Defined contribution is at the top of the pensions agenda with the rise of automatic enrolment. Our panel of experts discusses the issues facing the industry
Chair: Chris Parrott, Pensions Manager, Heathrow Airport Holdings
Nigel Aston, Managing Director, Head of UK DC, State Street Global Advisors
Tim Banks, Managing Director, Pension Strategy Group, AllianceBernstein
Scott Brooks, Investment Development Manager, Scottish Widows
Simon Chinnery, Head of UK DC, J.P. Morgan Asset Management
Andy Dickson, Investment Director, UK Institutional Business, Standard Life Investments
Robin Hames, Head of Marketing, Capita Employee Benefits
Philip Mowbray, Senior Director, Moody’s Analytics
Chair: DC is the main focus of almost everybody at the moment. Let’s start with something that the regulator and everybody seems to be fixated on – quality. It’s quite easy to use this buzzword of ‘quality’, but what does it actually mean?
Brooks: The default is an obvious starting point, and the quality of member support and communications that fits around that. The knowledge gap is immense in the market just now. With the advent of auto enrolment it just feels to me we’re bringing an awful lot of new people into this industry who don’t understand it, don’t like it, and all they know about it is the negative press sentiment we hear about it. The biggest piece that I feel we have to do to improve quality is help members through this new world and the education piece that ties into that.
Mowbray: From the perspective of the scheme member, engagement and communication is a critical aspect of quality. At the most basic level we need to help people to understand what their expectations are. After that, we need an improvement in engagement to help people track towards these expectations, or to get to a point where they understand the extent to which they are achieving them. In terms of the investment, we need to consider how the member can track performance and the outcome from a default investment against their objective or expectation. If you don’t get these right, it’s going to be very difficult for members and employers to assess the value or quality in relation to their DC plan.
Aston: Quality in DC basically comes down to three components: administration, communication, and investment. Five or 10 years ago the big providers were competing on how good their administration was. Now some have better servicing standards than others, but everyone’s servicing is, by and large, good enough so it’s now a utility; it’s a hygiene factor. A lot of the effort on communications in the past was expended on getting people to join – with auto-enrolment we no longer need to do that, and the opt-out rates are relatively low so far. I think asset management is where we can all do a better job. In the past there have been a lot of frictional costs to investment: the cost of distribution, the cost of marketing and advertising for example, with traditional active managers competing against each other for shelf space on platforms. On the other end of the spectrum we’ve had the low level costs of ‘plain vanilla’ passive. I think the future of quality investment for DC will lie somewhere in between those two extremes – whether that’s smart beta or tactical asset allocation of underlying indexed components- There seems to be a rich seam of investment capability that we can mine which is the best of both worlds.
Chinnery: I’ll just focus on the quality of the investment proposition, and one issue I have is about ensuring people have access to the full range of investments. My concern is quality will suffer if they don’t. If we look at the DB landscape then there is a full range of asset classes being used but in DC that isn’t the case – property, infrastructure, alternatives are virtually absent and emerging markets and high yield are much less prevalent than in DB. Somehow the message appears to be ‘quality for DB is different to quality for DC members’, I think that’s disappointing.
Dickson: The real measure of quality in DC won’t become apparent until the future, when the benefits are paid out to the members. So, at this juncture how you define quality is the responsibility of the fiduciaries who are selecting the providers for the plan. What you can do is demonstrate quality of process. For example, in the investment arena the design of the investment process coupled with the talent within the organisation can be tested, and if you can demonstrate you can deliver repeatable performance then that’s what will be used to define quality and selections are made on that basis.
Banks: For us quality really translates as good governance. What we think members would expect to see is someone on the hook for making value judgments about all the different features that the panel talked about and how they come together in their best interests, and the fact that those are not set in stone, that they are reviewed for best practice right throughout that incredibly long savings journey.
Brooks: I’d be interested in the panel’s views on the expectations of this new population of savers, the ‘reluctant investors’ that are being forced into a pension as opposed to selecting a pension. Will they have a different mindset in terms of expectations for what that’s going to provide them with? Does that therefore mean that the investment content, the communications piece, do they look different for that population versus DC or DB typical members?
