The Defined Contribution Debate

Employee Benefits brought together a panel of industry commentators to discuss the changing face of defined contribution pension investments

Over the past few years, the writing has been on the wall for final salary or defined benefit (DB) pensions. There was little doubt defined contribution (DC or money purchase) schemes would become the new world order, but growing concerns were voiced that DC had been run as a sideshow to DB, with low levels of governance. There were particular worries about the strength of investments in default funds, which typically house the investments of more than 80% of all DC members. The Pensions Regulator (TPR) made it clear in 2011 that it would seek higher standards in future.

Workplace Savings Quarterly contributing editor Padraig Floyd asked the panel how DC investments had developed in recent years.

Andrew Dickson, investment director at Standard Life Investments, says there is a focus on more diversification in investment strategies. “The traditional approach of just using a single asset class of equities is proving too bumpy a ride for most DC savers. Asset managers are also coming up with more innovative solutions that will provide more predictability of outcome for DC savers.”

Risk-and-return objectives

Hilary Vince, DC strategy manager at Schroders, agrees market volatility has brought a greater focus on the downside for DC members’ funds and there has been a move towards risk-and-return objectives rather than focusing on one asset class. “DC schemes and members are becoming much more outcome-orientated and so is the Regulator,” says Vince. But she points out that DC investment has not developed dramatically. “There have been new solutions, but there is still a way to go. We can see new solutions coming through and learn from the innovative solutions put in place in DB schemes.”

Paul Black, head of DC investments at LCP, agrees that DB has a lot of lessons for DC schemes, and there is more work to be done to make those a reality for DC. The concept of lifestyle, where members’ funds aim for growth for most of their working lives and are then consolidated as they approach retirement, remains prevalent, but how it is delivered is changing, he says.

Many believe the changes already experienced will affect how DC schemes are run in future. There was little innovation for a decade and then, suddenly, changes, says Tim Banks, head of client relations at pensions strategy group Alliance Bernstein. More intelligent investment components have been introduced and are being packaged in an easier-to-understand way for staff.

Banks acknowledges the growth in the multi-asset approach, but as well as diversification, the crucial component has been dynamism, with investments managed more actively, even if a large proportion are passive investments.

“We are not just managing members’ pots with hindsight,” he says. “Having consideration for an individual’s risk capacity right through that journey is very important. We are also seeing a level of innovation that allows you to tailor investments to individual needs in a way that lifestyle just doesn’t really allow.”

Ian Colquhoun, head of corporate platform at Axa Wealth, says employers and trustees are thinking more about the investment solutions for DC schemes, as many schemes try to improve the outcomes for members by reducing the risk and volatility they are exposed to.

“But there are also those who have implemented new schemes and are designing something that really works on a blank sheet of paper for members,” he says. “That is a real change.”

A typical DC default fund five years ago was very different from today’s versions, says Nigel Aston, business development director at DCisions. Research by his firm showed that in late 2006, a typical default fund was 94% equities with a strong bias to UK companies. Of those defaults, 63% were held in passive index-tracker funds, or what Aston calls the “set-and-forget mentality”. By the end of 2011, this had fallen to 78% equities, with less domestic bias and only 48% in passive funds.

Asset managers recommend a far lower equity exposure for default funds, says Aston: only 54%, of which 40% should be in the UK. Only 8% of asset managers recommended tracker funds. There is a bias to consider for the last point, as few fund managers specialise in index tracker funds and most are active managers.

Regulation and governance

The Regulator has set out guidelines on DC scheme investment and governance. There are concerns that TPR could, in time, make these too prescriptive and effectively dictate what DC schemes should look like and how they should invest.

There was consensus that a balance is needed as the outcome for an individual consumer is based on who they work for, who advises that scheme and who the asset manager is. “TPR is rightly concerned there is a huge disparity in those consumer outcomes depending on factors over which the individual saver has little control,” says Aston.

But Debi O’Donovan, editor of Employee Benefits, says the Regulator may worry that in five or 10 years’ time, low levels of DC retirement income will hit the headlines. “It could be the next pensions mis-selling scandal,” she says.

Floyd agrees that is a fair point, but asks whether prescription would mean a one-size-fits-all approach, “effectively institutionalising mediocrity within DC schemes”.

Prescription is difficult, says Banks, but governance must be improved. “Let us consider the position of trustees. They are deciding on asset allocation, fund management decisions and judging whether they did a good job. I don’t think any of us could really describe that as a very robust governance model.”

