DC: Improving the outcome

Our expert panel discusses some of the latest developments in the DC space, such as the need for better governance, improving default strategies and defined ambition

Chair: Chris Parrott
- Pensions Manager, Heathrow Airport Holdings
Nigel Aston - Managing Director, Head of UK DC, State Street Global Advisors (SSgA)
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
Jonathan Lipkin - Directory, Public Policy, Investment Management Association
Philip Mowbray - Senior Director, Moody’s Analytics

Chair: Perhaps we should start with the increasing importance of DC, as it is something that no longer takes five minutes at the end of a lengthy DB trustee meeting. How can we better improve DC governance to ensure members get the best investment outcome?

Mowbray: We appear fixated with asset returns, volatility - the natural language of the asset manager; we need to create more transparency for employers and members in terms of scheme objectives and more explicit target outcomes. We should use metrics for governance and risk budgeting that relate to member outcomes. Coming back to the transparency point: unless scheme objectives and outcomes are communicated at the outset of the engagement process, it’s difficult to force that governance model to work.

Hames: I think that’s definitely part of it. I suppose what we could do with is a healthy dose of honesty and plain speaking in the conversations that go both up and down. I think we have to not get fixated with the investment debate.
The conversation would need to be with both the sponsors about what’s a realistic contribution level, and with members about their responsibility in all of this and what they need to accept and take on. And if they don’t, well, then they should anticipate poorer outcomes as a result. Yes, investment is important but contributions is a huge issue for DC and one which was chosen to be ignored in the regulator’s latest code of conduct, or parked shall we say.

Aston: In a way I feel quite sorry for sponsors because they’re faced with some quite complex choices between the different constructs through which we can deliver DC. A lot of our time seems to be taken up choosing between contract-based, trust-based and master trust when really it’s what those different vehicles are delivering in terms of outcomes that counts. So it’s quite helpful in terms of governance if the regulator seems to see less distinction between those various vehicles. TPR seems to be saying, regardless of how you deliver outcomes to members, you need to tick certain boxes and one of them is investment, one of them is contributions and one of them is improved oversight and governance.

Banks: I think it’s clear that we need a better governance framework. When you have collective buying decisions being made on behalf of the many and those many being disengaged, then I’m afraid we are in an industry where we do need a clear regulatory framework. Let’s have clear roles and responsibilities, let’s debate as professionals about who is best placed to do what, and then all come together to deliver a more coherent product. Within that we need to not get too prescriptive but we do need to set down what we think ‘good’ looks like and that’s the debate we’re having at the moment.

Dickson: The one thing I feel is missed out is alignment of interest, so the fiduciary if its trust-based or if it’s a governance committee at a corporate level, and addressing all the issues not just with investment but adequacy in DC and getting the contribution risks there. It doesn’t to me appear to be enough representation on those fiduciary boards or governance committees. If you have active DC members who are part of that decision making process, I think that would be a force for good that would start driving the design and the future of DC in the UK.

Lipkin: When you look at it from a member perspective, many members won’t even necessarily realise they’re in a trust-based as opposed to a contract-based scheme. To the extent that they understand what a DC pension is about, what they will see is something very similar regardless of the delivery architecture. It goes back to Philip‘s (Mowbrey) point that you need greater transparency and clarity around objectives first and foremost, but also clarity around responsibilities and then from there clear implementation and review.

Chinnery: Anything we can do to help the debate move from wooliness of investment outcome to some sort of specifics really would help everyone, because at the moment the word ‘outcome’ is banded around and I know we’ve ranted on about this before but it’s really unhelpful. I absolutely agree that all the investment stuff has got to be proven that it’s working but I think that has to link to what that means in terms of outcome.

Banks: In the absence of a market consensus of what good looks like in DC there has been a focus on cost. Governance has often been very deliberately arbitraged out of the model in terms of chasing lower cost. I think we have to recognise in doing all of this that we need a very open debate and to be very clear to members why we’re designing what is provided, as it is to a cost constraint. We’ve all independently just talked about all of the various different issues which you can solve, but you’ve got to solve them within what is in global terms a very low price band. That is an issue that needs to be communicated to individuals.

