Broad industry consensus is that NEST is on track to perform, reports Christopher Andrews

The National Employment Savings Trust (NEST) has its work cut out for it. It has been tasked with nothing less than bringing about a radical cultural shift, getting those who have never saved for retirement to do just that; it is a high profile, high stakes initiative.

While the past few months have seen some planned changes to NEST, particularly around how auto-enrolment will work – a three month grace period, minimum salaries in line with income tax personal allowance and the like – all eyes are currently looking to NEST’s default fund. As the great majority of those auto-enrolled into the scheme will end up in the default, it is paramount that they get it right.

As it stands, there seems to be broad consensus that the corporation is indeed moving in the right direction with its target date fund approach. Members select the year they plan to retire, which can be adjusted as they get closer to that date, and are slotted into the appropriate fund; relatively little thought and little action is required. “Broadly I think their strategy is the correct one, in so much as they have identified target date funds as the default solution, which I think is a very appropriate strategy,” says Julian Webb, head of DC at Fidelity Investment Managers.

Webb says that the default will, apparently from the mandates NEST has issued, achieve diversification, which is also appropriate. These include global equities, UK gilts, UK index-linked fixed interest, low-risk cash management, and diversified beta. And, he says, the relatively straightforward decision-making process will work well for those who may not be particularly sophisticated in terms of investment knowledge.

“It may not be suitable for everybody, but then it’s not intended to be,” says Clare Ward, director – private sector at Xafinity Paymaster. “It’s a scheme that's primarily targeted at lower earning individuals. Obviously it's not going to have the sophistication of a DC scheme targeted at senior executives.”

Cause for concern?
While most agree that the corporation is on the right track, this isn't to say that NEST isn't suffering its share of criticism, whether deserved or not.
A primary area of contention for some concerns its plans for the ‘foundation’ stage in a member’s fund lifecycle, where members are going to be ‘introduced to risk slowly’. By limiting visible volatility in initial pension statements, so the argument goes, members won’t be scared off, and growth assets can be introduced down the line.

The problem, however, argue opponents to the idea, is that using this approach NEST is likely to have a significant weighting towards cash and gilts at the beginning of the fund cycle, neither of which provide protection against inflation. As Scottish Life’s investment marketing manager, Lorna Blyth, points out, this means that members could see the value of their pensions fall in real terms.

“If the aim of NEST is to encourage people to save for their future, a better start might be to include educating people on the right investment approach rather than making broad brush assumptions about their appetite for, and ability to take, risk,” she says.

If members see the value of their pot falling in real terms, this could defeat the purpose of removing that volatility in the first place: to avoid scaring off members. In turn, says Stephen Lefley, head of corporate distribution at Zurich Corporate Pensions, “this could easily lead to the positive impact of inertia in the face of auto-enrolment being replaced by an active flight away from a vehicle seen as offering a poor return, especially one that, by virtue of being a new product, has no proven track record.”

According to Russell Investments' calculations, generally for every pound invested over a member's lifetime starting from the age of 25, £4 will be generated by the time they retire. This makes NEST's foundation decision quite significant, says the firm's co-chair, global consulting and advisory services, John Stannard, because the impact on those early years is indeed important. “This is a question of compound interest, and it makes a big difference,” he says. “This seems like a move to avoid headline risk rather than something in the best interest of the investors.”

On the other side of the coin, however, if targeted members are as risk averse as NEST believes them to be, then keeping them on board in the early days by removing any shock figures from their statements could make sense.

“Consumers feel the pain of losses far more intensely than they enjoy the pleasure of gains; and our data shows that certain cohorts react adversely to seeing their balance drop,” says Nigel Aston, business development director at PensionDCisions. "These segments tend to include those who are less financially savvy so, for its target market, NEST has made the right decision.”

Speaking to NEST, one gets the feeling they are slightly bemused by negative assumptions in the press, particularly concerning investment decisions which they haven’t actually published yet. While we wait to see their investment strategy in the coming months, speculation abounds.

