The DC debate

Written by Pensions Age team
April 2014

Panel

Chair: Chris Parrott, Pensions Manager, Heathrow Airport Holdings
Nico Aspinall, Head of Investment, Towers Watson
Stephen Bowles, Head of UK Institutional Defined Contribution, Schroders
Andy Dickson, Investment Director, UK Institutional Business, Standard Life Investments
Robin Hames, Head of Marketing, Capita Employee Benefits
Katie Weber, Director, Defined Contribution Sales Client Relations, Pension Strategies Group, AllianceBernstein

Auto-enrolment


Chair: As we move into the next phase of auto-enrolment (AE), what do we see as the big issues? Is capacity an issue?

Aspinall:: Capacity is an issue. We are starting to see occasions where providers don’t quote, or put what we see as excessive quotes out; so there’s certainly some picking and choosing going on by the providers for the companies now coming into this market. As a result, their members run the risk of getting less by default.

Hames: The reality is that we are now moving from working with a group of employers who generally had a pension scheme in place, who needed help adapting to the new environment, to working with employers who’ve never had to do pensions in the past. These employers are probably poorly prepared in terms of what’s required, will probably get very little help from some of the providers out there, and will be fairly reluctant to pay for much help. Saying that, by and large, we will have simpler problems to solve, so I think we will find a happy medium.

What’s interesting is that we are also seeing a number of the providers starting to gear up for the micros market whereas beforehand they weren’t. For example, we’ve seen Standard Life and Legal & General starting to determine a simpler core product for that market, so I don’t think we should be too depressed - we’ll cope one way or the other.

Chair: Is it a worry that we will be moving from corporates that employ a permanent pension professional to corporates that will rely on an HR or payroll representative and for whom pensions is low down on their list of priorities?

Hames: This will be more of an issue next year. This year, in the 50 to 250 member market you’ve either got HR or payroll people who will be able to cope with some guidance. Once we hit the micros, where employers are very small, and there is little or no in-house expertise, that’s really when the providers will have to step up alongside Nest to give some assistance to those employers.

Aspinall:: And that’s where we will, hopefully, see the success of the strategy – seeing people who have never had pensions being brought into the pensions system. I’m not sure how much the actual implementation was on the DWP’s radar to begin with, although Nest obviously resourced up and has been planning for this for a while. So the test of auto-enrolment has not happened yet - it’s coming up; this is the time when we will see if it is possible to have every eligible job-holder enrolled in a pension scheme.

Bowles: A lot of the larger schemes have now auto-enrolled and they’ve spent an awful lot of time and money engaging in essentially operational, administrative and infrastructure issues. That’s meant, from an asset management point of view, they’ve spent a lot less time engaging on the investment piece. So my hope is that now the operational infrastructure piece is almost out of the way, a lot of these larger schemes will bring their focus back to investments.

On a separate note, there is a capacity issue going forward and that could drive a number of the medium-sized employers to work with some of the newer providers in the market - newer providers that generally seem to be competing around price rather than necessarily the details of the proposition. From an asset management perspective what competing on price generally means is that they’re not necessarily putting in place the best investment proposition, but they’re putting in place an investment proposition that’s guided by their fee budget and therefore by costs.

Dickson: I’m interested to see what impact this year and next is going to have on the advisory community; coupled with RDR the advisory community is having to remodel its entire business and it will be interesting to see if those SME and then micro employers have any budget to pay for advice for the design of an auto-enrolment scheme. If they don’t then Nest will be the fall-back position along with perhaps the other newer master trusts that have entered the market. Time will tell whether capacity will be a huge issue but I think Nest is legislatively required to be that fall-back position if it is, so I don’t think the overall auto-enrolment strategy will be at risk.

Weber: I certainly agree that the wave of schemes going through auto-enrolment this year presents an opportunity for new and existing master trust providers where the traditional providers may not have capacity or desire. Of course Nest presents an option but it’s certainly not the only option. And whilst the administrative issues around AE compliance dominated the attention of the first to stage though AE, the quality of the investment offering and of the default fund in particular must come in to focus. In preparing to meet the AE demand, many master trusts have addressed the investment piece already with significant changes to the investment line-up, premised on scalability, good governance and value for money and therefore can offer a good alternative for those still to stage.