Aston: To date though, hasn’t most of the governance that’s been applied to plans been outside of the debate about cost? I.e. it’s either provided ‘free’ by trustees and governance teams or it’s paid for explicitly to a consultant rather than being part of the cost of the plan itself.
I agree that there shouldn’t really be a difference between contract and trust-based, but the reason that people have gone to contract-based schemes is that people wanted lower cost and they have very deliberately wanted to take the risk out of the model and I think we have to acknowledge that.

Banks: If you talk to employers you know that it’s a light touch solution for them whichever way you want to frame that. That has been a very deliberate movement in the market and impacts the way that benefits will be provided. Clearly, if we already had good governance in the DC model, we wouldn’t need a new regulatory framework.

Hames: I think it’s been part of a broader benefits governance model when it is tended to be done contract-based. That’s maybe a little piece of the debate that is being missed as well, that pensions don’t sit on their own anymore. When we move from DB to DC there’s all sorts of other elements within the benefits package that the employer is interested in ensuring are attractive and meaningful to them.

Chair: We’ve talked about the employer but what about the member? What is the member’s role in the process? Where does the balance lie?

Banks: Well, members are not engaged in this debate and that’s clearly not a good thing. Research shows members are in the ‘do it for me’ camp and that may be largely because historically in DB schemes everything was done for them. Collective buying decisions are made on behalf of individuals by typically a few people. That’s why it’s so important that those few people are aligned in their decision making with the interests of the members.

Dickson: I think we may see a change as DC matures in the UK because if we look at the Australian market there isn’t much more engagement and they’ve got a different approach. There’s a much higher proportion of infrastructure for example and people get that, it’s tangible, they know that they’re actually investing in that. There was a survey this year looking at people’s values in terms of how important ESG and SRI approaches are to individuals and when you tap into that aspect of people’s psyche they do get genuinely engaged. Nest has done some fantastic work in terms of the research it did for its target future membership and that ESG and SRI one is a very high priority for the members. We’re not there yet at all but I really firmly believe that, once people start seeing their money going into something and if it’s communicated about where their money is being invested, that’s a natural conduit to engineer genuine engagement.

Aston: I think that true member engagement around the investment aspects of DC might take a little while to come, but I share your optimism to a degree. However, we work within an industry that has tried to educate people to be their own investment adviser for the last two decades and that hasn’t worked; I just think it’s unrealistic to expect people to make those complex investment choices. That’s not saying that workplace savers will have no interest in certain aspects of their plan, but it’s our job as experts to make sure there is good investment capability at the heart of the proposition.

Lipkin: The other aspect of what has to happen with both actual and future scheme members is that we need to do more to ensure that people trust the industry collectively to deliver on their behalf.

Banks: I think that’s right, but how are we going to avoid all the headlines in a few years’ time that talk about adequacy? I totally agree we have to re-establish trust but you can see, at these low contribution rates, exactly where we’re going to get to after two, three, four years’ experience of a new pensions model.

Lipkin: You have to start having a very explicit conversation about how you get those adequate outcomes. How is it that you achieve a two thirds replacement rate in DB? You don’t do it on a 10 per cent joint employer and employee contribution. I know it looks self-serving for the pensions industry to say: ‘You should be making contributions of 20 per cent by the time you are in your 40s’. But frankly if you don’t have that conversation, people will go around saying DC is inferior. I agree with Tim (Banks) and I think there’s an educational piece to say: ‘Investment cannot do all of that heavy lift, you are going to need the right level of contributions’.

Chinnery: The only thing I would add to that is that maybe people aren’t going to change any time soon and we have to get on and design the investment structure that will do the best with what we have now. We use research on participant behaviour to understand what people are actually doing rather than what we think they should be doing. We then build that into the design of the glidepath to give it a basis of reality and to help us manage members, with whatever they are contributing, towards a minimum targeted income-replacement rate.

Hames: We did some research earlier this year among 3,000 employees across the UK and there’s definitely a trust issue about us as an industry but I think there is a trust issue across most professional services industries whether banks, lawyers, estate agents, anyone. But where the trust does lie from the feedback that we had is with the employer. You put the word ‘workplace’ in front of ‘pension’ and suddenly the imagery that you get back from people is much more positive than ‘pension’ on its own. ‘Pension’ on its own is bad, sold to me by some fellow on the street or whatever, whereas a workplace pension is my employer doing something for me.

