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(De)Faulty Towers

Written by Pádraig Floyd
June 2014

The Chancellor of the Exchequer, George Osborne, introduced a number of radical changes to the pensions arena in his last budget.

Despite coverage to the contrary, abolition of compulsory annuitisation wasn’t one of them – he actually did away with that in 2011 – but introduced reforms that will force every defined contribution (DC) scheme to review their default funds.

By giving every member of a DC pension the right to take their whole pension fund in cash – subject to their marginal rate of tax – he has thrown the cat among the pigeons for the vast majority of DC plans.

Almost every plan has adopted some form of lifestyling or glidepath – the mechanism to de-risk an individual’s fund from a predetermined time from ‘normal‘ retirement. Though there is no such thing as normal retirement any more, this may be the fund’s traditional retirement age or the state retirement age.

De-risking involves moving growth assets, largely equity and perhaps property in a DC fund, into bonds and cash. This is not only considered safer by limiting volatility in the years immediately before retirement, but is a proxy for the purchase of an annuity, the assumed default for most retirees.

In a world in which scheme members have greater access or the ability to drawdown their funds, lifestyle is no longer appropriate. If the member wishes to stay invested to generate income from the fund, lifestyle means they will be gliding out of growth at exactly the time you want to be in it when the fund is at its largest, says Axa Investment Managers head of institutional clients group Tim Gardener.

“In terms of structured default funds, the pre-retirement default fund should focus on growth and not the risk the member will retire between the ages of 60 and 70.”

Need for change?

Like it or not, and many won’t having spent the last few years preparing for auto-enrolment, regulatory change means a mandatory review, but the difference between heading for drawdown as opposed to purchasing an annuity are very different states, says Spence Johnson senior consultant Rob Holford.

“Current designs still de-risk into cash and you lose exposure to inflation and equities. Drawdown, if invested, you need to keep it in one fund which is not good either.

“The quick and dirty redesign is to hold more equities. Whether that helps either party it remains to be seen.”

State Street Global Advisors senior DC strategist, Alistair Byrne, favours caution as it remains to be seen how many members will use the flexibility at their disposal. He believes the number of annuity purchases will decline sharply.

However, he doesn’t believe the changes make much difference to the structure required for most investors in the early years of membership.

“Inflation plus 4 per cent or 5 per cent returns is consistent with equity levels of return, then as retirement approaches, the appetite for volatility decreases and inflation plus 2 per cent or 3 per cent using diversified funds might be considered,” he suggests.

Managing volatility

Diversified funds, or diversified growth funds (DGFs) as they are more commonly known, are broadly designed to deliver equity-like returns with reduced volatility – perhaps two-thirds of equity.

They have become the default fund for default funds, as trustees and employers like the controlled exposure to growth they offer at a lower price than active management.

The latest DGF survey from Spence Johnson shows DGFs grew by £22 billion in 2013 to reach £97 billion and this is expected to reach £211 billion in 2018.

Axa’s Gardener agrees volatility is important. Too much and the member or provider will panic and make the wrong decisions because they are more cautious. But this must not start too early.

“You don’t get any more certainty with DGFs, but they are ideally suited for the older investor, offering broader diversification for those who want to glide into less volatile assets.”

Byrne agrees arguing there are, as yet, limited alternatives where schemes must keep a watchful eye on liquidity.

“DGFs have reduced volatility, but members may be giving up some performance that would be achieved if the member had been invested in equities.

“However, for a modest reduction in return, a more than proportionate reduction in volatility is an attractive trade-off,” he adds.

Tell it how it is...

The decision about the default fund is only half the problem. The rest is likely to be communication and how to do it effectively. Auto-enrolment allowed a good deal of discretion – people had to be in unless they chose to opt out and once in, if they didn’t make choices, the trustees or sponsor would determine the investment journey working on the assumption of an annuity purchase.

Though that assumption was reasonable, where members can access their fund such an asset allocation is likely to lead to complaints and demands for recompense.

This means schemes must have a better idea of what members want – or at least warn members, earlier, of their options.

To achieve this, schemes should not communicate fund sizes, but attempt to predict replacement ratios, says Schroders head of DC Stephen Bowles.

“There is lot of value in reminding members of the idea of generating income in retirement and this still makes a lot of sense from a moral and common sense points of view,” he asserts.

Looking at performance is tricky because it is how it is measured over time that makes all the difference, he adds.

“There is a mismatch between measuring performance in a solution and targeting the outcomes of members.”

True multi-asset approaches

DGFs won’t be enough on their own, and for independent strategic adviser David Calfo the budget changes require schemes to start looking at some of the difficult issues that have been considered insoluble in the past. That has to include a review of the position on liquidity and illiquid assets.

Calfo sees the concerns about daily liquidity less as a regulatory and operational mountain as a “cultural/historic fascination”. The relaxation of annuity rules will force the industry to create products with a longer life that generate income and provide growth, says Calfo.

“Large DB schemes have exposure to real estate and own property and this must have a role to play.

“Infrastructure is less clear-cut, as it depends on how long you can wait for the returns, but they should feature in the discussion.”

All change?

Of course, nothing need change now. Without regulations in place, schemes cannot make changes. As long as your scheme is performing within the existing parameters set by the regulator, there won’t be a problem, says National Association of Pension Funds head of investment affairs Paul Lee.

“However,” he adds, “in the short to medium term [the budget] calls into question whether there can be such a thing as a default fund.

“You need access to an ongoing fund until the point you need to withdraw. This would suggest much lower levels of tapering and de-risking.”

That may lead schemes to build a default that hedged against the member drawing down or buying an annuity, a situation unlikely to satisfy either investor, or the regulator in the long term.

KPMG pensions & advisory head of DC investment Stephen Budge reiterates the need for communication.

“Funding should be focused on where [the member] will leave the scheme.

“The full default will be for those who do not know what to do or answer a questionnaire. The others can make their choice focusing on the annuity or drawdown option if they so choose.”

Though funds may be advised to wait and see what the regulations say, there can be few DC defaults in place that offer the flexibility for members to choose either drawdown or an annuity at retirement.

Running a rule over their existing arrangement would be sensible preparation for a major review and in so doing, challenging the opinions of their advisers.

Pádraig Floyd is a freelance journalist

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