Chair: Do you think the outlook is still positive for corporates delivering on their auto-enrolment obligations or do you see any concerns?

Hames: It will be interesting to see what happens with the opt-out rates because one of the things that larger employers have been able to do is devote resource to communication and engagement with employees, and I very much doubt that smaller employers will. They will rely on the statutory notices, perhaps apply some very bland generic comms from the providers because they won’t see it as their role to engage, they’ll see it as their role simply to put in place the mechanism.

Dickson: There is currently a positive association with auto-enrolment because opt-out rates are low, markets have been favourable (and a lot of the investment strategies are heavily equity biased – index tracking), and contributions are extremely low from a member’s perspective (1 per cent gross before tax relief). But the real challenge will be if equity markets become more stressed, coupled with increased employee contributions - that will be the real acid test if members see erosion in their savings as they are being asked to pay more.

Bowles: I see auto-enrolment as a logical step towards compulsion and an auto-escalation system; if we really want to provide realistic levels of benefits to supplement the state pension, then that’s the way to go. As has been said, at the moment it’s quite a positive message – opt-out rates are really low, the economy is picking up and that’s a really good position for us to be in as a country in terms of moving towards a compulsion auto-escalation environment. If those opt-out rates dramatically increase and the economy starts to decline, that puts us in a much more difficult position. So we need to make hay while the sun shines; we need to get this thing moving and get a positive outcome so we can move the whole system to where it needs to be.

Aspinall:: The concerns around opt-out in my view are slightly over-stated. My biggest concern with auto-enrolment is just how small the contributions are. As soon as you ‘auto’ anything to someone, they believe you are looking after them. There is a risk that they think a 2 per cent contribution will be enough to retire on and that it will save them enough to augment the state pension. So what triggers an individual or society to start opting out? We shall see.

Hames: The acid test will be when member contributions treble – and let’s not beat around the bush with percentages; that’s what they do, they treble, and then they go up again. How will people react?

Dickson: If that also coincides with some negative investment returns for the members then that could be the trigger for opting out.

Chair: And therein lies the big problem - the trebling of employee contributions and the pressure on employers to pay more – and perhaps more than the current upper limits. We’re talking about long-term sustainability and whilst investment returns are positive and people are looking at statements and saying, “I’ve got something for my money, great”. It’s when it flips the other way and potentially coincides with the employer asked to pay more at any point in time, that is when the real stress test will come through and could people, and particularly the micro employers, will just say, “that’s it, we no longer care”.

Bowles: I take on board what you guys are all saying but they’re trebling from 1 to 3 per cent; and while I understand the stresses employers will face, actually this is all about the outcome at the end; it’s all about generating a sufficient pension otherwise why are we bothering? And the reality is, contributions will need to be much higher than 3 per cent so if we’re stressing about 3, we’re really not in a great place here.

Weber: It’s true that a ramp-up in contributions may put a strain on employers and employees, but the fact of the matter is that we as an industry and as a society need AE and any future variations of AE to be a success. The key will be in planning, support and effective communication and to ensure members understand the long-term investment objective of saving into a pension and ensure they don’t get unnecessarily spooked by short term market fluctuations which will inevitably happen along the journey.

Charging caps

Chair: I’ve sat in a lot of these roundtables for the last couple of years and I’ve heard people commenting on being unable to provide the right products if there is an unrealistic charging cap; and if we’re talking about a charging cap going forward of potentially as low 0.5 per cent, what is the incentive for you guys, as asset managers, asset providers or solution providers to actually do that?

Dickson: It’s still unclear what the charge cap will look like in terms of its overall design. If it was to be a flat 50 basis points and, for example, include transaction fees, then that would be untenable and impractical to operate within that constraint. If it was a 75 basis point that could go up to 100 basis points and transaction fees were in addition to that; and if the overall fee budget was over the lifetime of a scheme, then that would enable the deployment of some of the types of strategies that would enable us to better support members and meet their objectives, particularly when they are at the latter stage of the savings cycle. All the design that I’ve seen to date is predicated upon predetermined retirement ages and we’ll have to wait and see if that is actually practical.