In fact, 50% of asset managers believe they should be allocating assets for DC schemes, according to Aston’s research, but only 10% of trustees agree with this assertion, and 71% think it should be the trustees themselves.

“No one is quite sure who is best placed to do asset allocation and who should be responsible for doing it,” says Aston. “At the minimum, it is a team game and everyone in that team should decide who is doing what, otherwise consumers may get bad outcomes and with everyone pointing the finger at everybody else.”

The Department for Work and Pensions has issued guidance about clarifying roles and responsibilities, and members should know someone is responsible for this advice, says Banks. “Members do have expectations, it is just that they don’t tell you until it goes wrong. One of those expectations is that they believe somebody is actively looking after their pensions strategy on a daily basis.”

Vince says many schemes do not have many advisers, if any, or even governance committees, and this is where TPR must ensure there is a uniform approach for DC schemes of any size or structure.

The issue of a wide range of member outcomes is hard to solve, says Black. “Nobody knows what the best solution is and we are all looking for more innovation in DC. It is difficult to say we want lots of innovation and we all want uniformity, because those two don’t work together.”

The panel recognised that greater scrutiny of DC funds by TPR is likely to change the way it regulates. As members shoulder all the risk, regulation will seek to protect them. This will result in what Banks refers to as “the retail regulatory overview” and Aston calls “the retailisation” of DC.

This is a reasonable development, as these funds resemble retail structures and, in the case of contract–based schemes such as group stakeholder and personal pensions, are in fact individual contracts between the individual member and the provider.

“We have to marry the best of both worlds,” says Colquhoun, “the retail side focusing on individuals’ requirements and the institutional bearing in mind that getting scale and keeping down fees make a huge difference over 20-30 years.”

But one of the biggest obstacles to improving DC is engagement with members, because most DC members don’t want to – and are in no position to – make investment decisions, says Vince.

“Default has become a bit of a dirty word, but it is not,” she says. “A default is entirely appropriate as long as it is the right default and it is an entirely appropriate place for the vast majority of DC members to be.”

With a default, there is less need to communicate the minutiae, Vince adds, because members only need to know what they are in, what it is designed to do and what it might deliver.

Dickson agrees, but advocates making more effort to explain the risk members face over their investment period. “This is where problems have often arisen,” he says, “because they do not understand the language used and so expectation is mismatched to actual experience.”

Some employers are already trying to find a common language, even down to the names of the funds they offer, says Colquhoun. “They are trying to name funds using a language that fits the culture of the company and the people around them. That is very helpful in terms of people beginning to understand the risk they are taking.”

Some employers’ desire to take greater control – even in running a contract-based scheme – is partly a result of them having to comply with auto-enrolment. For many, DC is their only offering and they would prefer to offer the best scheme they can within budgetary and regulatory constraints.

Black says he has seen governance committees become far more prevalent. Getting value for money is another key driver. In a trust-based scheme, this is reviewed regularly, and is now happening across the board.

Governance issues

An interesting development in DC, says Dickson, is that as more young staff join, there is greater focus on environmental, social and governance (ESG) issues. “We focus on our approach to the ESG scrutiny we apply to the companies we invest in. That will be part of an agenda for future DC governance oversight.”

But what are the key points employers should be considering when reviewing DC investments? “Put in place a solution that provides more predictability for DC members,” says Dickson.

Aston urges employers to forget the market itself, because each provider has its own agenda. “But right at the end of that value chain is a real person who is a consumer and our view is to turn the whole thing round and start at the bottom with the consumer,” he says.

Colquhoun says employers are now trying to understand what staff want, how they want to retire and the risk they are prepared to take along the way. “It’s about going back to basics. Understand your workforce and how it is made up, the type of risk they want to take and how you can get them there in a way that is simple to understand and in which they can make their own decisions.”

Black adds: “I expect more governance, whether contract-based or trust-based. Employers should try to create as good and predictable a pension as possible. If people approach retirement age but haven’t saved enough, the employer will find its HR policies affected because it can’t retire people and bring in new blood.”

Employers running a contract-based scheme should expect more governance and more regulation and so more work, says Vince. Most important is know your audience (employees) and target a good level of income in retirement, if possible.

“Look at the volatility of the path in terms of how members will get there,” she says. “Also keep an eye on fees. There should be more focus on getting value for money for the fees you pay.”

A good default fund is the first critical element, says Banks, then a clear objective. “Diversification, volatility management, the ability to adapt quickly to change are all important,” he adds. “Also, a fund construct that is simple to understand, and let’s build independent oversight into the model.”

Read more articles from the Workplace Savings Quarterly