Chinnery: Absolutely. The message that politicians and the industry are creating is of a two tier pension system. I think the concern is that for those new reluctant investors cost is the only determinant, so what happens underneath the bonnet doesn’t really matter as long as it’s cheap. For many others, who are in better plans, that will mean they will get a more diversified, higher quality product.
Chair: I don’t think there’s such a thing as a reluctant investor. It’s always been the case that people will fall into one of two things: they will want somebody to tell them what to do, or in the DB environment it’s join and somebody will worry about that for you. On the other hand there are people who think, rightly or wrongly, that they know what they’re doing. There’s always been those two populations and I can’t really see that this generation will be any different.
Aston: I think you’re probably right, but with auto-enrolment the first of those two camps is going to be a lot bigger. In fact it’s always been much bigger than the second camp.
Dickson: For those that want it done for them the difference between DB and DC is that in DC the member is taking all the risk. So they’ll be looking for that plan to not provide any nasty surprises, because it catches the attention of the consumer when they lose money much more than when they make money.
Mowbray: It is too easy for our reluctant investor to focus on cost. Cost is such a simple thing to communicate: you can rank it in league tables - it’s easy for an adviser, it’s easy for a consumer. The investment industry needs to find better ways to communicate the value of their investment proposition in terms that are relevant to a DC member. Unless members can get some definitive information stating, for instance, that investment option ‘A’ is better than investment option ‘B’, it is natural they will go for the lower cost option. Be it performance indices based on retirement income outcomes, or something else, the investment industry needs to come up with a way to simplify the messages used to communicate value.
Dickson: If you can provide greater predictability of outcome then that resonates.
Mowbray: That’s certainly part of it. And finding a way to present that predictability, if that’s the metric you’re talking about, in some way that’s comparable between different schemes or investment options, is the sort of thing the industry should think about.
Brooks: The other difficulty you’ve got in this market is that everyone is going to become much shorter term in terms of investment performance comparisons, due to auto enrolment. These new reluctant investors will look at their pot after one or two years and will end up making the wrong decision to cease investment based upon a very short time horizon, if markets have not been good. This all comes back to the education piece that’s needed to support this new market.
Aston: We also need to measure the whole journey rather than just a single element of it. Lifestyle de-risking, for example – there are there’s good lifestyle and bad lifestyle arrangements. You need to look at the whole thing start to finish and not measure the individual components, which is what we’ve done so far.
Chair: One of the things that comes into it is the amount of money that’s being paid in. We can all agree we’re not saving enough. Pensions is perceived as dull and boring, and the question here is could we do something to make saving cool? Even if it’s not saving into a pension, it’s saving.
Aston: ‘No’ is my simple answer. In the US what they call ‘automaticity’ - making things automatic: has proven to be a good way to go. Whether that’s automatic escalation or periodically increasing the amount that goes into the plan, as happens in Australia. All of our research at SSgA seems to suggest that people have got a much higher tolerance for having their savings rates increased than we give them credit for. People want to save; let’s make that easy for them.
Mowbray: Providers in the US retirement savings market have also made considerable efforts over many years, seeking to build engagement and increase savings rates through education, with much more limited success. So whether it’s a legislative stick, or the application of behavioural economics to ‘save more tomorrow’, I think that anything the industry can do to remove barriers to increasing savings rates is going to be critical.
Dickson: I do think there’s hope, perhaps not necessarily to make pensions ‘cool’ per se, but we could make it more relevant, more tangible for individuals. We’ve seen this in the Australian market with infrastructure for example, where there’s a greater connectivity to individuals’ actual savings. They see where their money is being invested. We don’t have that landscape here in DC, certainly not yet.
Banks: I think that’s right, it’s a generational thing. We’ve got a whole generation of pension savers that are at best confused about what they have. Once everybody’s in the same thing and we have comparability, then there’s a much better chance of engagement.
Brooks: Is it possible to make it cool? Probably not. Does it need a name change? Most definitely. Pensions have such a slight against them now it almost feels like something fairly drastic needs to be done.
Hames: I’m not entirely sure I agree. Will pensions ever be cool? No. But does it need to be cool? Not necessarily. You don’t do it because it’s cool, you do it because you have to. When we did a survey earlier this year, we found if you stick ‘workplace’ on the front of ‘pensions’ then you get a very different reaction from people, to the extent that over half of people said saving in a workplace pension should be compulsory. The ‘workplace’, the employer, was the saving grace of the image about pensions. Pensions alone was probably what some man on the street tries to flog you. Workplace pensions was what your employer puts in place for you.
