Lynn Strongin Dodds explains why the time has come for a stronger focus on DC

Although the death knell for defined benefit schemes has been ringing for some time and pension reform is on its way, most employees are still not ready for defined contribution. Greater education and engagement will help but expectations must also be managed. The National Employment Savings Trust (NEST) will herald in a new era but it will not solve all the problems.

One of the main problems is that there are too many people underestimating the contributions they will need to make to their pension pots and misjudging the returns they will garner. Paul Leandro, associate at independent actuary and consultant firm Barnet Waddingham, "If you look at the statistics, about 90% of employees hope to receive 50% of their final salary in retirement. If this is going to be funded purely from DC schemes, it could be a tough road. This is why it is important to manage aspirations and to get people to realise that they have to regularly review their own arrangements."

There is a hope according to a new study from Clear Path Analysis, which canvassed 44 UK DC schemes that the roll out of NEST will encourage DC managers to improve their efforts to engage with members and communicate. Due to make its debut in 2012, NEST is the government's flagship pension scheme to help encourage people to save for retirement. Under the scheme, employers are required to introduce auto-enrolment and employees have to join workplace pension schemes unless they actively opt out. NEST will be the default fund for those employers that do not create alternative arrangements that are at least as good.

Although an important initiative, David Calfo, head of the group's DC Business Strategy at BNY Mellon, said: "NEST is not the be all and end all. It is intended for a certain part of the population which is very much needed but we have been here before with stakeholder pensions and it was not as successful as expected. The jury is still out on NEST."

Industry providers as well as employers are currently spreading the word. Kevin LeGrand, president of the Society of Pension Consultants, said: "I think there needs to be more emphasis on education but there also should be a recognition that there will always be a large core of people who will struggle to understand DC regardless of how much you try to explain it to them. A generational shift needs to take place because most middle-aged people have grown up with fairly generous DB schemes and this is what they expect. It will be different for those in their twenties."

Paul Marco, senior investment consultant at Towers Watson, echoes these sentiments. "There are only a certain number of people who are ever going to listen and efforts to educate the others have mainly fallen on deaf ears. The majority of the population does not want to make an investment decision which is why studies show that maybe 90% will use the default fund. As a result there should be more targeted information to people who want to make their own decisions, and then time and money spent on making sure that the governance, investment strategy and managers are in place for the default fund."

Tim Banks, director, sales and client relations at AllianceBernstein, adds: "As an industry a lot of time and effort has gone into educating the same 5% of the population. We think NEST is an important initiative because it will help get the concept of DC across to employees. I think it offers a great opportunity to make workplace pension schemes much more attractive to a membership which is often disengaged from the process as well as introducing flexibility into investment decisions."

Julian Lyne, head of UK institutional business with F&C Asset Management, believes that "NEST will create a benchmark for what DC should look like. This does not mean that all companies will replicate NEST in terms of fund choice or contribution rates, but it will lead to much more consideration about individual scheme design and what is appropriate for specific company circumstances."

The bottom line though, according to LeGrand, are the contributions. "NEST is clearly something everyone will be watching and it could determine the basis of how other DC schemes are set up. However, we remain concerned that the level of money that is going into DC schemes is far too low and unless it is increased all the rest is window dressing. Employees will not receive a decent outcome for their retirement without a decent sum of money being put it."

Under NEST for example, total contributions will be 8%, of which 3% will come from the employer, 4% from the employee and 1% from the Government, in the form of tax relief. That is less than the average contribution rate of private-sector DC schemes as well as DB, which is roughly 20%. The danger is that employers will be tempted to move down to these new levels.

To address these problems, market participants believe there should be more attention paid to improving the returns as well as transparency of the default funds that the bulk of the population will be investing in. As Andrew Benton, head of international institutional sales and business development of Baring Asset Management, says: "There is a lot of discussion about default funds being the only focus for investors. This is not a bad thing as long as the default funds are well designed. "

To date, the most popular and widely used strategy for default funds is the so called life styling approach. This typically entails investing in an equity-based fund during an employee's younger years to tackle inflation risk and generate higher returns before gradually switching into fixed interest securities in the run up to retirement to help counter pension conversion risk.

The problem though with this model, according to Banks is that it may be adept at reducing risks immediately before retirement, but it is often less able to manage the investment opportunity at earlier stages in a member's life. "Lifestyle funds target a specific end date and tend to be designed around the aim of buying an annuity on a fixed date. This can be dangerous because today there is no set retirement date. We advocate a much more flexible and dynamic approach."

At the beginning of the year, AllianceBernstein launched a range of target date funds which build a savings pot matched to the employee's chosen retirement date by investing in a range of assets. These are the fastest growing products in the US and are expected to gain traction in the UK.

Baring Asset Management also believes in taking a proactive stance and offers a multi-asset-class fund which combines strategic and tactical asset allocation to reduce volatility and deliver inflation beating returns. Fund managers calculate the likely return, correlation and risk factors for each individual asset class and then crunch the numbers through a model that recommends a ten year optimal asset allocation strategy for the portfolio.

Calfo also believes there should be more emphasis on the liabilities in the DC scheme. "There is a great deal of attention on the assets but not much on the liabilities. I think one of the biggest challenges going forward is finding a way to crack the dilemma of coming up with products that consider both sides of the balance sheet. We need to be able to harness the knowledge and expertise of fund managers who have experience in LDI for DB plans and apply it to DC."

While market participants may differ on investment strategies, all expect to see an increase in the number of DC platforms on the market ranging from the all encompassing platform covering pensions, insurance products, and wider savings opportunities to the more bespoke. Lyne says: "I think there will be a divide in the DC market between those companies offering platforms that include a range of financial products such as ISAs alongside a pension with a scheme specific fund offering and those that will simply offer a vanilla DC scheme."

Lynn Strongin Dodds is a freelance journalist

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