Chair: I absolutely agree with you - the fact that somebody is going to retire at 65 and that’s when you give up on investment I believe is fundamentally wrong.

Bowles: So what do charge caps do? Do they do anything on the debate about outcomes and what the right outcomes should be? Directly, no - it’s all just about a fee budget; indirectly they do because to deliver an outcome-based solution there has to be some element of management within there, and I’m not necessarily talking about active equity funds or anything like that, but there has to be somebody taking some decisions that are going to get you towards that outcome. We don’t know what all the details are yet but it’s likely that charge caps will have all sorts of consequences in terms of DC investment design.

Aspinall:: I’ve spent a lot of time in closed rooms railing against charge caps but the reality is we need to work within whatever budget the DWP and Steve Webb sets. The politicians clearly don’t trust the savings sector and financial services generally. To an extent they’re just picking up on a public mood and in my view that’s what it comes down to. Fundamentally whether it’s 150 basis points or 75 basis points of budget, someone has got to restore trust in this industry.

Bowles: I agree with your point about rebuilding trust but I would argue that it’s not necessarily our part of the market that needs to rebuild that trust; so is it the larger pension schemes which we’re generally involved with that have to rebuild that trust with their membership? I would argue perhaps it isn’t. Perhaps instead it is other parts of the market. If you look at where the impetus has come from for charge caps, has it come from current savings within FTSE 100, FTSE 250 companies? No, broadly it hasn’t. Where has it come from? It’s come from large back books of business that have been around since the 80s that have got initial charges and other more opaque charging structures running through them. So are we, the individuals around this table, capable of rebuilding that trust? Are we interacting with the right people to be able to rebuild it?

Aspinall:: I agree that’s the question we should all be asking and we need to be raising that challenge with our trustee clients, and internally, as we think about what propositions we should be building. That’s the piece that needs to be addressed.

Hames: I agree there is a fundamental trust issue. When you get the front page of The Times talking about the hidden fees that are eating away at our pensions and the failure to disclose transaction charges, it is an issue because people will assume that it is the investment managers who are the ‘fat cats’ in the City that are creaming off their pension. So two things: I think the politicians are probably right in that we need a cap as a stake in the ground that says “you will be looked after”. We need disclosure of charges. But the other twist on this is that, we talk about innovation and long-term investment, but as soon as ‘pot follows member’ comes along, a pension is going to be a series of short-term investments because people are going to be moving from pot to pot and they’re going to be moving from strategy to strategy. So if you put in place an investment strategy that says, “I need to have the money for 30 or 40 years for this to benefit me”, well, is the money going to be there for 30 or 40 years when most people change jobs eight to 10 times in their working lifetime? A lot of people will do ‘pot follows member’ because the natural inclination is to want all your money in one place. So I’m quite interested to see how the investment community is going to cope.

Bowles: I don’t know what the flows of ‘pot follows member’ will be but the flows now in our funds are significant. The days when an asset manager just had a direct relationship with an individual pension scheme are long gone. The way that we interact is mainly distributing through aggregators and through platforms, so if you look at flows in and out of our funds now on a daily basis they’re quite significant.

Dickson: I just wanted to remind everyone that ‘pot follows member’, if that manifests itself, will clearly add to the movement of assets, but DC is unequivocally going to be a cash-flow positive business. We’re going to see contributions ranked up, we will see investment growth, and so it just seems crazy that we wouldn’t include the full suite of investment assets in order to optimise the returns for members.

Chair: Any more thoughts about whether a reduced charging cap limits product development?

Weber: I think charge capping sends the wrong messages to the market and I think it tends to get individuals to focus on the wrong types of issues. It is likely to hinder the innovation that we see across the product spectrum and it limits the choice and the kind of price discovery that the market needs in order to come up with innovative solutions that are going to meet the needs of DC members over the long-term. So while I understand the rationale for charge capping, it puts the emphasis and the focus on a lot of the wrong issues.

Communication

Chair: Are plan communications keeping place with the increasing use of technology?