Aston: State Street’s research backs that up. People do trust their employer, and they see pension planning as a job to be shared between them and their workplace. Interestingly, when we asked people about why they were in the default, 51 per cent had actually chosen the default fund, rather than had made no choice at all. When we asked them why they chose the default fund one of the main reasons was that it was endorsed by their employer.
Chair: And as the employer is paying it’s a great thing. Do we think that the employer is paying enough? Do we think the employee is paying enough? Are we going to follow the Australian model and step it up in a few years’ time?
Chinnery: We have to, because it looks like the cost of living isn’t going down any time soon, and we’re going to live longer. Yes, people are working longer, but I do think that the auto escalation experiment as Tim [Banks] said should just continue. I’d be interested to see where the pain threshold is. One per cent of your salary may not reach it but when it gets higher maybe there will be higher opt out rates.
Dickson: The reason DC is referred to as the poor relation to DB is because it delivers a lower pension outcome, and the member takes all the risk. But the reason there’s a lower pension outcome is because there’s generally been much less put into it. I’d agree with the sentiment that it’s a joint responsibility of employers and employees. So, perhaps that responsibility should go both ways in terms of paying adequate contributions into DC schemes.
Brooks: Research shows that employees are looking for around £24,500 per annum in retirement, but at 8 per cent contribution rates it will never be there. Research shows that you’d have to look at a contribution rate probably far closer to 14 per cent on average to get anywhere near £24.5k per annum. I’m not sure, for this new population especially, how that’s going to land.
Aston: The PPI figures that came out showed a contribution rate of around 14 per cent on average would be required depending on the charges applied.
Hames: What was really telling about the PPI research and where I think the pressure will have to be put on government as well is this issue of the triple lock being maintained for the state pension. If you get rid of the triple lock then you have got to do something about DC. Eight per cent is probably OK for lower earners, not good enough for medium earners, but get rid of the triple lock and 8 per cent is woeful for medium earners.
Mowbray: The current minimum employer contribution is not going to produce an adequate lifestyle for many, other than lower earners who will hope to rely on the state. Increasing the compulsory employer contribution in a sustainable way would help. However, assuming any such increase is small, this will ultimately boil down to how much income employees are willing to defer to support a reasonable standard of living in retirement. How do you explain to someone that they either give up another 5 per cent of their salary today, or live on baked beans when they stop work? How do you motivate them to make a decision and take action? It’s not proving to be easy.
Brooks: Can we break down our statements into terms of ‘you’ve paid in £100 this month but the company’s contributed X per cent over and above that’? That suddenly brings it to life because you see that actually it has only cost £100, but your starting point is 70-80 per cent higher than that already. If you position it that way then suddenly you go ‘I’ve got it, that’s why I pay into this’.
Mowbray: Or an extra 1 per cent contribution will get you £X more in retirement income. Take the 5 per cent or whatever the employer might be putting in today, and quantify that in terms of the impact on your lifestyle in retirement.
Chinnery: It’s difficult, because it’s about the carrot and the stick and the balance between the two. You’re telling people that they are in a pretty difficult place but there’s something they can do about it. You don’t want people to give up and opt out, you want them to appreciate the benefit of what they’re getting, and to try and put in a bit more, so how do you balance that?
Chair: No matter what we do, whether we encourage people to pay 14 per cent or whatever it is, unless there’s some joined-up thinking on this it’s going to come to a shuddering halt. If the government doesn’t start looking at the annual allowance - what is it really there for, is it just going to be frozen or are we going to be moving up - we will soon get to a point where the annual allowance will take away people it’s not intended to. I want to move onto mastertrusts and just get people’s view. Are mastertrusts the great saviour that people think they are? Are they the thing that will drive people away from small schemes and into bigger schemes? And who’s going to look after these things?
Aston: Mastertrusts give you scale and the potential for good governance, and then it’s a question of how well these are delivered in reality. Scale drives lower costs and increased efficiency and that should be passed on to the members and the employer. However, mastertrusts aren’t the only way of getting scale. You can achieve economies through the good providers as well as the larger plans. When you get to governance, again, there’s owner trust arrangements and contract-based schemes where you’ve got great governance and others where you have less good oversight. The question on mastertrusts is whether the governance is really as truly independent as it purports to be. There’s a broad range of different mastertrusts from the not-for-profit to the commercial. I would welcome the DWP and pension regulator’s view on that, just to make sure that employers and members get what they pay for.
