Francesca Fabrizi, Editor-in-Chief of Pensions Age magazine, is joined by Richard Watts, co-head of investment and Julian Lyne, global head of consultant relations, at F&C Investments to discuss DC and how the arrival of auto-enrolment is putting a focus on the structure of DC going forward
What are the main issues facing DC at the moment?
Lyne: One of the interesting aspects of DC for 2013 is that it has become the primary focus for individuals when they retire to actually generate enough income in retirement. Clearly DC has been around for 20-odd years, but I think as we move further into the 2020s and beyond, we are going to have individuals retiring solely on DC income and what that means is two-fold.
Firstly, we have the implications of auto-enrolment where we suddenly have, for the first time, mass DC membership for people who perhaps have never been in a pension of any type, but also perhaps have never saved, so we have got to think about the member communication and education challenges that presents.
From a scheme’s perspective, the payroll demands for everyone in their employment joining a pension scheme is also another challenge which we need to overcome.
Then if we look at when people are actually in their pension schemes, one of the key aspects is the investment decision – how do you take people who in the mainstream are not going to be engaged, are not going to perhaps be aware of the challenges and opportunities that face them from an investment decision. And how does the industry as a whole provide the support, education and the investment options required so that during their working life they save sufficiently in order to provide that level of income in retirement that I mentioned at the beginning.
So for DC in 2013 it is a very different proposition than it has been, certainly for the last twenty years or so.
As you mentioned, with the arrival of auto-enrolment, there will be so many more people entering DC schemes, a lot of those people with limited investment knowledge. That in itself will put a focus on the role of default funds, which have come under some criticism of late. How do we think default funds can be improved?
Lyne: If we look at DC investment as a standalone issue, one of the things that has affected appropriate DC investment has been the lack of innovation. That combined with question-marks around the governance of DC schemes really pushes the issue of default funds up the agenda. We were in a trustee meeting recently when the trustee said he had an “epiphany” – realising that for the last five or ten years they had spent a lot of money on engagement, communication, websites, posters and it didn’t actually affect the amount of take-up in default funds. Historically default fund take-up has been around the 80-90% mark and that has been thrown at trustees and governance bodies as being a problem, because you need to get your members to make their own decisions. And I think with auto-enrolment, and with the number of contributing factors, trustees are actually saying it’s not only about ensuring that members make their own decisions, it is also about ensuring that the default funds are fit for purpose, are governed and monitored so that when the 80-90% of members elect default funds (or non-elect and end up in a default fund), they are actually in an investment that makes sense for them.
If we look at the innovation which we have seen over the last twenty years with respect to default funds and lifestyle and target-dated funds, what we are actually seeing is slowly innovation coming to the fore. The reasons as to why there has been a delay with that include the dominance of DB schemes both in terms of the agendas that trustees have; I would also look at the pension providers and investment managers, in that the actual innovation that they look to deliver into DC has just not been a priority, so now if we look at the growth stage we are looking at things like target-dated funds, diversified growth funds, looking to deliver lower volatility through a broader range of asset classes; and if we look at the decumulation stage, we are starting to see some innovation in terms of making sure the investment options that we offer DC members are appropriate to the decisions they make as they near retirement, and are appropriate to the decisions they make at retirement, such as the purchase of an annuity, or perhaps income drawdown.
So slowly we are beginning to see a realisation that default funds are important, that the governance surrounding those default funds has to be appropriate and slowly we are seeing investment managers and consultants step up to the plate in terms of delivering DC investment options that actually make sense both from a cost perspective and an operational robustness standpoint.
You have mentioned target-dated funds – can they really improve the outcomes for members?
Watts: The short answer to your question is no. Julian talked about the lack of innovation within a DC context and there is nothing fundamentally innovative about a target-dated fund. All that a target-dated fund is doing is providing a packaging mechanism for investments that a DC member could reasonably access today, and they are paying a fiduciary to do that packaging.
The challenge with the target-dated funds innovation is that it can create an expectation from the individual member’s perspective that it is doing more than it actually is. In many contexts it is giving members access to precisely the same investment strategies and outcomes that are available in the market today, but they may believe it is doing more than that to achieve a more DB style outcome, in a DC context, which clearly it can’t.
