Time to start hitting the target

Christopher Andrews finds that default funds need to change – and fast – if defined contribution (DC) scheme members are to see their retirement expectations being met

For many years there has been a drive within the pensions industry to improve education and communication, getting members to take more of an active interest in their own retirement provision. To a degree this drive has seen some success, evidenced by the number of DC scheme members who simply tick their plan's default option and then forget about it; there are some 82 per cent in a default option – where the scheme allows – down from 91 per cent last year, according to the NAPF's annual survey.

Of course, despite the level of financial prowess among scheme members, for many, the default could actually be the best option available to them, providing it is properly structured and effectively mirrors the members' risk appetite. However, the question remains whether the majority of default funds are actually delivering the goods and living up to member expectations. The answer is probably not.

A standard lifestyle option, used by the majority of DC plans, generally consists of a portfolio of passively managed global equities, switching into bonds and cash five or 10 years before retirement. This can work given the right market conditions, and there is a degree of diversification involved by the very nature of global equities. But if the timing is wrong, you're in trouble.

For example, in current market conditions, if a member is, say, 55 and their fund has not yet switched into bonds and cash, then "arguably your entire plan has gone down the drain because you've just lost 30 per cent of everything you've built up," says Steve Rumbles, head of UK DC at BlackRock. Alternatively, given the automated nature of most lifestyle funds – which don't take account of market conditions – for a 60 year old whose fund has actually switched into bonds and cash, those vast equity losses will have been crystallised, with no chance of recovery, even if retirement is delayed.

However, for a 25 year old, current conditions are theoretically good news, as equity units can be bought cheaply now, and these should rise again in value. But, says Rumbles, 25 year olds generally don't see this rosy picture and react poorly to market losses whatever the time frame, failing to appreciate that pensions are a long term savings plan. "On that basis," he says, "the default option is not meeting members' expectations of why they selected it in the first place."

Meeting expectations
So how can these expectations actually be met? Ideally members want limited volatility as their fund grows and a pot of money at the end, representative of what they've put into it. This means that how default funds are managed, their asset mix, and how the lifestyling element functions, need a re-think.

In terms of that lifestyling element, according to Dr Alistair Byrne, senior lecturer in finance at the University of Edinburgh Business School, we need to develop a more dynamic approach, with mechanisms that actually take account of market conditions. "So something that would potentially switch off the lifestyling mechanism if market conditions warranted that," he says. "Most of what's out there at the moment is deterministic, pre- programmed switching."

Alternatively, says Gary Smith, senior consultant at Watson Wyatt, the move into protection assets should perhaps be made earlier, or "perhaps the transition from growth to transition shouldn't be a linear process, maybe it should be an accelerating transition." (BlackRock’s DC Banking programme goes some way towards accomplishing this already).

Both of these would help to avoid crystallising loss, and smooth the transition away from equities. But perhaps an all equities portfolio isn't appropriate in the first place. Rather, there is now a move towards diversified growth approaches for default funds, containing equities, as well as alternative assets which should perform differently if there is volatility in equity markets, being spread across several active fund managers.

The benefit of this, says Julian Webb, head of DC business development at Fidelity, is diversification and removal of single manager risk, while being able (for trust based DC anyway) to change the mix of assets and managers at will without the members having to select alternative funds. "The member selects the fund wrapper, and then the trustees decide on the components of that fund," he says.
Webb points out that diversified growth funds are also being used to provide risk graded options, depending on the risk appetite of the member. "And if you get this structure right," he says, "it negates the need for lots of funds, so it simplifies the structure of the fund line-up as well".

And Rumbles argues that diversified growth funds do live within a lifestyle matrix, not as an alternative to lifestyle but as an alternative to equities within the lifestyle plan. He also says that there are ways to use risk graded funds to better match member expectations. This may involve starting off in a safer fund allowing the member to settle in, and then moving into an aggressive fund before returning to that safer option in the run-up to fully switching into cash and bonds. "It fits in more with how members behave. We as an industry have to recognise who our end client is, and deliver products that work for those people."

Nick Leitch, head of investment management at Scottish Life, says there are a number of other elements which should become standard offerings within the default arrangement. These include that improved automatic lifestyling, but also a range of risk profiling solutions, a proper asset allocation mix and, very importantly, a governance overlay. "Charge is important as well," he says, pointing out that Scottish Life provides these offerings at no additional cost within their fund range. "And this is key. In today's environment employers have got to focus on saving as much money as possible."

Cost and governance
Not all firms are providing these services gratis; active management and governance overlay usually come at a cost, and "costs are probably too high, as a very broad generalisation," says Smith, believing that there needs to be much more focus on added value. And he thinks that employers need to consider if they have the governance budget to allow active management in the first place, as many schemes put active management in the default without any real governance overlay to monitor it.

"You may end up paying a reasonably higher fee for, quite frankly, a fairly mediocre active manager that's not adding any extra value," he says.

"It is difficult to work with active management in contract based schemes for the reason of governance," agrees Dr Byrne. "If a problem does arise with a manager it can be difficult to deal with in a contract based scheme. It is difficult for trustees, but at least the mechanisms are there."

It is worth noting that even in contract based schemes, pressure has been growing to increase the standard of governance, and management style committees to oversee and review pension arrangements are being strongly encouraged. "And we're going to see pressure coming from members asking questions regarding investment returns and default funds, but also from the Regulator, who has already made it clear in relation to DC that they're expecting (more) employer engagement," says Tony Barnard, technical consultant at Gissings. "At the moment it is all described as good practice; the question is how long it will remain just good practice before it becomes [mandatory] to have some form of management committee in place if you're running a DC scheme."

Engaging members
While Barnard sees this pressure coming from members eventually, at the moment that pressure isn't really being applied, despite considerable improvements in communication and education. This will probably change in April, and will more likely come as shouting and fist waving rather than calm dialogue. As a case in point, Rumbles says that on one of BlackRock's member record keeping platforms, they have 175,000 members, and despite the state of the economy, have only received a pitiful 10 phone calls about the markets.

However, come April, which is typically when members start to receive benefit statements, look out. "I would expect the calls in May and June to go through the roof, when people see a statement that says you've saved £10,000 this year, you should be very proud of yourself, but unfortunately you've lost it all and a bit more. That's when the hurricane will hit."

And after 2012, when auto enrolment is introduced, this hurricane could be all the more destructive in terms of litigation. "By [auto enrolment's] very nature, people are going to be enrolled in default funds, and that's why we can't just sit back and say we can't solve the default problem, we have to," says Webb.

"There's a window of opportunity in the next couple of years where trustees and employers really need to be getting to grips with their DC," says Smith. "The current crisis has tested and put the spotlight on provision, and now we need to take the initiative and come out of this in a much stronger way."

- Pensions Age April 2009