Factors to consider in defined contribution pension investments

The investment model is a critical element of any contract-based DC pension scheme and there are many factors to consider, says Ceri Jones

Putting an investment model for a contract-based defined contribution (DC) pension scheme into place is not as straightforward as it may first appear. One challenge for employers is that the model should be durable. Once a scheme is in place, it is often not revisited for years and contributions could be left trapped by underperforming managers and an outdated default structure. The investment model should also accommodate the needs of the majority of employees, not just the preferences of the managerial hierarchy.

Most consultants now recommend employers offer a small range of seven to 10 investment funds, a number not so large that it baffles members, but still sufficient to offer a decent choice. The growing trend is to white-label these funds so they appear endorsed by the employer, which most employees will trust, and to purposely obscure distractions such as the names of star fund managers or well-known companies.

Accessing specialised funds

If, however, a member would like access to a wider range of more specialised funds, such as an emerging market growth fund or a single country fund, these might be made available through a supplementary listing in a scheme’s literature or via a web link.

The first task a good adviser will undertake is to profile employees, including their salaries, sex, age, dependants and investment preferences, so an appropriate model can be put in place. In reality, the vast majority of members opt to do nothing and stay in the default fund, so this is where the greatest endeavour should be made.

Some older schemes still use cash for the default fund, which, for young members, is throwing away years of potential growth opportunity. Most employers now use traditional lifestyle funds that are heavily invested in equities at younger ages and switch progressively into the safety of cash, gilts and other fixed-income funds for the last decade or so leading up to retirement. Some do this by switching at predetermined dates leading up to the scheme’s normal retirement date, but a newer model is the target date fund, which is focused on the date the member intends to retire. These work best where scheme members are realistic about when they will be able to afford to retire.

Consultants split on lifestyling

Lifestyling is an issue that splits consultants. Some argue that lifestyling delivers what it sets out to achieve, most of the time. However, the concept is likely to become more problematic as retirement ages become more flexible in the future and there is a growing danger of switching out of equity markets too early.

Also, each member’s risk appetite will depend on their individual wealth in the round, so the most appropriate specific investment for their portfolio will depend very much on their existing financial assets and how much diversification or duplication there is.

Charlie Carrick, sales director at JLT Online Benefits, says: “No one fund can possibly suit everyone. The aim is to get people to understand the choices. The days of invest and forget should now be behind us.”

Volatility of equities

The events of recent years have highlighted the volatility of equities. The FTSE All-share index dropped 32% in 2008, which for anyone invested in UK equity funds was incredibly painful. One way the investment industry has been getting round this weakness is by using multi-asset class funds that invest across the range of equities, fixed interest and alternative investments, such as commodities, property and currencies, that aim to offer equity-like returns for reduced volatility. Such funds are run by an increasing number of providers, such as Standard Life, BlackRock and JPMorgan. Some also use derivatives to make money when an asset’s price falls by shorting, or selling, the investment.

Brian Henderson, principal, intellectual capital for DC at Mercer, Europe, says: “The principle of using an absolute return fund within the growth phase of lifestyling has a lot of appeal. However, you have to be careful. It may look simple – aiming for a return in excess of cash with low volatility – but under the bonnet it is complex and needs careful handling.

“Analysis shows that when members are [aged] anywhere from their early 20s to their 40s, it is the contribution that is most significant in the piece, rather than the investment return, and therefore there is the argument that as the pot gets bigger, diversification should be added.”

Manager of manager structures

Another solution to the problem of high volatility in single-asset-class funds is the modern manager of manager structures offered by consultancies such as Jardine Lloyd Thompson and Towry Law. Consultants set the mandates, targets and asset allocations themselves, which are rebalanced at least quarterly. BlackRock also offers an option to automatically switch gains made from equities into the safety of index-linked gilts.

