Staff should be educated about DC scheme investment options

There is a myriad of fund choices for staff in DC pensions but do they have the skills to judge them? Sally Hamilton investigates

One of the most dramatic differences between a defined contribution (DC) pension and a defined benefit scheme is that in a DC plan the members ultimately take responsibility for where their money is invested and live with the consequences of the decisions they make.

However, while there may be many fund options available to members, research shows that most will choose the default fund.

According to the 2006 Annual pension survey by the National Association of Pension Funds (NAPF), DC pensions offer ten or more funds on average. The NAPF also found that 83% of schemes offer a default fund. Of these, 82% are lifestyle funds which are intended to reduce risk as retirement draws near, and the rest are managed, global equities or cash and guaranteed funds.

Patrick Race, European head of DC investment at Mercers Human Resource Consulting, says the quality of default funds will be increasingly in the spotlight in the future. “Employers with group personal plans and stakeholders might not have the responsibility for the performance of a pension, but they don’t want disgruntled scheme members coming back to them at retirement and complaining about their rubbish pension plan,” he says.

The type of default fund varies, but the trend is to provide the lifestyle variety, which broadly invests 100% in equities in the early years and switches piecemeal into safer investments such as bonds and cash five to 10 years before retirement.

Alan Hubbard, chief operating officer of DC Link, an administrator of DC pensions, says of lifestyle funds: “The gradual move from equities to bonds gives some protection against wild fluctuations in the stock market, but the danger is they miss out on strong equity performance.”

Mercers’ Race adds that the asset classes and strategies used by managers are starting to change. “Managers are starting to introduce alternative investments in default funds, such as derivatives, private equity and real estate.” And he anticipates a greater role for new-style ‘banking’ funds where investment profits are banked along the way and kept safely – protected against inflation – until scheme members retire.

Hubbard says lack of investment knowledge and confidence, as well as apathy, are key problems for scheme members. He says this situation will only get worse unless individuals or their employers pay for them to receive independent advice. “Our research shows that less than 3% of DC scheme members are in what we call freestyle funds, making their own decisions about where to invest. Even then this can be as risky as they often just pick the best-performing funds at the time. If people had one-to-one advice the take-up of pensions would be greater and investment choices more varied.”

But before picking particular investment funds, employees need to understand investment risk. Des Hamilton, technical director of The Pensions Advisory Service, which offers advice on occupational, private and state pensions, says: “In simplistic terms, the younger you are, the more you can handle stock market volatility. If you are close to retirement you are less able to tolerate that risk. This is why so many pension savers end up investing their money in lifestyle funds.”

Other investment options:

Life style funds
These have a strong, if not a 100% focus on equities in the early years, typically in global funds, and are the most commonly offered default plan. NAPF figures show that in 2004, 56% of DC pensions offered lifestyle funds, compared with 90% in 2006.

Cash funds
Cash funds are straightforward deposit accounts that pay interest. Although the investment is safe, because its face value will not fall, its real value will be eroded by inflation. Cash is usually kept only when scheme members approach retirement, but can also be useful to switch into when other markets such as equities look uncertain. A few DC pensions use cash as their default fund, an option the NAPF describes as “sub optimal”.

Bond funds
UK government bonds are known as gilts, UK company bonds are called corporate bonds. These are loans where the borrower pays the holder interest and agrees to repay the loans at a specific date in the future. Bonds are traded like shares with values tending to rise when interest rates fall and vice versa. Bonds, especially gilts, are perceived as low risk, because a government is unlikely to go bust. The yields on corporate bonds are higher because of the greater likelihood of a company failing.

Equity funds
Investing only in the shares of one company is highly risky since the money could be wiped out if the firm goes under. Equity funds buy the shares of many different companies to spread the risk. Equities and equity funds produce good returns over long periods, although their short-term performance can be volatile and lead to big falls. The main types of equity fund are actively managed, where fund managers make investment choices; and tracker funds, also called passively-managed funds, which try to mirror the performance of an index of shares such as the FTSE 100.The long-term performance for equities is persuasive. The Barclay Capital Gilt Equity Survey 2007 shows that the real value of equities rose 11.4% last year, compared with a 4.4% fall for gilts and a 0.4% rise for cash. Over ten years, the figures show annual rises of 4.9% for equities, 4.6% for gilts and 2.6% for cash. Over 20 years, the figures are respectively a positive return of 6.9%, 5.6% and 3.7%.

Specialist funds
These actively-managed funds invest in certain equities such as technology and smaller companies and are considered high risk.

Overseas funds
These are funds that invest in the shares of foreign companies by country such as the US, Japan or regions, such as Europe. They come in various styles, including trackers and specialist, but they all carry the additional factor of currency risk.

Property funds
These invest directly in commercial property such as offices, shops and factories. The investments earn money from rent and the increasing capital value of the properties. These funds have done well in the last few years, but values can fall just as sharply.

Managed funds
These are made up of a mixture of different types of investment such as equity, bonds and cash and possibly property and overseas equities. The spread reduces risk, but can make these funds unspectacular performers.

Ethical funds
These funds either screen out organisations such as arms manufacturers or pick companies for their ethical credentials. In 1999, just 5% of DC funds offered ethical options, now this has risen to 38%. This is expected to increase, however, due to the government’s proposed system of personal accounts which will automatically enrol employees into pensions from 2012 and will require ethical funds to be an option

ADVISER’S VIEW

Richard Batty, a global strategist at Standard Life Investments, describes his current view of the range of investments in his company’s UK Balanced Fund, which includes equities, bonds, property and cash. “In general we still favour equities over bonds, even though they are less favourable than they were 18 months ago.” The balance of the fund changes, depending on the fund manager’s view of what is likely to happen over the next nine to 12 month period.

The fund has a strong exposure to equities in the UK, US and Europe but only a small exposure to Japan and even less to Pacific Basin countries and emerging markets such as Latin America. “We’ve been concerned by the slowdown in the US economy, which is important factor driving world growth,” Batty adds.

The fund, which holds very little cash, is heavily invested in US Treasury and Eurozone bonds. As for property, the fund has been reducing its position, which was already quite small. “The yields are lower than on cash, but we still like central London office space because there is a low vacancy rate.”

CASE STUDY: Skipton Building Society

Skipton Building Society offers its employees a company-sponsored stakeholder pension from Norwich Union. It recently ran a national roadshow to encourage staff to increase their pension contributions from the previous minimum of 0.5% to at least 3%, and take a more active interest in the scheme performance by monitoring it online.

As a result, around a third of employees increased their contributions, which they can now make by salary sacrifice.

Paul Scott, pensions expert at Pearson Jones, the society’s independent financial advice subsidiary, says: “There are 45 funds available in the pension, although 92% of people currently end up in the default fund, which is a balanced managed fund, until they are 55, after which they are switched to safe investments.” Scott believes the level of contributions is a crucial factor in a defined contribution pension. If an employee now contributes the minimum 3%, Skipton’s contribution is 5%. This rises in steps to a maximum top up of 8% on a 6% employee contribution.

“We take the pension issue seriously, as although all the regulatory risk is with the individual on a stakeholder plan, Skipton is the largest employer in the area and wants people to retire on a decent pension,” says Scott.

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