Hames: It’s an interesting one about scale, because we talk about mastertrusts and we talk about scale but what we’re actually seeing is a proliferation of mastertrusts coming to market because the entry threshold is low. By its very logic if mastertrusts are all about scale then a large number of those mastertrusts entering the market must fail or they won’t achieve scale because all we’ll have is as many mastertrusts as you used to have large owner trusts. You can’t argue against the logic of scale being there to create some mass market schemes with really good governance and really being able to drive value out of the investment managers and make greater demands on consultants. But it will be interesting to see how long it takes to get to that point and what the casualties would be along the way.
Banks: The mastertrusts that succeed are very likely in the medium term to be not for profits that already have scale, because they can quite clearly evidence the good governance threshold. The interesting dynamic, and we have a number of mastertrusts as clients, is that they don’t just see the pension as an accumulation vehicle. They actually have the ability to be able to think about managing the pension scheme end to end.
Brooks: What is interesting is the new requirement to set up independent governance committees. In actual fact in the contract-based world you will have two levels of governance, at the independent committee level and also governance at an FCA level that you don’t have in mastertrusts. So there’s an argument to say that governance would be better in the contract world than the mastertrust world.
Banks: It’s not a level playing field is it? For life assurers you’ve got micro regulation and cost of capital, what’s a mastertrust got? Are we going to set out some sort of licensing system from the regulator? I believe that looks like the direction of travel but that’s also incredibly difficult to do because we’re talking about a 15 year commercial model and we’re also talking about cross subsidies between members. When you open up one you have to open up the other, and cross subsidies of members is the one thing that politicians do not want to talk about because people with large pots are clearly subsidising people with small pots.
Chair: Moving on to charges, the proposed pension charges cap - is it workable? Is it reasonable? Is it sustainable?
Mowbray: In theory, yes, but it would fundamentally distort the market. In most cases, price controls distort and complicate what should be competitive market behaviour. There are exceptions, but I don’t think the DC market is one of them. I think a charge cap would have a negative impact on the quality and value for money of the choices available to employees and DC pension schemes. That said, if the industry has failed to adequately demonstrate or quantify the value of its services, then with that backdrop politicians will find it easy to focus on price, particularly where there is an element of compulsion. Some form of comply or explain option might be workable in the shorter term as the market develops.
Chinnery: Our major concern is that it will limit access to some high quality investment solutions and that will impact on where members end up. The OFT clearly went against a charging cap and there’s nowhere else in the world where there’s any evidence that price controls work. That’s a pretty bad place to start from, but it’s a political decision so we’re going to get a charge cap. The industry will live with it because that’s what we do. The other issue around this is the transaction cost debate. I think it is very technical, it’s very complicated. I think politicians get it in one way but also they kind of don’t want to get it, so they’ll just go ‘it’s complicated, so what, get over it, give us a single figure’. From an end member point of view they just need to know what the price is.
Banks: I’ve been really surprised at the industry’s reaction to this. Quality is completely inconsistent with mandatory price controls. If I look at the biggest innovation in DC investment over the last 10 years, it’s diversified growth funds, which at 75bp become extremely difficult if not impossible to use within a default. This has been an industry wide initiative with governance committees deciding this is a positive innovation for members in terms of outcomes, but we have politicians telling us that we’re wrong. I find that extraordinary. If you take a price cap at 75 basis points to its logical conclusion you create a market analogous to the energy market. There is no incentive to invest capital in pension provision, you will get no new providers, whether that’s full service providers or investment providers. Do we really want no innovation in DC pensions market when we’ve got a market of 25 million people who’ve been auto-enrolled?
Hames: If the charge cap applies to the default fund that still leaves a lot of innovation around outside the default fund and maybe there’s a piece that says that better communication and engagement will allow people to explore other avenues if they realise that the default is the cheap fund and they look elsewhere. I’d say if the investment industry can show lots of proof points that added cost has delivered better outcomes, shout it. Show that when people pay more they’ve got a better outcome. I agree the cap could stifle innovation but we need to show innovation has delivered something for the member. We need to better price in terms of what might fall out of the equation in a charge cap, not just the investment but all the other bits that sit around a pension, then maybe you’ve got an argument.