In terms of this low-risk foundation period, Mark Fawcett, the corporation’s chief investment officer, says that despite criticisms, this will have very little, if any, impact on long-term returns and final pot sizes. “We’re talking about a few years where they're just beginning to build up a pot,” he says.

“I think people’s gut reaction is because of things like compound interest. What’s different with a pension is that you’re making small contributions every month. You haven’t got a big initial lump sum here, and that’s why the maths is different.

“Also, we have done research with our target market and we know that quite a lot of the people who were involved in the study did react very badly to loss. So I think there’s enough evidence to say you should treat this with some caution, but at the same time all we’re talking about is a few years right at the start when the pot is very small, so it doesn’t have an impact on the long-term returns.”

Despite NEST's reasoning though, Stuart Fowler, founder and investment director at consultancy No Monkey Business says the corporation is “pandering rather than educating” with this initial low risk approach, which he describes as dangerous.

Fowler also believes that NEST has failed to explain how they are going to deal with inflation risk, both at the beginning and end of membership; though again it is worth noting that NEST has not yet actually published its investment strategy.

“There are social policy issues surrounding this, and they are all focused on the accumulation of savings for retirement. But NEST doesn’t seem to have focused on the way in which retirement benefits will be taken. And that seems to me a bit short-sighted.”

Fowler believes that, as such, NEST doesn’t have a firm grasp on its liabilities as it doesn’t know specifically what retirement option its members will take, meaning its ‘glide path’ approach will be out of kilter.

“That's why I'm saying the way to deal with that is to educate, to lead, so that you shape the kind of annuity they end up with,” he says.

"When it comes to annuitizing, the vast majority of people take a level annuity rather than inflation linked,” counters Fawcett. “We can't force or advise anyone to take an inflation linked annuity, because people’s circumstances will differ. We won’t be discouraging them though.”

This idea of advice, and financial education, is something of a central theme with NEST, though at this point it is unclear exactly what form that education will, or should, take. Give people too much information at the beginning, for example how much they will actually need to save to be able to purchase a decent retirement income, and it could put them off saving all together. It's something of a balancing act.

Will it work?
Of course the big question, irrespective of how well the system is understood by members, is whether NEST will deliver, and this will rely heavily on that default fund performing. It will also require wide-spread employer support, and opt-out rates to be, as Fidelity's Webb says, "at the lower end of the spectrum"; though it is worth noting that Xafinity's Ward believes government has been over-optimistic in its figures, initially predicting some two-thirds opting in. Based on her experience of auto-enrol schemes, with NEST: "You're going to be lucky if you get 50 per cent opting in," she says.

But even if all of these things indeed come together, this is arguably only a starting point, not really capable at this point of delivering 'meaningful' retirement income for the majority opted into it.

As Martin Scott, partner at law firm Mayer Brown says, NEST is "unlikely to help too much because of the amount of money going in".

"Three per cent of not a huge amount of money is not going to produce a big enough pot at the end, particularly if annuity rates continue to be as low as they have been over the past five years," he says. "It is just a start."

Scott says for this to change we will have to move in the direction of Australia, increasing employer-side contribution levels once employers get used to the idea of compulsion, though this could "prove politically difficult" he says. "In saying that, just because it won't provide the best pension in the world doesn't mean we shouldn't do it."

And what does NEST itself hope to deliver? "Investment markets are always challenging, and we want to make sure that the members' experience of saving in a pension is ultimately a happy one," says Fawcett. "We're designing the scheme for members who have different characteristics to many people who are currently saving in a pension scheme, and we're trying to do our best for them."

And for those casting the nets of negative speculation? "It is good for the country for more people to save for a pension. Assuming we're doing a decent job, and I think we've got enough feedback to suggest we are, then I think one should be more positive really."

Christopher Andrews is a freelance journalist

Share Story: