PANEL

Chair: Chris Parrott -Pensions Manager, Heathrow Airport Holdings



Peter Glancy - Head of Corporate Propositions, Scottish Widows
David Hutchins - Head of DC Investments, AllianceBernstein
Philip Mowbray -Head of Product Risk, Barrie & Hibbert
Simon Chinnery - Managing Director and Head of UK DC, J.P. Morga n Asset Management
George Emmerson - Investment Director, UK Institutional Business, Standard Life Investments
Nigel Aston - Managing Director, Head of UK DC, State Street Global Advisors

Tackling fees

Chair: I would like to begin today’s discussion with a focus on the topical issue of fees. What are the panel’s thoughts on Steve Webb’s comments about naming and shaming so-called high charging pension providers?

Emmerson: There is certainly a perception in the market that low cost can still equal good value, that it can also equal a risk control and it can also equal good member outcomes by simply utilising passive funds, whether you blend them, whether you use them in isolation etc. In our view that is a myth because it’s not all about price. That doesn’t mean that the most expensive fund or portfolio out there is the right one, but an appropriate price to get the right level of risk control and the right level of return for the future member outcome is probably appropriate. Keeping it less than 1 per cent probably is a necessity; keeping it down nearer to 50-60 bps is probably a necessity; but just saying that the cheapest is the best I think has been proven not to be the case. So while the government may have decided that low cost equals good value, as an industry we should do our best to push against that and say that’s not always the case.

Aston: I think the debate to date has been either active or passive – active has come at a higher cost, but has a predictability and a smoothing effect on capital markets’ volatility, whereas passive comes at a lower cost but members feel every single bump of the market. However, I don’t think the decision should be as binary as active or passive, and I believe the new model will be active and passive.

We would probably all agree that 80 per cent of the value in a portfolio’s growth comes from asset allocation, whereas currently about 80 per cent of the cost of investment management goes towards stock picking in active funds. So I would suggest that within efficient markets, using passive components and mixing them actively is a way of reducing costs, while still gaining the benefit of active asset allocation and governance and the smoothing out of those performance peaks and troughs.

Glancy: I think Steve Webb’s ploy of naming and shaming is preferable to legislating and charge caps because charge caps will kill off innovation and competitive forces in the market in the long term. He has also had some considerable success in signalling his intentions to the market because legislating in a coalition government is going to be horrendously difficult – he seems to be getting a good response just by sending signals to the market and seeing the market reacting to those signals.

There’s also a bit of a myth around the levels of charges. Going forward I would expect most of the big brand pension providers to be writing schemes where the scheme and the default fund is in the region of 20-60 bps. When the OFT conducts it data gathering exercise and its review of the market, that will hopefully bring out some of the truths about the level of charging in the industry and get us away from some of the sensationalist stories that we’ve seen in the press. So I am looking forward to getting some facts out there about charges.
There are some outliers where the charges might be high and we need to tackle those charging structures that give the industry a bad name, but I think in the main the big brand providers have fairly low levels of charges.


Mowbray:To bring value rather than cost back into the debate we need to link the DC investment solution to the longer term savings objective. In order to consider the value of a DC investment plan, pension savers and their advisers or employers need to have a clearer understanding of what a good outcome looks like, or in Steve Webb’s language, what a defined ambition might be. How do the distinct elements of a DC investment plan – all with some associated cost – contribute to the longer term outcome for the saver? If we can start to think about what the saver is trying to get out over the relatively long term, the different levels of value-add that you can get from those fundamentally different services start to become more transparent, and you can create a coherent proposition based on value rather than cost. The market doesn’t really have this picture yet, and the industry has not worked hard enough to explain it.

Aston: So it’s about attribution of value, attribution of performance?

Mowbray: Absolutely. This notion of ‘outcome’ is bandied around, but feels like a big gap in understanding and it makes any ‘value’-based argument appear quite subjective.

Chinnery: Well, in the longer term, I suspect the defence of ‘it was the cheapest option at the time’ will not be acceptable when people’s pensions don’t provide them enough to get them over the retirement line.

Emmerson: Just to follow on from Nigel [Aston’s] comment, ‘active management’ in the past has meant alpha and beta, and the active bit was alpha and, whether the member knows it or not, certainly as an industry we know that the lion’s share of returns comes from beta. That drives predominantly what your returns are because, as we all know, sometimes alpha is great and sometimes it is horrendous, so maybe it’s average at best.

I think, however, the definition of ‘active management’ is changing and we are talking more about active management in terms of everything from dynamic asset allocation right the way through to absolute return where you’re making a conscious decision of, for example, whether you want your beta to come from equities or credit or real estate, and blending it. So it is taking active management to a completely different level and that, I think, has a fee that’s appropriate to go along with it.

Chair: As an end user, an end supplier, I worry about this. I worry about the fact that we’re going to have a market-driven process which pushes down charges to, for example, 30 bps which most providers aren’t going to be able to sustain. Will some ask ‘where’s the commercial value in that’? Will some make a decision at some point to say ‘I’m out’. Will some not wish to develop anything because of low profitability, so will not develop communication, modellers or anything else that is needed to help people understand what is wrong or right with their product? I do fear that we may end up with a second-rate pension system.

Aston: That is worrying and if innovation is stifled that is a problem. However, innovation hasn’t been stifled over the last two decades by cost constraints, and we still haven’t come up with default funds that people deserve.

Emmerson: We also need to look at some of the differentiators in the market as to what people are actually buying. Is it contract-based or is it trust-based DC; does it go down a master trust route; what is the legal structure that wraps around it? Because my experience is that you see very different approaches from both employers and trustees depending on whether it’s a trust-based or master trust scheme, versus a contract-based one; and how you account for the fees that are more than just asset management costs of running a portfolio but also include admin costs, member comms costs, and so on.

Chair: It comes down to choice of what you want to provide to your staff. That will be somewhere in the range of a low-cost stakeholder product up to a high-cost self invested personal pension. You take your choice from that range and you pay for that choice.

Hutchins: The question I would ask around fees is do we still look at DC as primarily a distribution problem, more than an investment problem? I think it also comes down to some of the other questions on today’s agenda such as ‘why is the product not better’?


Is that because we spend most of our time working out how to sell and distribute the product rather than on the actual quality of the product underneath? Then, as we squeeze fees, the thing that’s actually being squeezed most is the quality of the product because there is such a cost of distributing it to this market.
So at the moment people think this is an investment management fee problem whereas the problem is actually how do we reduce the cost of distribution in DC?

Aston: Part of that problem comes back to this whole choice that schemes face – do I go master trust, do I go trust, do I go contract-based? There’s a regulatory decision they have to make which is compounded by having two different regulators which is really unhelpful. If the amount of energy that gets put into deciding the scheme construct was put into designing the investment vehicle itself, then we might have better outcomes.

Emmerson: There are even some employers in the market who no longer see the benefit of providing pension provision for their employees because maybe they’ve got legacy DB pensions that are crippling the sponsors through deficit repair plans, through PPF levies etc, and the trustees coming through the system now are saying they don’t want a repeat of that.

Hutchins: There is no doubt that those finance directors with a DB legacy want as little to do with pensions as possible going forward.

Emmerson: Absolutely, and they don’t actually want a high take-up rate; so if they have a 60 per cent take-up rate in their DC scheme and then we do all this great work, produce great literature and do roadshows to get their take-up rate to 100 per cent, they’re still not happy because it’s just increased their cost base through the employer contributions. So actually are we knocking on a door that’s not ready to open?

Glancy: This is one of the challenges with the way the government has chosen to approach this because it has chosen to resolve the nation’s pensions problems through the workplace. You’ve got the purchase decision-maker who is the employer, who is often not that engaged, or sometimes very disengaged if they have legacy issues, making a purchase decision on behalf of beneficiaries who are the employees, and if they’re not that engaged then what’s the employer’s incentive? Do they employ the due diligence to put in place something that delivers good outcomes for their workforce? That’s a real disconnect in our market.

Hutchins: That’s an alignment issue – the person making the purchase isn’t aligned with a good outcome.

Chinnery: But there is a longer term issue as well which, although it may not be very prominent at the moment, is around having a workforce that cannot afford to retire.

Aston: You’re right. In the longer term, the interests of an individual who’s aiming for retirement readiness and needs money to live need to be aligned with those of the employers who need that person to be able to retire so they can recruit fresh talent. But at the moment the pain of auto-enrolment and the pain of DB isn’t helping people do that.

Hutchins: I was going to bring it back to auto-enrolment, and one of the real disappointments of auto-enrolment for me has been how much concentration has really focused on the quality of what we’re putting people in. We’ve been so focused on the practical issues of getting money out of someone’s pay cheque into a pension scheme that we almost don’t care where it ends up.

I know that’s not true of all employers, you do see some good employers offering good products, but on the whole the auto-enrolment debate has been focused on the front end, the distribution, not the quality of the product.

Chair: You are right. Everything is focusing on the front end and not on what’s happening once the money is being delivered. I think there’s also another issue at the other end of the spectrum around the fact that all the decision-makers are being forced out of pension arrangements through tax laws. That means they are completely disengaged with the needs of employees.

Default funds

Chair: Moving the debate on, the general consensus is that DC default funds are failing. What can we do to improve their design and delivery?

Hutchins: I think it is the governance of the default that has been lacking – we have been applying too many DB models to DC governance when actually DC needs a different model, the reason being that in DB you have an engaged investor, i.e. the employer, whereas in DC you have an unengaged investor, which means that the trustees and plan sponsor have a very different role.
The other part of that is how can the same group simultaneously make all the investment decisions, set the objectives and review the performance and do that independently? The 80 or 90 per cent of members that go into a default are trusting people to run that default for them, but is it actually being governed in a way that they would see as appropriate?

Chinnery: In terms of the design, the focus has to shift from just getting the average person to a better outcome, to getting the majority over a replacement income target; getting them across a line, even if that’s just a minimum line. When it comes to delivery and member engagement, my belief is that it should all be around the savings side of things, not explaining the investment structures. The questions we should be asking members are: What have you got? What do you need? Where do you need to get to? How are you going to get there?

Mowbray: The investment industry has traditionally been, and remains, focused on wealth accumulation. The risks facing a DC investor in decumulation are fundamentally different to those in accumulation. As an industry, we seem to be focused on details of investment structure; these are concepts that the market understands and is comfortable with. But in many cases, these details may be of limited importance to the longer term DC savings outcome.
To date, few investment providers have attempted to deal with the specific problems associated with decumulation. That’s a fundamental issue that needs to be fixed – in future, all these new DC investors will be drawing down income, and they will be concerned with the amount of income they can get.
While we are certainly working with a few notable exceptions, in general, there isn’t anything that allows a DC saver or adviser to relate investment options to outcomes. I think David [Hutchin’s] earlier comment is important; a lot of this stems from the governance framework for DC defaults. In many cases, there isn’t the right governance framework set up around DC schemes or default investment options.

Chair: So how can we fix that?

Mowbray: There are three thoughts. As I started off with, we need to be able to define what a good outcome actually is – otherwise it’s very difficult to deliver any sort of outcome-based investment. Second, we need to help the member or adviser link what they’re investing in to that outcome – most likely, you need some kind of economic model to do that. Then finally you need the right products to help you get to that outcome.

Glancy: When we talk about DC default funds as failing, I think it depends on your definition of failing. As a provider we’ve got hundreds of thousands of people in DC and I tend not to get letters from customers saying ‘we think our DC defaults are failing us’. So how do we define failing? Is it against a benchmark or is it in relation to expectations? The big problem we have in DC at the moment, unlike DB, is that people don’t have an expectation of what they’re going to get at the end of the process.

If we look at what the government has done with the state element of the pension, they’ve moved it from something providing a very uncertain outcome to something that’s now very certain; and anything we are doing on the private side of pensions is now a top-up to something that is very certain. So if we can find a way of engaging with people to help them understand and help them model what might be realistic in terms of an ambition for them to have from their private pension provision, we can work back from that to come up with structures that help to get them there, even give them checkpoints along the way so that they can take corrective action in terms of contribution levels or investment choices and so on. It’s much easier to have that dialogue now that we have a flat-rate state pension.

Hutchins: But are we anywhere near that kind of engagement model today? My concern has always been around ‘what is a good outcome’? It’s not just around the pension, it’s how much it costs me to get there, how much do I have to save, and there are all kinds of factors you have to take into account. The DB mindset would be to set up some kind of objective for an income, but in DB that was fine because you just designed the benefit for individuals. Here they’re paying the costs of that benefit. So you need to ask how much do I have to pay in, what’s the certainty of achieving that outcome, and then you come back to the earlier point of how do we keep it simple?

Aston: I think it should appear simple – so let’s say that default funds aren’t failing; let’s put it in a more positive light and ask what are the three things we could do to improve default funds? Firstly, I strongly believe that cost and transparency are real issues. I think we can do things better at lower cost, and that’s not to say we go rock bottom, but I think there’s too much fat built into it at the moment, so cost is important. The second one is governance – governance should be embedded into the fund itself so that if the consultant who advised them moves away from the plan, or if the member moves away from that original employer, the governance remains with the unit holder because it’s built into the fund itself rather than through an outside source; it becomes embedded with advice and governance. The third is design – at the moment we present DC in terms of two journeys rather than one. There’s the savings journey and then there’s the payout journey, but we need to stitch those two together, just like in DB, and make that one process rather than two.

There are two ways to do that – the first is through smart communication, so trying to re-establish the link between ‘money in’ and ‘money out’. The second is by using sophisticated investment techniques – there’s no reason why you couldn’t lock in some elements of income as you go along, for example, by buying def-erred annuities, buying long-dated inflation-protected bonds; all sorts of sophisticated techniques that we use in LDI but which we rarely touch in DC.

Mowbray: If you were a retire-ment investor in the US market you might be buying a structured portfolio of inflation-linked bonds to do exactly that.

Emmerson: There is a quite simple link, I think, in terms of the thought process between DB and DC, because all DC is, in fact, is a whole series of discounted cash flow. All you have to do in the very simple world is to work out what you want to retire on from a monetary point of view, discount it back to today and take into account longevity, investment returns and more importantly, the contribution rate which is probably the biggest failing today in that people are trying to make £10 turn into £100 over the course of a few years and that’s just not going to happen.

So it’s quite simple to think of it as a discount rate, find an investment strategy that puts you on that journey, review it, make sure you take account of what’s happening, but also make sure your contribution rate is correct, and that of course is where the biggest issue is because most people can’t afford to put in what they need to put in to get to that end point in the future.

I would also question whether default funds have to be simple, because simple doesn’t necessarily equal good outcome. For a trust-based scheme where there is a governance structure around it, i.e. the trustees, does the individual underneath need to know what’s going on? Does the individual need to know that you might be using derivatives or swaps or whatever else?

Also, when it comes to decumulation, there’s also a misnomer that you have to go into bonds, but why would you buy government bonds at the moment? Why would you buy inflation-linked bonds at the moment in your portfolio? There are easier ways of managing your future inflation and interest rate risk if you get to a point where you think you’re going to buy an annuity.

So there are lots of ways of taking the DB thought process and putting it into DC to make it appropriate for DC, so LDI for example. It’s not that difficult to create a portfolio that manages LDI in DC. Now it’s difficult to explain it to the member, but does that matter? As long as the member understands the journey that they’re on and where they’re going, and it’s monitored and measured, either by trustees or by IFAs or whoever else, then you can actually get on with that journey which should be smoother and result in a better outcome for the member.

So there’s a big division between trust-based where you can have that input, you can have that focus, and contract-based where it’s quite difficult because there’s very little governance for the guy on the street where he’s got his own little pot and he’s trying to
do that.

Aston: Put the governance in the fund and then it doesn’t matter about the legal construct.

Emmerson: But it doesn’t have to be simple.

Hutchins: I think what we would all agree is that it doesn’t necessarily need to be simple underneath, but simple upfront.

Chair: I’m glad you’ve brought it back to simplicity because, from an employer perspective, when I was introducing DC schemes in the early 2000s, what were the drivers behind it? Cost, simplicity and restricted governance required. But over the last 18 months, I’ve become more and more concerned about the lack of governance that’s gone on.

Chinnery: And as we said before, governance has to be embedded because I doubt that people know what they want to retire on or how they are going to get there. They have unrealistic expectations. However, they do have a view of when they want to retire and what they can afford to put in. Governance must have the goal of focusing on getting the majority of people over a minimum income replacement and then designing a strategy that will deliver this through carefully managed and diversified asset allocation, not just about throwing different investments together.