Mowbray: The question is about how we can empower employees to take some sort of fiduciary responsibility for their future standard of living. There seem to be two challenges here. One is transparency: you’ve got to be open with the employee that an 8 per cent contribution for 20 years is not going to produce a decent pension. Without information of that kind, how can you expect an individual to be able to make sensible decisions, or to take responsibility for them? Second, if you expect employees to engage and take responsibility, they need access to appropriate investment and risk management solutions. At the moment I’m not convinced these are available to the DC member and I think this is part of the reason people fail to engage.

Chair: Let’s move briefly to discuss perhaps the issue for small schemes; is master trust the answer for everything? Is consolidation into a Nest-like provider the right thing? What do we do about these legacy schemes, particularly those with horrendous charges?

There’s a bit of a danger that the messaging from the regulator and DWP that scale equals a good thing could distort the market. For instance, The Pensions Regulator has talked about schemes with less than a 1,000 members, that they should effectively go into a master trust. But we know that there are smaller schemes that are really well run and there are big schemes that are not so well run.

Banks: There is a regulatory agenda there to get scale, to create industry wide schemes, super trusts, whatever we might want to call them. Let’s acknowledge there are many ways of getting scale. On average you can understand why people might believe that trustees in a very small scheme might not have the resources to govern their DC scheme as well, but as we said, on average there are some great schemes who are small, who are really engaged, who run their schemes well. I’m sure equally there are bad examples too.

Aston: At the moment it’s really hard to tell which are the good schemes and which are the bad schemes, regardless of their size. That’s partly because of the reporting requirements, or lack of them. Maybe the answer to get to increased transparency isn’t necessarily regulation about size or rules about what a scheme should look like, but regulation about reporting itself – get it out in the open and let people compare.

Dickson: I think if you legislate or regulate for a direction that small is not permitted, then you’re just removing choice from a free market. So intuitively that doesn’t feel the right thing to do. But some legacy schemes that have horrendous charges that, in the context of legislation existing, is going to put people into those types of schemes, I think that is something that should get addressed.

Hames: I agree to a certain extent but I do think there is an argument that says for a large part of the market scale is important, scale will give you greater buying power, it will give you the opportunity to access expertise. I think whilst this flits around free market choice, it is difficult to argue that it wouldn’t be very useful for a very large proportion of the UK to utilise scale and be in a small number of large schemes at low cost.

Chair: On the default debate, are DC defaults actually failing? There are some well designed DC default funds out there and I think there are some people who positively opt into a default. I would welcome your views on this.

Aston: There are some people who proactively opt for the default. We did a significant piece of research a few months ago where we asked exactly that question as one of many, i.e. ‘did you choose the default or did you truly default?’ and 50 per cent in our survey of people who were in the default chose it and there are some good reasons why they did so.
Member’s perception of volatility is not matched by the reality of where they are invested. To test this we asked our survey respondents to rank seven ways of saving for retirement in order of risk. Unsurprisingly, saving in a building society came out top. Pensions actually did well, coming third. However, investing in the stock market came second to bottom, just ahead of betting on the horses and slightly behind lending money to friends and family.
There is clearly a disconnect here – members don’t seem to trust the stock market, but don’t realise that much of their retirement savings are actually invested in it. The answer doesn’t lie in teaching members to make their own decisions, as we have in the past. The answer is to put in place robust and future-proofed default products and, over time, try to engage savers to at least understand how they are likely to behave, even if we should not try to teach them the difference between bonds and equities, as we have in the past.

Lipkin: One of the big risks for default strategies is that members think that they’ve been very carefully tailored specifically to them, when in reality a wide variety of techniques could have been used to develop the default strategy. This is a particular danger if you move a small number of large schemes with tens of millions of people saving in them. So there’s a communications challenge about what the default really is.

Dickson: Perhaps there’s not as a diverse range of assets employed to construct that investment strategy than there could be. If you started with a blank sheet of paper to design an investment solution for the DC, then why would you not harness a liquidity premium that DB strategies use? But we can’t do that because we require daily pricing so that is an anomaly that should be challenged and just deliver the most optimum outcome for members through the investment strategy.