Some advisers are putting collective advice on their platforms to explain these relatively new investment options while benefiting from combined purchasing power. Many of these platforms also feature modelling tools that can help engage members and encourage them to boost their contributions to deliver a bigger pension.

Once the fund range has been selected and packaged, an adviser should give a presentation to all staff explaining the new investment options, whether they are charging an hourly fee or are remunerated by commission paid by the provider (which may be a huge 30% of the first year’s contributions). This advice should be completely impartial, ensuring less-wealthy staff also receive advice and that it includes issues such as life cover and state benefits.

What is expected of advisers

Exactly what is expected of the adviser should be discussed with the employer and the scope of the guidance should be put in writing beforehand.

Once employers have run a seminar, they may see that it can help greatly and will want to repeat the process. Advice worth up to £150 a year may be provided to each employee without incurring a liability for income tax, as long as it is about pensions and not general financial or tax advice, and if it is available to all staff.

Investment models used in contract-based DC plans will come under greater scrutiny than ever as employers’ schemes are granted qualifying status in lieu of the National Employment Savings Trust (formerly known as personal accounts), due to be introduced in October 2012. Richard Wilson, senior policy adviser at industry body the National Association of Pension Funds, says: “The structure of the default fund has attracted the attention of The Pensions Regulator and, as Nests are rolled out and employers start to auto-enrol staff, inevitably there will be more focus on the investment structure.”

So, although it may be complex, taking the time to put an appropriate investment strategy in place for contract-based DC schemes will pay off in the long run.

Shariah and religious options

Shariah fund options are increasingly offered in contract-based DC schemes provided by organisations with Muslims among their workforce. These funds do not invest in industries such as armaments, tobacco and alcohol, and have very strict rules around borrowing and mortgages. They differ from ethical funds in the critical respect that if there is no Shariah fund option, a Muslim will not be able to join the pension scheme.

Mark Jaffray, senior investment consultant at Hymans Robertson, says: “There is potential for employees to argue that the absence of a Shariah option is discrimination. You can imagine [employers] thinking they have to offer a Shariah fund, even if it is only for one or two people, to avoid potential legal issues.”

However, the cost for a third-party administrator to handle each additional fund is about £2,000-£3,000. This could be put up as an argument against offering a fund designed for a minority of members, because it would contravene pension equivalence regulations by creating an unfair financial burden on the remaining members.

However, many people who are not Muslims appreciate the notion of investing in well-run, debt-light, socially-responsible companies.

Case study: BT keeps in touch with tradition

When BT set up a new contract-based DC pension scheme with Standard Life in February 2009, it opted for a traditional investment configuration, largely to mirror the telecoms company’s legacy DC plans and to enable the 17,500 members’ pots to be switched easily across to the new scheme.

The investment range comprises a traditional lifestyle default fund – a passive 50 global/50 UK equity lifestyle default fund run by Barclays Global Investors, which is used by 85% of members – and a core range of funds. There is also a self-investment option, used by 0.5% of members.

Because the company had switched over from a defined benefit scheme, the trustees retained an interest in the new plan and made two noteworthy innovations.

Governance committee

The first is a governance committee, which meets quarterly and is focused on how to encourage members to engage with their pensions, especially with regard to their investment choices. The committee is made up of staff and employer representatives, chaired by an independent, and is given detailed demographic breakdowns of members’ fund choices and investment activity.

The second innovation is the inclusion of a bespoke BT share price tracker fund, with the expectation that staff will fold the proceeds of their share option plans directly into the fund.

Andrew Dickson, senior business development manager at Standard Life, says: “People really do understand their share option plans. They understand they will benefit from tax relief, and that if they put the proceeds of a maturing share option plan into one of these funds, then £10,000 can be turned into £12,000, with no capital gains tax to pay in future.

“This fund also means that members can avoid all the hassle of dealing with the paperwork and share certificates.”

BT’s next share option scheme, maturing in April, will be the first since the new scheme was put in place.

More articles on: Special report 2010: Contract-based pension investment