Flexible retirement

Chair: Moving the discussion on, can the industry better support flexible retirement?

Chinnery: We have to because the reality is that people are going to have to be more flexible if they can’t afford to retire; they’ll be going part-time and job sharing – doing whatever is needed to earn for longer. I think the challenge will be how we create protection around a minimum income level that then frees up capital to apply to risk assets for longer.

At the moment life-cycling glides you into buying an annuity, but if retirement is deferred then a large dollop of cash and gilts may not be the best place to be. The problem is that with one lifecycle, how, without getting members engaged, do you build in deferred options which need to kick in before the ‘de-risking stage’ begins. In the US if you change your target retirement year you simply switch funds.

Aston: I think it’s helpful to look at real data here. At SSgA we’ve been running a six monthly investor survey in the US (which is a more mature market so I think things will follow here) and when we ask people ‘what do you do at retirement?’, the vast majority don’t take any income at all from their 401K for the first five years, they live off other assets and leave the retirement plan to roll forward and carry on being invested. Now, we may not get there quickly here in the UK, but I think ultimately people will choose to take income from different pots of money and won’t have that sort of crystallising effect they currently do.

Glancy: I think that’s where the answer actually lies. If we are trying to solve flexible retirement just looking at the pensions wrapper in isolation, we’re going to come up with a sub-optimal design. If the average person postpones their retirement from 60 to 65 they can increase their annual income by 45 per cent in terms of the annuity stream that they can purchase, so if people have accumulated other assets and they can postpone that crystallisation point, that’s the best way to do it. At the top end people can use products like income drawdown, at the bottom end people should be looking at cash accounts, cash savings, ISAs, these sorts of things. The biggest downward pressure on annuities has been increasing longevity, and the annuity rates start to improve exponentially as you get a little bit older.

Hutchins: But you’re paying for that because you’re not taking five years worth of income. There’s no free lunch in that essentially.

Emmerson: But you are making your time horizon longer so you can start to look at taking rewarded risk and avoiding unrewarded risk in however and whatever shape or form you want.

Hutchins: But where do we think this world is going? Our view is that the world we’re moving to is a kind of ‘beyond retirement’ approach to saving, which is our retirement bridge concept where you go from accumulation to decumulation directly from your pot, into an annuity at 75/80, where actually an annuity still looks like a good option. So really what we’re saying is that 75 is the new 65. An annuity is not actually a bad outcome – it’s just about buying it at the point when you need the insurance.

Aston: Can I throw in a question? Fifty per cent of people qualify for an enhanced annuity, so isn’t it right that those people should be buying an annuity sooner rather than those people who don’t? But the problem is, you don’t know which 50 per cent it’s going to be, so how do we conquer that?

Emmerson: And also is that enhanced annuity going to fit with waiting another five years where you’ve got enough assets to live on and not be struggling, not be at poverty level, where actually that extra five years could make almost a 50 per cent difference to the impaired annuity you then purchase in five years time rather than the one today; because who knows what’ll happen to annuity rates over the space of any two, three or five year period because we’re in a world of low growth where you need sustainable yield. Will that still be the case in 40 years? None of us know that.

Glancy: In addition to the income element there’s also the emotional element of intergenerational transfer, your legacy to your kids. Once you’ve purchased an annuity, it’s gone. If you’re keeping the money invested, you can pass it on to your estate. With income drawdown, yes there’s a tax charge; pre-retirement savings, but it’s then going to your estate once you’re gone and that’s an emotional thing.

Future of DC

Chair: I think the first point on the future of DC is what the scheme design is going to look like going forward? Is master trust/super-sizing the answer?

Glancy: I see two ends of the spectrum here. One is you’ve got trust-based, the other you’ve got contract-based. The big advantage of trust-based is that people trust their employer, they trust their colleagues/the trustees etc. Trust is important because you’ve got to put your money in, you’ve got to leave it there, so there’s a big emotional thing. Then on the contract-based side you’ve got the consumer protection that you get from the FSA. If anything goes wrong you can call on that consumer protection. Also on the contract-based side you’ve got to make the right recommendations and decisions for the individual as opposed to the collective. So for me the answer lies in taking the best bits from trust-based and the best bits from contract-based and bringing them together, probably under a single regulator, to get rid of the regulatory arbitrage.