So the challenge with target-dated funds is to ensure that there is appropriate and robust governance in place such that the investment mechanism that is being employed within each fund is actually going to deliver what the member expects. But fundamentally there is no magic there – they won’t improve the overall outcome.
So other than the issues around default funds, what other governance issues are trustees facing at the moment?
Watts: One of the main issues we are exploring with a number of trustees is where to put your money during the period when you are starting to think about annuitising, so you are starting to think about the annuity purchase, so instead of investing in just a pure risk asset, whether it is a more modern solution like a diversified growth fund or whether it is a traditional pool of equities, as you approach retirement, typically a member will lifestyle out of that risk asset into something which is less risky, just to avoid the potential outcome that markets cash at the point you want to retire and you have got a smaller retirement savings pot.
The challenge with that is you want to buy something that roughly matches the price movements of an annuity. You also, in a DC context, want to buy something that is cheap and can be dealt on a daily basis – I am not saying by the way that cheap is necessarily a bad thing. Low management fees for example are one of the things that you should look for in an asset management solution. What that has meant is that a lot of schemes are buying long-dated government bond funds, typically funds that are passively replicating gilt indices. Well if you look at the correlation between a long-dated gilt index and annuity prices, you will find that correlation is quite poor – unsurprisingly because the composition of a long-dated gilt index is determined entirely by where the debt management office wants to issue its debt, and they pay no heed to the prices of annuities when they think about that composition.
So we have been working with trustees to design better solutions which provide a more accurate match to the annuities that their members are going to buy in the future.
We have talked a lot about trustee-based DC, what about those DC funds, such as contract based, that don’t have trustees involved – how can they be improved?
Lyne: Certainly The Pensions Regulator has taken a look at how the governance of contract based schemes can be developed and what they should focus on. I think there are two elements here. There is the regulatory standpoint that comes to the fore; and there is also an aspect here of competitive advantage. The conversations that Richard and I have been having with trust-based schemes have been replicated by the conversations we are having with contract-based providers and we live in a competitive world as pension providers, as well as fund management, so there is always that drive to ensure that the actual pension proposition that schemes and consultants are offering the membership is appropriate and fit for purpose. So I am probably less concerned by that than some of the press has suggested.
I think if you look at something like Nest for example, as an informal benchmark of what a scheme should be (and here I am not talking about the contribution rates and certainly the fund choices as Nest is targeting a very specific audience) – but I think what you will begin to see with Nest is innovation, appropriateness, governance and all of those things will start becoming more mainstream in terms of contract-based arrangements because people will look at their arrangement and compare it to Nest – what are the charges, what are the fund offerings, and certainly we are seeing where Nest is starting to innovate, other schemes are looking at whether it is applicable for them.
So I think what you will find is a combination of commercial factors coming to the fore in terms of the providers, and also the focus and noise on governance, really pushing that agenda through. If you look at DC schemes, they are part of a pension provision, that is part of an employee benefit and it is imperative that companies – the sponsoring companies – keep a sharp eye on what’s being offered, but I think the combination of those factors will drive through the necessary change, the necessary focus, be it innovation, be it on charges.
Just picking up on that innovation point, there has been a lot of discussion in the market on risk-sharing in DC schemes and Steve Webb’s idea of defined ambition, whatever that actually means - what are your thoughts on that? Why hasn’t there been more innovation in DC in the past?
If we think back to why there hasn’t been the innovation, I think that comes back to the point we started with which is that the focus for fund managers, consultants and trustees has been so dominated by DB that that has created a little bit of a time lag in terms of innovation that comes to the fore. If you look at what Steve Webb is saying, clearly from an aspirational point defined ambition, risk-sharing is all very positive, but if I look at how that can actually be delivered in the real world, clearly there are two aspects. On the one hand there is the scheme design aspect, in terms of hybrid schemes for example and whilst there are schemes that have a more risk sharing approach between the employer and the DC member we are not seeing a lot of take-up for that sort of approach. A couple of reasons for this being the complexity but also anecdotally we are not seeing a huge appetite from employers to take on that risk sharing. I spoke at a conference recently that looked at DB versus DC and the way I started was by asking the 120 firms in the room that had just set up pension schemes if any of them would actually set up something that was not DC-only, and there wasn’t a single show of hands. So I think we need to be realistic in terms of the appetite that employers have for sharing risk. Clearly there are exceptions and there have been some reasonably high profile examples towards the back end of last year.