Banks: Lifestyle traditionally has only ever been changed with the benefit of hindsight and that’s clearly not what a member would expect you to be doing for them in a default investment strategy.

Chinnery: There is a worrying trend towards greater and greater customisation based on ‘slicing and dicing’ the member data by consultants leading to the oxymoron ‘create multiple defaults’ for different segments of a workforce. The mantra is that one size can’t fit all but in creating complexity are we getting any closer to helping them get to a point where they can retire?

Aston: Yes, we can do that by giving people realistic expectations, not letting them down on those expectations and delivering against their objectives.
It’s critically important to communicate these things effectively so people understand what they might be getting, but one of the key design faults of DC is unhelpful dislocation between saving and payout.

Banks: The industry in terms of product innovation has failed individuals and particularly at current low interest rates. The NAPF did a very good report last year outlining that people were effectively defaulting into a single life non-escalating annuity. There’s no doubt that annuitising at age 65 has a large opportunity cost to it and you’re buying insurance that you potentially don’t need or want. So one of the things we’re doing is launching a bridging product to get you from accumulation to a point at which you do need to tackle longevity risk. So we believe that the market is going to innovate here. If you can do that at low cost, and on a collective basis, then link it to the accumulation piece so that you can go through retirement not just to this cliff edge, then you end up with a much more flexible framework for letting people make intelligent decisions or defaulting into intelligent decisions.

Chair: There is a third issue affecting the outcome. Investment return and conversion rates are crucial, but then so are charges. What are your thoughts on the OFT review of charges, and on the two-tier charging structure that’s in place with a number of schemes?

Aston: I think active member discounts have become indefensible. You can understand why in the past active member discounts were put in place. It’s quite seductive to everyone involved, other than the consumer, and you’ve got to start with things from a standpoint of what’s good for the consumer. I think that whole two-tier thing is just a no-go now.

Banks: I couldn’t agree more. The simple fact of the matter is that deferred members consume a lot less of the services than active members, you can’t justify it on economic grounds, and it doesn’t pass the reasonableness test. But let’s not forget that the reason that these two-tier charging structures exist is because brokers and clients asked for them, so let’s put the problem properly in its context.

Dickson: There are definitely some employers who like that dynamic of it looking more competitive for retaining staff and if the second charge or the deferred charge is within a respectable level, i.e. better than you would get as a retail individual customer, then you can understand why some clients would choose it. But my understanding is there’s not very many of these around, so it’s a bit of an anomaly that’s grabbed quite a lot of headlines.

Hames: It’s easy to broad brush this topic and conclude that all active member discounts are ‘bad’. If implemented prudently they did fulfill a function. As long as the starting point was to actually discount - in other words you start at a decent and fair level for the leaver and then work down to a very attractive price for the member. Not all were done this way and it is right to challenge those where leavers are suffering high charges. A price cap could help with this as a maximum charge would soon root out any previous poor practice.

Aston: But it’s about the big picture, isn’t it? All these little things impact the trust that people have in the industry in the same way that people hate dual pricing on their mortgage rates or the interest they get from building society savings for new and existing customers.

Chair: I think there is a place for active member discounts. As a corporate, why should we do something special for the people who no longer input into our business? That said, as long as this is not going to the extreme of inflating the deferred member rate from the ‘standard’ charge, but rather discounting down for active members, I don’t see there being an issue. I agree with you completely that there aren’t that many of these charging bases around and this is just another piece of scare mongering. This is all about choice and I think in the same way you can walk down a high street and you do your shopping at Aldi or at Waitrose, you want your choice because each offers a different service at a different value.

Chinnery: It’s about being able to demonstrate value, isn’t it? As an industry we haven’t been very coherent about explaining what our value proposition is. On the high street people are looking for value but that means different things to different people. Value might be better quality, greater durability or three for the price of one! It may also be a funny thing like brand - what you want to say about yourself by buying a particular brand. We just have something that says: ‘give me your money for years and when you retire you’ll get something back’, but we can’t say what and no, you can’t spend any of it before. Just trust us! We can’t even say ‘look, we can prove that by buying this, it will get you to a better place’.