Aston: If we can get past the regulatory arbitrage that would be excellent. But I think the one thing that’s really important is scale and at the moment schemes tend to be tailored or bespoke because it’s viewed that employer A is different to employer B and then different to employer C. That’s not often the case. A 25 year old in employer A has got much more in common with a 25 year old in B and C than they have with a 60 year old in A. So we should be bespoking by the type of person you are, not by where you work, and the amount of energy expended in personalising communications and delivery based on your employer rather than based on the sort of person you are is considerable.

Emmerson: And if you look at some of the benefits that you can see over in Europe and Australia in terms of grouping DC, either into industry groupings, collective DC, whatever you want to call it, they have managed to get the critical point of scale so that they can have assets that they can manage very actively and use lots of bells and whistles and nuts and bolts, but collectively for the end user it’s keeping it within a realistic price bracket. Then you can have that commonality of the 25 year old in employer A, B, C and D and you get some consistency there.

Hutchins: I’m going to slightly disagree - there’s a whole raft of ways where you can build scale, and it doesn’t necessarily have to be at the trust or the provider level. Any fund is a scaling solution. It’s a way of providing individual stock selection, advice or whatever in a common investment trust or common fund to actually provide a scaled solution. So when you look at it you don’t need a lot of scale to get a very cheap scheme. You don’t need much money.
The next question is, is the alignment between the person running the scheme and the individual savers the most important thing in DC? And if so, how do we get that alignment when you’ve got a million members compared to when you have a thousand members in your pension scheme? Let’s think for example about the history of the mutuals in the UK – were they run for the benefit of the membership or the benefit of the management? So, the challenge with the master trust model is how we get the right alignment with the individual savers, because that’s ultimately what they’ve got to do.

Emmerson: And you could wrap all that up as the word ‘governance’.

Mowbray: I think there is a cost associated with good governance and I think that inevitably points to a bit of economy of scale. You are going to need to drive that quality.

Chair: I think master trust is a good idea for the moment. However over time, as these things become bigger, an employer is going to want more say in how that master trust works or choose to bring any pension arrangement back under their control.

Chinnery: It’s a useful aggregator at the moment.

Chair: How can we encourage members to save more?

Aston: Can I give you a concrete example of something that SSgA has done? In the US we have programmes called Retirement Boot Camps, which work on the same principles of behavioural finance. What we’ve done for particular plans is we’ve said ‘OK, let’s say the employer is putting in 5 per cent, and the employee 5 per cent. For six months it is going to go up to 5 per cent and 10 per cent, so the employee is going to put in 10 per cent’. Everyone is enrolled into that six month programme but you can opt out immediately if you want to. Our experience is that around three quarters of people don’t opt out. The interesting thing that happens at the end of the six months is that most people don’t go back to their previous lower level of saving. It’s just taking advantage of human nature, if you like, to give savers better results.

Hutchins: I think all the auto-escalation issues are far easier in a world where people are actually getting pay rises. So I think the challenge has been the markets today.

Emmerson: I also wonder if the word ‘pensions’ is the right one to use. It should be ‘savings’ because people associate the word ‘pensions’ with the government and legislation, and they don’t trust the government.

Glancy: To me this is all about education and engagement, and I would just stick with two simple messages. One is that anything you are now saving into a private pension is going to be over and above a flat-rate state pension so you’ve removed that uncertainty, that’s a powerful message. The second one is, even if you look at the auto-enrolment levels, come 2018 whatever you put in, between the employer contribution and the tax relief, you’re going to double your money, so you’ve got 100 per cent growth on your investment from day one, so that to me is an inherently good product. Those two simple messages – get them across.

Mowbray: I guess it’s a combination of inevitable compulsion, we’re moving in that direction already; and it is about engagement, so there’s absolutely a stick and there’s a carrot. A lot of the conversation today has been about target rate funds and such things - there’s an awful lot of focus on the details of investment structure and not enough industry focus on the customer outcome. I realise that’s not an easy thing for the industry to deal with but it is fundamental.

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