I think if you then look to the investment proposition that you can deliver for risk sharing and defined ambition, we need to be very careful because talking about having guaranteed funds or CPPI, or guarantees makes it sound like a really simple solution but if you look at the investment / economic environment we are in, any sort of guarantee or consistency of return with no downside will cost, either in terms of the cost of protection if you are doing a CPPI type approach or in terms of the opportunity costs of investment. i.e. I can give you certainty of return if I am delivering no return at all, or plus one or plus a half.
So I think the opportunity costs of these sorts of guarantees need to be looked at. We have looked at it from an investment standpoint and it is a very challenging environment to deliver at reasonable cost.
One other thing I would like to say here is that I am conscious of the unintended consequences of delivering guarantees, or certainty for members. There is a whole raft of debate about the contribution rates that Nest has, a whole raft of debate around what is a legitimate contribution rate for a DC member, and I think if we give certainty in investment proposals, there is a risk that members assume that they are paying enough, and I think one commentator has said Steve Webb is looking at the wrong question here – it is not about the investment proposition and certainty, it is about increasing the contributions. That is something we have got to be very mindful of.
Watts: To add to that, DC is a challenging environment in which to innovate, the actual amount of appetite to spend money on investment strategies is very low indeed - quite reasonably so, because fundamentally a DC savings solution is quite an expensive thing to put in place. You are setting up small accounts for lots of individuals that you want to deal daily that have to be fully, legally segregated and that is an infrastructure which carries with it a reasonable cost, and you see that when you just look at the baseline costs of any DC platform. What that tends to mean therefore is that the fees that trustees or scheme members are prepared to pay for a DC style solution are very low. That means then that you are getting simple strategies. The other challenge is that a lot of the innovation requests that have come to us have been trying to ape the DB outcomes and the problem with the DB outcome is that you have a single guarantor sat behind it which in theory has bottomless pockets so it doesn’t matter whether you have written the wrong guarantee – you are still probably going to get the right outcome.
In a DC context someone has actually got to physically pay for the insurance that is effectively embedded within that guarantee and while that can be done relatively cheaply it is still a reasonably meaningful percentage haircut on the return of the asset pot that you expect to see.
So overall then what do you think the main challenges will be in the near future for DC that trustees and DC providers should be thinking about?
Watts: Julian has already hit on one of the biggest which is under-funding. We collectively are not saving enough for our retirements and that is going to be one of the biggest challenges and it is challenge that is certainly going to have repercussions for the whole pensions savings industry, not only have you got under-funding but that is then going to drive changing regulation, and it is going to drive tax uncertainty and those two things taken together are very bad. If the tax treatment that we expect to receive on our pensions savings changes then that is going to dis-incentivise people from saving. If the regulation provides uncertainty about what we can receive and when we can receive it, again that drives uncertainty at pensions saving which will then drive people to disengage or look for alternative channels for saving towards their retirement.
Lyne: If we look at what DC schemes are looking to do, they are looking to deliver a suitable level of income in retirement for individual members and going back to my earlier point we are increasingly going to come to a stage where members are retiring with only DC incomes. So from a high level standpoint we need to give people confidence that the DC scheme they are in, be it trust based or contact based, will provide them with sufficient means to generate that income and a compelling reason to save. As a society we need to understand the implications of that from a fiscal standpoint.
So basically I think the challenges are clear. We need to have a compelling DC proposition and the way that we achieve that is by genuine added-value innovation in the DC space and that means value for money, appropriate and operationally robust and if you bring all those things together and then wrap them in the governance and education and communication standpoint we are gong to be in a better place.
But, if people don’t put enough into the system they won’t get enough out and it is up to the system, be that consultants, trustees, fund providers, to ensure that the system works effectively to provide that appropriate level of income in retirement.
