growing unease with which people view the type of DC vehicle that has been offered in the marketplace over the past 10 or more years.
Some saving is better than none, but plans have to be called into question if you’d have been better stuffing your mattress than participating in an employer’s DC scheme.
Of course, that’s overly simplistic, nevertheless, a number of structural defects have been identified in the structures of DC that had been deployed.
The biggest is the core investment approach. More than eight out of 10 members fail to make any active decisions upon how their fund should be invested, according to research and confirmed by a recent survey conducted by PensionsDCisions and the National Association of Pension Funds (NAPF), no matter how good the education or communication programme is behind the scheme. In such circumstances, the default fund takes on tremendous importance. It is likely to be the single engine of return for that individual’s retirement savings, because the common view is that once a member of an employer scheme, one’s financial security is assured, or ‘sorted’.
A one-size-fits-all approach is sensible in the retail market, where many can share the benefits of commoditised products. In a long-term vehicle such as a pension scheme, investment needs to have the qualities of Goldilocks’s favourite porridge: neither too hot nor too cool, but just right.
However, surveys have shown that asset allocation in DC default funds is anything but sophisticated. The PensionsDCisions/NAPF survey found that 82% of members either select or are opted into the default option, which typically has a high equity exposure. Of those surveyed, 71% of plans use a 100% allocation to equities, while a multi-asset approach is used in only 27% of plans. Over all plans, the average equity allocation is 91%.
But the core investment is not the only problem, not by a long chalk. It’s all very well concentrating on the money contributions going in and how they generate (or don’t generate) returns, but there comes a time in every member’s life when they are approaching retirement and something needs to be done to protect their position.
Many use lifestyling over three to 15 years to derisk a DC pot as retirement approaches, by switching the assets away from high risk classes such as equities into low risk assets such as gilts.
This approach has been exposed in recent years as a crude and ineffectual method that can lead to considerable member detriment, as it takes no account of market timing.
This would require a degree of dynamism not generally found in default funds and there are questions as to whether the blunt instrument of automatic switching can ever satisfactorily oversee the transition of assets.
Glidepaths – the term used to describe this transition period from the standard default position to a derisked one – are increasing in length to spread the transition over a longer period to mitigate some of the volatility we’ve seen in the equity markets in the past 10 years, but some consider that more intervention is crucial.
As a result, new strategies are being sought to more closely meet the needs of members. These articulate investment objectives in relation to time as opposed to level of risk, and include absolute return or return relative to benchmark. The one that has attracted most coverage has been target date funds, which have been used since 2007 in the US and were hailed as the answer to DC’s problems. (For why that may not be the case, see see sidebar. )
Providers are seeking to deliver products that offer greater diversification, such as the flavour of the month, diversified growth funds, generally via a multi-asset approach.
David Aird, managing director, UK distributions at Investec Asset Management, says that members in default funds have effectively opted to delegate or relinquish responsibility to a third-party manager, the fund needs to be actively managed throughout the life of the investment to maximise the risk/return outcome for the investor.
“A static or passive default fund may deliver a materially different outcome at retirement from that expected by the investor,” says Aird. “Default funds should be constructed as multi-asset solutions that invest in truly uncorrelated assets, thus widening the opportunity set and dampening volatility.”
As accumulation can take more than 30 years, investors will benefit hugely from better performing default funds compounding at higher rates of return, he adds.
As far as derisking is concerned, it is here to stay, for the reason that there is little member engagement and they refuse to make decisions on their own. And while the debate rages as to whether trust or contract DC is preferable, it is far more important that a scheme is reviewed on a regular basis, says David McCourt, policy adviser, investment and governance, at the NAPF.
“DC is now creeping into adulthood here in the UK, and although it has been very bland to date, it is catching up with developments in the US.
“It is up to product providers to get a bit cleverer and look at ideas from around the world,” he says.
While there remains a long way to go before the provision of DC can be said to be truly fit for purpose, it will deliver something, and something better than nothing. But like DB before the ‘discovery’ of liability-driven investment, it may unwittingly contain many unrewarded risks. At least the industry is now fully aware of the need to develop new approaches.
Ultimately, it is highly unlikely that we will create a ‘silver bullet’ that can offer a single integrated plug-and-play solution to these problems facing DC. Therefore, as a matter of urgency, the industry should look at how each of these different elements combine in a more sophisticated whole. If that means it costs more, that may be a price that members – and perhaps employers from a governance point of view – will be prepared to pay.
For more on the innovations being introduced by UK DC providers, go to tinyurl.com/PM-default, where you can view the PensionsDCisions study in association with Pensions Management and Pensions Week. A summary of highlights is also available.
Target date funds
The US experience of target date funds should serve as a warning to UK scheme sponsors considering using the funds as a default option for their members.
Target date funds – which reduce the risk of a portfolio the closer it gets to a predetermined date – have even been talked about as a possible default fund for personal accounts.
But in 2008, US funds with a 2010 target date had a diverse range of returns, of between -3.6% and -41%, which has led to widespread mistrust of the funds.
This was due to a number of funds that should have had a very conservative asset mix being heavily weighted in equities.
An investigation by the Securities and Exchange Commission (SEC) this summer found some funds had as much as 71% equity exposure.
“It’s not about the losses,” says Cynthia Mallett, vice- president of product and market strategies for MetLife’s corporate benefit funding group. “It’s more about the losses being more than expected, and that is what points to disclosure and clarity.”
She says a number of types of funds, such as target risk funds or target allocation funds, were remarketed as target date funds without their underlying portfolio structure being changed.
Following on from the SEC’s report and interest from the Department of Labor, US commentators are expecting new regulations over the construction and transparency of funds that are marketed as target date to emerge in early 2010.
For UK schemes assessing the funds, Mallett has some advice: “The most important things to consider are clarity of communications and clarity of purpose.”
owen.walker@ft.com