Banks: If we do end up with a charge cap we will have to disclose to members that this system is built to a cost constraint. This is not the best investment you can get, actually this is an investment built so that the overall pensions charge can be 75bps.
Aston: The CEO of Amazon, Jeff Bezos, believes that constraint actually drives innovation rather than impedes it. He’d say that the way that to get out of these constraints is to invent your way out. to date most diversified growth funds have been offered by the traditional active-only managers, but a new breed of diversified growth funds is emerging which blend the best of active and passive and achieve that at considerably less cost.
Brooks: I would add that any sort of charge cap probably removes our ability as an insurer to continue to pay for member advice. It just seems like leaving an awful lot more members out there high and dry in terms of ongoing investment advice, so that would be another concern of ours. The intent is good, it’s just I think that the ramifications when you actually feed it through are quite significant.
Dickson: We don’t think the cap is necessary. The market on the sell side is generally efficient as there are schemes that are being priced at sub 50 basis points. At Standard Life Investments we provide both overall investment solutions to clients as well as componentry of overall investment solutions. Our capabilities are deployed in both those contexts within the proposed price cap frame. But our concern is that it will stifle innovation. It seems at odds with the defined ambition consultation that’s looking at providing greater certainty, not just greater predictability but greater certainty. That comes at a cost. Just when the DC market in the UK is at a juncture where it’s going to really develop scale and become the mainstream workplace pension provision, we’re going to run the risk of stifling further innovation to deliver the even better solutions.
Chair: It’s a bizarre situation. Anyway, we’ve mentioned defined ambition so let’s move on to that. Nigel, you’ve been helping the Pensions Management Institute with this.
Aston: The timing of defined ambition is not ideal. Steve Webb has talked about leaving a legacy and that’s around three things – auto enrolment, the charge cap, and defined ambition. You could argue each of those has great merit in certain circumstances, but do we really need all three of them at the same time? That’s what makes this very difficult. However, I think what DA has given us is a new framework within which to talk about perhaps the biggest challenge of DC, which is how savers move from accumulation into decumulation.
Mowbray: We talked a lot about value and cost, and I think defined ambition at some point could provide a clearer framework in which we can talk about value. The point you made was absolutely right— worrying about an extra 25 basis points in charges if you’re generating an additional return of 1 per cent may be irrelevant, but people see that 25bps is a cost out of their account today. The benefit of the 1 per cent return is less easily quantified. Defined ambition gives us a framework to turn that into something more concrete for the member. If it does nothing else other than build a communication framework that makes more sense to the scheme member, then that wouldn’t be a bad result.
Hames: I can’t see it impacting on the DC market because I think those employers who have gone DC have done so because they don’t want to share the risk and little is going to persuade them otherwise. The latest paper is so focused on coming up with something new that it ignores what we’ve already got – cash balance barely got a passing mention in the latest paper.
Chinnery: If you look at what’s happening around DA, collective DC, the Dutch model, speaking to a number of my Dutch colleagues it’s clearly complicated, and it’s getting more complicated. I do think that isn’t a model that anybody should step lightly into. Yes, there is a successful Danish model, but that model has been running in a particular way for many years. There’s a big question mark around the social acceptability of shared intergenerational risk which us Brits may have a different view about. I do think it’s worth looking at in the longer term, anything that provides more certainty or visibility towards where you’re going, and I don’t mean necessarily the guarantee piece, is great from our point of view. Also we welcome the promise from the minister that a charge cap won’t apply for that, but one has to be a little bit cynical about that too because you never know what might happen.
Brooks: This can’t all happen at once. To come in with a pricing cap and then to come in with defined ambition all at the same time as the industry is trying to get through auto enrolment, the systems are going to fall over. The DWP should be focusing its energy on making auto enrolment work.
Chair: Let’s move on to default investment strategies. What is the best investment strategy to achieve the right outcome?