Dickson: Pockets of it, yes, but there’s no uniformity across the board. A few years ago I did a research trip to Australia where there is a much more mature DC market. One of the key lessons learned down there, right across the whole value chain, was the resource that had been in place to enrol people into pensions was redeployed in engagement. What that meant was you had large corporates that actually had significant resource teams of individuals that were there to act as champions for the pension scheme and encourage people to make AVCs, and so on. I don’t think we’re there yet because all of the focus with auto-enrolment in the UK has been on complying with legislation. It’s an obvious next step to utilise technology, and technology has moved on exponentially over the last few years so while as I said, we’re not quite there yet, I think this will change in the next couple of years, if not sooner.

Bowles: A key question here is how do we use some of this newer technology and communication to deliver effective ‘one on many’ advice? I don’t have the answer but I think that’s going to be crucial in terms of delivering outcomes. You can do so much through generic communication; you can do so much through defaults and investment and scheme design; but I think there’s a real requirement for some sort of effective way to deliver a ‘one on many’ advice structure and hopefully that’s where the technology piece will come in.

Hames: This is a big area of focus for us in terms of our Orbit platform. What we’ve seen is an increased use of technology but it’s often been used to simply move paper-based communications onto a screen rather than utilising technology to create personalised communications. We’ve done a lot of work utilising new personas, user experience, user-centred development of technology that says simply transferring a message from a piece of paper onto a screen achieves nothing. You might get a few more people to look at it but if it’s not about them it is an irrelevant message and that’s where the next step change in schemes utilising technology is going to be; we will see them starting to realise that technology allows you to talk to an audience of one. If you do personas, etc, then you can start saying very specific messages. We also need to understand that not everyone wants everything via technology – there is a significant number who want some offline, some online, a combination of this but the more personalised you can make it the more effective it’s going to be.

Weber: From a communications point of view not everyone wants to receive everything online, and not everybody has the ability to do so. We work with some schemes, for example, where the workforce isn’t computer based at all; they’re around the country and they may not have smartphones or that kind of thing, so online communications are really worthless to that particular population. The point of effective communication is to meet people where they want to be met; you need to make sure that you are on message and are delivering the right type of information. There are some great examples in the States of firms that have done a really good job of innovating and utilising technology to create really effective communication campaigns but there’s also a risk there of muddying the message because pensions are about long-term savings and technology gives instant access and instant gratification; so there’s a risk there of people suddenly checking their pension pot on a daily basis, checking performance, and that could scare them off.

Chair: Is that instant gratification or instant disappointment?

Weber: Well it could be either.

Aspinall:: I don’t think we should be talking about communications separately from investment as if they’re two different silos - we’ve got to be much more realistic about what people can actually choose and not throw too much choice at them. A 22-year-old is not going to be choosing between asset classes or even risk budgets; they should instead be talking about what contribution levels are going in. Also, talking to them about outcomes 40-something years down the line feels to me a little bit unrealistic. The discussion needs to be more about budgeting, getting the right amount in or taking advantage of the tax and employer contributions. Then that flows through to the fact that no one retires by default. At retirement you make choices. You can make them on the day you retire or you can make them weeks or months or years in advance - we just need to take that engagement back to influence the investment design; and I think innovations to come will integration the communications with the investment. America has spent a long time doing ‘to and through’ - looking at how you take your pre-retirement funds and start to make them income generative, and shaping your life around that. That’s really complex and you could put some algorithms and pro formas around that but it’s going to need to be desperately personalised. Which technology supports that, whether it’s paper or a screen or a smart phone, to me that’s a moot point; we have to get to the heart of what we’re actually trying to achieve and that’s trying to get people to do the right things in their pension and wider financial lives. That’s the innovation that I look for and whether it’s two or three years away, I don’t know, but the desire and ambition needs to be there.

Hames: I think it’s important to highlight that this can’t just be about pensions; it’s got to be built into a whole benefits and reward package, because when we get to DC it’s a different ball game now. We have probably got half a million people accessing DC pensions online and they can access information daily. We haven’t seen that this has driven a behaviour of short-termism - quite the opposite. Most have actually increased contributions because they’re more engaged and they don’t react violently to movements in investments because, particularly at the moment, they’re not huge funds. Those who do have larger funds have probably become more accustomed to market movements. So I don’t think we should be afraid of actually giving people instant access. I don’t think it drives negative behaviour.

Chair: How do these issues differ between contract and trust-based schemes?

Aspinall:: Well who knows how long contract-based schemes will last in their current forms. I honestly can’t see contract-based schemes as a business proposition lasting particularly long without radical reform to address the lack of an outcome-orientated fiduciary within them. Trusts and master trusts there are problems with both of them but fundamentally the veil has been pierced of point of sale regulation for GPPs. I would be very nervous if I ran a contract-based scheme because all of the regulations are designed so the provider can say the member understood the product when they bought it, well, guess what? They were auto-enrolled into it, they did not buy it and at some stage when and if markets tank and people can’t retire, someone might have to be on the hook.

Dickson: My own view is that the resources that contract DC providers have is much greater than the majority of trust-based DC schemes and the regulatory responsibilities that contract providers adhere to requires them to ensure that they treat their customers fairly, in the language that’s used, and there are principles that have to be followed.

Bowles: I would have to say I probably don’t agree that contract-based is finished. There is a significant pool of assets sitting with insurers in contract-based arrangements, be it stakeholder, be it personal pensions, be it legacy policies. The issue though isn’t whether contract is good or bad; the issue is the difference in the regulatory structures. Some of the barriers that exist within contract-based schemes reduce investment flexibility and reduce the providers’ ability to do the things they want to do. In a lot of cases, the providers of these products would like to undertake action around the investment proposition but because the contract is in place they simply can’t do it. So there’s a framework there that needs to be sorted - some of it is to do with mending trust, some of it is to do with improving governance, and some of it is to do with the government and the legislation and making sure that these schemes can operate in the way that they want to.

Weber: I agree - there are plenty of examples of good contract-based arrangements but of course there is room and scope for making some changes. I think going forward they will be re-vamped and we will see some more prescriptive language around what the expectations are for contract-based schemes and around the quality of contract-based schemes. But I think it’s difficult to say with absolute certainty that they are going to disappear because we have seen plenty of examples of decent contract-based schemes.

Hames: A key issue will be how the independent governance committees function and how the issues with contract law are dealt with. Also, if you look at what providers in the GPP space have done, they’ve probably shown more innovation - certainly for smaller employers – and they’ve got far better default strategies in place than many trust-based schemes. We still see a lot of traditional out-moded default strategies in place with such arrangements.

Pre-retirement solutions

Chair: Let’s move on to the topic of pre-retirement solutions because we all talk at length about capital growth and building up retirement funds but what do you do when you actually come to retirement, whenever retirement may be these days? What’s the panel’s view on how people can support DC members through retirement?

Weber: This is something that AllianceBernstein is really looking at - trying to deliver more innovation in the pre-retirement space and also post-retirement. We are also trying to address that very question of ‘what is retirement’ and making sure that we support individuals at the right time. The focus to date has always been on the accumulation phase, and it’s time we started thinking more about the run-up to retirement and decumulation. There is room here to innovate and there are lots of other providers that are starting to put their best thinking to work to come up with innovative solutions that will meet the void that exists in the market. There is also plenty of appetite among the schemes that we’re speaking to and the advisers that we’re speaking to for this. There is recognition that this is a hot button issue especially now that we’ve gone through or are going through the exercise of auto-enrolment, because we’ll have a whole cohort of individuals who are near retirement in DC arrangements. There’s a political issue here and there’s a potential legal issue too if we don’t get people to a decent place in the run-up to retirement.

Dickson: This is something we are looking at in recognition that the cliff-edge retirement model and existing investment strategies used in DC default funds are not currently best designed to support outwith annuity purchase. We are looking at developing a portfolio that both preserves capital and provides income at yield levels that offer greater value than annuities.

Bowles: There’s no doubt that there’s a huge increase in demand and interest in this space - partly driven by growth in DC, partly driven by demand for outcome-based solutions. So the demand is there, but the asset flow isn’t yet. If you look at where the hump of money is in DC, it’s mainly with the 40 year olds and they’re still 20 years away from this, mainly. That does create some issues because there’s a lot of innovation going on out there but the actual assets aren’t necessarily there to support some of the solutions, so there is an issue about how quickly some of this stuff can come through. The other issue is that trust-based schemes at the moment are just not interested in paying income out in the main, certainly from the conversations I have had.

Aspinall:: The pre-retirement investment piece is something we’ve been really supportive of for a number of years and something that we’ve seen in the market relatively recently is a number of decent funds coming to market which are much more annuity price aware. They are starting to address what’s really missing which is true certainty in the run-up to retirement and at the same time being able to take your pension in a number of different ways.

Hames: I agree with a lot of what’s being said and I think it comes back to the piece about communication. Perhaps there’s a little bit too much focus or concern about the fact that everyone’s going into default funds; should we be as concerned if they’re still in the default fund as they get towards their retirement age? Or have we engaged them enough to take personal responsibility when they’ve got larger funds to look at all the other innovations that the investment experts will be able to come up with, charge cap or no charge cap, outside the default arrangement?

Chair: Is there any onus on us to make sure the default fund is the right default fund for people as they move through their working lives?

Hames: Well, I think we should see it as a success if every member, when they’re getting to within a 10-year time horizon to their likely retirement, starts to think about moving the money out of the default structure into something that looks more like what they want to do.

Aspinall:: I think we need to come down to earth to our audience and just recognise that for the vast majority of people all the complexity that we ever want to talk about in designing these funds is just beyond them, and we need to get back to simplicity in some way. The reality is that the state pension is still the most important thing for most people.

Bowles: Well, on the point of the state pension, how can you expect people to make informed decisions when they don’t know what it is they’re getting? The state pension is an important part of the jigsaw puzzle that they’ve got no information on and yet we’re expecting them to make informed decisions when they can’t see the whole picture. That’s a whole other issue that needs to be addressed.

The Budget

Chair: What are the panel’s initial thoughts on the changes coming out of the Budget? In my opinion, whilst the proposals certainly provide choice, some of these seem completely at odds with the ‘good member outcomes’ that we have been discussing for some time. I can’t see face-to-face advice being possible as I doubt there is the capacity in the advisory market once you add in advice on PIE, ETV and any other exercises that might come along. Also, does this mean that lifestyle as an investment option falls away if the target moves to capital growth to maximise cash withdrawal?

Weber: We’re looking forward to the detail and obviously there’s a consultation under way, but we’re optimistic about the changes and how this will play out from an investment point of view. Based on what we know today, we suspect an increased likelihood that individuals will invest through retirement and that end-point sensitive strategies, such as most lifestyles today which presume that individuals will immediately annuitise, will no longer be appropriate. We anticipate a greater usage of TDF solutions that already facilitate a through-retirement approach (when required) in a way that traditional strategies don’t. We also expect there will be a greater use of collective drawdown. As we’re a TDF provider and also in the process of launching our flexible drawdown product, we’re looking forward to supporting our clients to address these new requirements.

Aspinall:: We are still waiting to hear how guidance will work and are concerned that in the light of the charge cap this cost could break the current pensions model. Until they see how real members behave schemes can only make assumptions to review their default’s pre-retirement investment. Personalisation could improve the default with dual de-risking, using data to estimate and invest for the cash members might take with the rest going into a duration-aware pot but still return-seeking pot. Starting this before retirement could make it more efficient and personal, but few trusts will take members past retirement into drawdown.

Hames: There’s no doubt that the Chancellor’s proposals have caught the public’s imagination and are a popular move. So, in this sense, it must be seen as a positive development. What has to be appreciated is that this truly is a game-changer. DC pensions will be employer-sponsored long-term savings plans. Effective, personalised communications and the availability of investment strategies aligned to the various options will become even more vital.

Bowles: It appears that generating a good outcome from a DC pension also now includes the purchase of a luxury sports car. I have to confess this was not amongst the outcomes I was expecting from auto-enrolment and the various other sensible initiatives that are being put in place to ensure members receive an adequate retirement income. At the very least it raises significant questions over the appropriateness of current lifestyle design, which surprisingly in many cases wasn’t targeting a sports car purchase.

Dickson: The budget changes are providing much greater control to DC members how they access their savings in future, which is good news. Clearly DC default strategies will need to change to include new ‘to and through’ retirement phase strategies. I expect we will see demand for portfolios that provide both capital preservation and income, and to deliver these twin objectives we will see increased use of multi-asset portfolios that may include higher yielding, less liquid asset classes such as loans and real estate.

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