Banks: It comes back to governance - you’ve got to have somebody on the member’s side making that value judgment. That’s why governance is essential in DC and let’s be really clear about it: if governance was working really well, we wouldn’t have officials talking about a price cap.

Aston: There is that point about transparency and making it easily explainable to people that’s absolutely true. But just to come back to the point of fees, we seem to be agreeing that we should avoid the argument that is low fees equals better but similarly we should avoid the argument which states that high fees equals good. Paying more certainly doesn’t guarantee a better result.

Lipkin: If we deconstructed the value chain, we could look first at what people are currently spending on different components (investment, administration, communication, governance and so forth) and second the things that money should be spent on. You then have the discussion in a way that allows decision makers to do what they think is best for members and not be unduly constrained. Of course investment is incredibly important, but there are also things that have a significant impact. For example, good communication can help members understand the value of contributions or not opting out.

Chair: I really want to talk about defined ambition. Is this something sustainable?

Dickson: It depends on your interpretation, but my sense on this is that there’s isn’t that much demand from employers to support an interpretation of defined ambition that results in any form of guarantee coming from the sponsor. In terms of variable interest for longer economic backdrops, full recovery etc the cost of guarantees is disproportionate to the benefit that they add, so I don’t see providers coming up with solutions that are going to deliver demonstrable value in the current backdrop anytime soon. It may form a small part of the overall landscape, so you’ve got stake benefits, DC and perhaps we’ll see a slice of future aggregated retirement benefits coming from whatever defined ambition manifests.

Hames: I think there is an absolute place for talking about defined ambition. It might be a little late, it would have been better 10 years ago, but if there’s anything that starts to encourage more employers into some form of risk sharing arrangement rather than immediately going from DB to DC then that’s got to be a good thing. I agree, I think those who don’t have a scheme or who have been DC for quite a while, will they want to increase the risk, highly unlikely. But there is still an awful lot of members in DB management where something like this, if we find different ways even if it’s only just making CARE schemes and cash balance schemes easier to put in place and regulate, that’s got to be a positive.

Aston: It’s like everything else, it depends where you’re coming from. DB-lite has got much more chance of succeeding than DC plus because, if as a sponsor you’re coming from one direction it looks very different than if you’ve already made the choice to pass risk on to the member through DC. Simon earlier was talking about moving into a position where we can give people more reassurance about what their outcomes might be and re-establishing that connection between how much you put in as a member and the income you get out; that’s all part of defined ambition as well. It’s just re-establishing the link that we’ve lost when we moved from DB. In short I think the defined ambition debate is a healthy thing, albeit I can understand why people find the timing of it a bit challenging.

Chinnery: Andy mentioned earlier that in DC it’s hard to get illiquid investments in because there is daily pricing and if that is part of a gap between what you could get from a DB return and what you could get from a DC, then if there is a way of risk sharing that would close that gap, then to me that’s a good thing. I encourage it from a ‘could we have a wider range of investment options and mixes’ point of view because if it’s good enough for DB, why shouldn’t it be good enough for DC? But my sense is that the focus has been on capital guarantees rather than guaranteeing an income.

Lipkin: To me defined ambition is in some ways one of the strongest expressions of a worry about the consequence of shifting risk onto individuals. Therefore, whatever you think about the appetite or viability for specifically DA schemes, the debate has the side effect of concentrating minds on what we can also do to improve DC. DC should be all about a better defined ambition as to what you are trying to achieve for scheme members.

Mowbray: We spent the first 20 minutes of this roundtable discussing outcomes and targets. The ‘defined ambition’ debate will get the market thinking more about these issues. In the current environment, it is not clear there is much demand for long-term guarantees. Cash balance plans can be realistically priced, but don’t really meet the objective of delivering better retirement income levels. There are other innovative solutions around — dynamic asset allocation hedging platforms, similar to CPPI, which can be aligned with a member’s target income level or range. I’m sure some banks will be happy to provide gap risk insurance. In the US there are a number of financial planning platforms that allow DC members or advisors to perform the risk management process themselves. Hopefully, these solutions may become more mainstream in the UK if the defined ambition debate continues to progress.

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