Investment funds are the lifeblood of pension schemes, and finding the right mix of risk and return is key for both employers and employees, says Ceri Jones
As insurance companies’ open architecture platforms have developed, hundreds of funds have become available, and defined contribution (DC) plans have been attracted by the flexibility and ease of administration offered. Two out of three contract-based DC schemes in the FTSE-100 now offer 50 or more investment options to members, according to Watson Wyatt’s annual FTSE-100 DC Pension plan survey, published in March.
Gary Smith, senior consultant at Watson Wyatt, says: “Excessive investment choice can really deter joiners, as well as lead to members making wrong fund choices and unintentionally taking on inappropriate risks and costs. As well as exposing their members to these risks, contract-based schemes are adding considerably to their governance burden by offering so much choice.”
Most consultants now suggest offering a limited range of funds, typically fewer than 10, which are monitored. Employers can then communicate to members that a greater choice is available through their pension provider’s website.
John Foster, consultant in the DC team at Hewitt Associates, says: “The key to the success of this arrangement is for the employer or the trustees to sign up to the principle that they will monitor the funds. This approach [needs] a commitment to change managers who underperform, [which] requires knowledge around the fund process and manager’s set-up.”
Nevertheless, access to such specialist funds could be a key differentiator of occupational plans, compared with the probably dumbed-down approach that could be taken with personal accounts (due to come into effect in 2012)
One danger is that when an employer sets up a pension plan or changes a scheme’s terms, it can invest considerable resources in member communications, but then fail to maintain the momentum as business priorities change. If staff are being encouraged to make a choice, there must be a clear commitment from their employer to sustain communications programmes once the initial enthusiasm fades away.
A common pitfall is over-cautiousness, where even young people invest in cash, fearful of the inherent risk in equities. A small range of white-label funds can be designed, which are flagged up according to their risk ratings and/or suitability for different age groups. Members then have to consider only their own risk tolerance, rather than having to learn about financial instruments, such as equities and bonds.
Selecting the default fund for members More than 90% of schemes with a default option offer the lifestyle approach, which progressively switches each member’s pot from high-risk/high-percentage-return equity funds at younger ages to the relative safety of cash and fixed interest as members approach retirement age. This has been criticised as a blunt instrument, but the consensus is that it works in varying degrees.
“The lifestyle approach continues to be a robust answer to dealing with market turbulence,” says Watson Wyatt’s Smith. “But if it is badly implemented through an over-simplistic investment design, poor switching mechanisms or excessive cost, then millions of members will be let down.”
An efficient lifestyle strategy will be able to take account of the risk tolerance of the individual, which will depend on their total wealth and family circumstances, and deal with matters such as whether the employee wants to work past retirement age. But the lifestyle model nearly always falls down if the employee retires unexpectedly early because of ill-health or redundancy. The other big challenge is that since A-Day, when pensions simplification legislation came into effect in April 2006, members do not have to buy an annuity on retirement but can, if they wish, stay invested in the market for a further period. This would make it suitable for many members to hold equities for longer.
In the future, the lifestyle concept could be developed with leverage at younger age groups to boost returns and with capital-guaranteed, structured products for members coming up to retirement, so they do not forgo all the returns that may be available from the equity markets.
Mark Miller, principal consultant at Towry Law, says: “Default funds can also be the manager’s mixed or managed funds or – arguably worse – tracker funds. There is a common misconception that trackers are both cheaper and safer, but trackers went down by 25-30% last year.”
Unexpected complications can occur where an employer sets up a new default fund, leaving existing members in legacy investments. Funds cannot be switched without members’ consent, and many are too apathetic to change.
“Despite enormous communication efforts, inertia is huge,” says Hewitt’s Foster. “For one of our clients, all employees were informed on several occasions over a few months about the actions they should take to move into a new default fund, but two-thirds still remain in the original default fund.”
But the bigger challenge is that members have experienced such poor investment performance, they are looking for reasons not to invest in pensions, so employers are not always getting value for their spend
Case Study: The International Union for Conservation of Nature
The International Union for Conservation of Nature (IUCN), the world’s largest professional global conservation network, which is headquartered in Switzerland, offers a wide range of funds to members of its contracted-in money purchase scheme.
The scheme has been taken up by 28 of its 31 employees based in Cambridge, as well 35 deferred members. The scheme’s default investment option, in which most members are invested, is a with-profits fund supplied by the plan’s provider, Standard Life. The IUCN previously considered changing the default to a managed fund but, after consulting its employees, had concerns about high levels of equities at a time when markets were riding high.
To help staff with investment decisions, the organisation provides group presentations and offers the facility for employees to obtain individual advice if they desire.
Given the mixed demographics of its pension scheme membership, market falls, and the publicity surrounding with-profits funds, the IUCN is keen to review its default options. Towry Law will give presentations to employees to explain the options and ascertain their views.
The IUCN has also set up an internal pension committee, which will help to formulate decisions.
Case Study: Aviva
Aviva, formerly Norwich Union, has launched a flexible benefits scheme and website as part of its rebranding exercise.
Reward director Helen Jackson says the package is part of “an integrated in-depth campaign”. Part of this has been a review of pension investment fund choices, and a booklet explaining the new choices has been sent to staff. Karen Jones, pensions director at Aviva, says: “The default fund is a white-label lifestyle arrangement that uses two diversified strategy funds for the accumulation phase and switches to 75% bonds and 25% cash by retirement age. The aim is to minimise downside risk while offering reasonable growth prospects.” The scheme also offers five white-label funds in the core range based on the main asset classes and 12 funds in the extended range offering a choice of riskier assets and managers. Members can make fund switches online.