Aston: We shouldn’t constrain ourselves to say that one model is necessarily better than another, but there seem to be a number of attributes they should all have. Default funds should be sophisticated ‘under the bonnet’ but intuitive and strightforwarrd to the people who use them. They should be adaptable so they’re not ‘set and forget’ - they change over time according to how the external markets are moving, and how people’s behaviours are evolving, and how legislation is moving. Coming back to the word we’ve all been using this morning, they should be predictable. All of our research at SSgA seems to suggest that people in DC plans see themselves principally as savers rather than investors. The problem is when they’ve made positive savings decisions members haven’t always been rewarded for that because of the volatility and the risk that’s inherent within typical default funds. It’s not just investment risk, it’s conversion risk, it’s policy risk, it’s inflation risk, all those different risks. We should strive to make sure that the default fund is future-proofed in some way, and again governance should ensure that however you put thesevehicles together they’re fit for purpose on day one and they’re fit for purpose in 20, 30, 40 years’ time when people who are relying on them actually come to take the money.
Banks: I agree. Members do have expectations from their default investment strategy, but they will of course only tell you after it’s gone wrong! They would expect someone on the hook for management of the strategy. The investment default needs to be in a form that the member can easily understand. But that the right level of sophistication in investments is within that strategy without engaging the individual member. Members would expect proactive management of everything that’s going on, and that’s not just investment. Yes, investment environments change, yes investment ideas change, but also the demographics of your scheme will change and the way in which people will want to access the funds will change. Actually having somebody on the hook for that forward looking view and an investment default that can cope with that change is incredibly important, and in DC we are talking about an individual outcome. This means that the responsibility of the fiduciary, is heightened in defined contribution. It’s a much bigger responsibility and therefore whoever the fiduciary is will need help in order to make all of that happen on an ongoing basis.
Dickson: I don’t think we’ve quite found the very best investment solution for DC yet. What we can do is look at what has transpired to be the best investment solutions for DB pensions that look to match the liabilities. DC’s no different, really the individual member has a future income liability and so it’s a case of having an investment strategy that can deliver to that. What we haven’t seen yet manifest itself in the DC arena is that full broader suite of asset classes and investment ideas harnessing the illiquidity premia using smarter ways to hedge out the risks of purchasing income such as LDI. What is encouraging though is that more DC scheme are now embracing the benefits of diversification in the growth phase thorugh absolute return strategies and DGFs.
Chinnery: Ultimately it’s about the conversation with the client. The elephant in the room is who has that conversation and of course with advisers who are increasingly feeling that they are wanting to move into the asset allocation space that’s fine - it’s all about competition but it isn’t fine if you don’t have any transparency around that. I do think we as an industry need to be accountable to the people putting the money in, and that looks like agreeing some measure of performance but also actually being able to have a straight and honest conversation around what is asset allocation. We would argue it’s not recommending a series of funds and putting them on a static basis to be reviewed annually but actually dynamically managing a process with the focus of targeting a minimum income replacement.
Mowbray: Providers of default investment solutions need to do more to demonstrate how their investment and risk management process is hooked into providing retirement income outcomes. The notion that a default investment solution has been designed to meet client needs is a standard part of everyone’s product marketing literature. The concept sits at the heart of lifestyle and target date solutions. However, what is typically missing and what is an essential part of a good default investment solution, is an explanation of what this marketing actually means to the member.
Hames: Although we all sit here and accept it’s a long term investment we actually present DC to the investor as a series of short term investments. We still struggle to get across what that means for my outcome, for my resulting pension, which is really the key bit as a member that I’m interested in. We automatically send members something every year that tells them what the fund has done in the short term, or people can even can go in on the system every day and see how it’s doing. It’s absolutely undermining our message that this is for the long term and you need to let it grow.
Mowbray: Some platforms really are trying to present that information differently, both during the initial enrolment process and on-going engagement. Unfortunately, unhelpful and prescriptive disclosure regulation often means that the useful information that firms provide to support better ‘long-term’ member engagement is swamped by a multitude of complex and often misleading information, which serves little purpose other than to comply with regulation.
Chair: One of the biggest things is DB thinking put into DC. They are completely different animals. To have an outcome that’s more DB-like, from an individual pot, where you’re buying something for yourself is not the one size fits all that you get from a DB pot. So what are we trying to get to? To move away from thinking, it must be more DB-like, towards thinking of the right solution for DC.
This has been yet again an extremely interesting debate on a topic that is increasingly at the forefront of the pensions debate in the UK, and I look forward to extending our discussions at a future event.
