Constructing a default investment fund suitable for all members of a pension scheme will vary according to myriad factors, some of which an employer will know, such as age and salary level, and some of which will be unknowable, such as private wealth and the existence of dependants.
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- After auto-enrolment, the regulator is becoming increasingly involved in the investment range and default funds on offer in workplace pension schemes.
- Most schemes use lifestyle funds, some of the traditional weaknesses of which can be overcome by using diversified, and often highly active, multi-asset investment funds.
- Employers cannot second-guess their members’ risk appetites, but a good ‘steady growth fund’ will be a reasonable fit for everyone.
This makes it tricky for an employer to put together a pension scheme with a default investment strategy that can cater to all members, yet the default option is where most members will invest their funds, either through apathy or because they believe their employer knows best.
On a broad basis, trying to match the level of risk in a default fund to members’ risk appetite is almost impossible because of the sheer variety of wealth, marital status and intrinsically different personality types in the workforce, risk itself is a coin with two sides.
So, for example, an employer might try to match different funds to different contribution levels, matching, for example, a low contribution to a low-risk fund on the assumption that a young, low earner should avoid high levels of risk because they do not have money to lose, whereas someone in their fifties and on a higher salary can afford to take more risk.
However, if a young, low earner takes insufficient investment risk, their fund may never grow significantly enough to provide sufficient income in retirement.
Dale Critchley, pensions technical manager at Friends Life, gives this example: £1,000 invested at 7% for 30 years produces £7,600, at 4% it makes £3,243, at 3% it makes £2,400 and at 1% it makes just £1,347. Such is the power of compounding.
Brian Kite, corporate pensions manager at Prudential, says: “The membership profile of defined contribution (DC) schemes is maturing as they cover an ever-wider range of industries and age groups. This has been reinforced by guidance from The Pensions Regulator and the Department for Work and Pensions (DWP) on the design of default options.
“While the industry still needs to guard against any tendency of some members towards ‘reckless conservatism’, putting all their savings in cash for some years, a lifestyle strategy which invests 100% in equities until near retirement may be just as inappropriate to some. The focus of default options, in particular, should be on member outcomes at retirement: seeking to produce more stability in the pension levels that members might expect.”
Prudential and other pension providers offer a range of lifestyle strategies with discreet risk/return trade-offs, but that still presupposes that members understand risk.
Another factor is that the contributions of young people are more important to the overall end result than investment performance at that early stage. However, when members are at an older age, the investment performance matters more than contributions.
Schemes with an age-related contribution structure may want to revisit that strategy, because it is younger staff who need contributions to be made as soon as possible. Rona Train, senior investment consultant at Hymans Robertson, says: “For this reason, some [employers] are rethinking whether an age-related basis is best.”
The standard default arrangement today is a lifestyle fund that progressively switches plan members out of equities and into bonds as they approach a typical retirement age. But there have always been issues around these funds because it is hard to know when a member plans to retire, and it is difficult to ask.
Also, in the current investment market, where assets are not behaving in a traditional way, bonds are no longer the risk-free investment they once were. In fact, the value of bonds has been pushed up because interest rates remain low and many central banks have been buying government bonds. Bonds are therefore widely considered unsustainably high, and could crash.
However, the good news is that any decline in a member’s bond investments would be offset by an increase in annuity rates at retirement, but most employees would not make that connection and would be disappointed with their employer’s pension scheme.
Steady balanced fund
Some employers have put in multiple funds labelled according to their risk, but there is also a trend to go the other way under auto-enrolment and provide a single, steady, balanced fund as the best fit for most employees.
Morten Nilsson, chief executive of Now: Pensions, says: “These decisions are so hard for people to make that a decent alternative is to offer a single, well-diversified growth fund for the growth stage, until transferring into lifestyling funds in the lead-up to retirement. Pensions saving is something that the employer contributes a great deal to, in time and money, and so one purpose is to ensure that employees are able to retire, generating sufficient money but not gambling it away.
“All savers need a fairly stable return. If it is too risky, the member will fall out and then become disincentivised and it could take a long time to recover from the fall. There is lot of commonality in the type of investment vehicle required.”
Such funds are a kind of second-generation diversified growth fund which depend heavily on the fund manager’s asset allocation and tactical investment skills, which vary greatly. They also carry relatively high fees of around 0.7% plus at a time when the Office of Fair Trading, pensions minister Steve Webb and the National Association of Pension Funds are all demanding lower fund charges.
Some of these funds are quite aggressive and use lots of derivatives to crank up returns, while others have capital preservation as a key priority.
Steady growth funds
The middle-ground, one-size-fits-all solutions are the ‘steady growth funds’, which have a particular risk return objective and, critically, mechanisms such as volatility caps that de-risk the equity content when the fund is starting to become volatile.
This is normally achieved by selling equity futures when the fund hits a certain volatility level because investment corrections often follow periods of high volatility.
Paternalistic employers still want to provide a tailored offering, however, says Peter Glancy, head of corporate pension propositions at Scottish Widows, which provides an enrolment service that involves one-to-one meetings with members to examine their appetite for risk. Members are also asked to complete a brief questionnaire that will profile them according to risk appetite.
Employers are increasingly nervous about the default funds they offer and regulatory ‘creep’. Stephen Bowles, head of defined contribution at Schroders, says: “We have no safe harbour here, unlike the US, and no trustees have yet been taken to task about their fund choices, but it must weigh on employers’ minds [because] we live in a litigious world and there is a big section in the DWP’s call for evidence on default funds and investment and how to encourage greater governance.”
Case study: BMI Healthcare decided on new investment strategy
BMI Healthcare operates 65 private hospitals across England, Scotland and Wales. Most of its employees are female, with typical hospital roles being nurses and healthcare assistants. Average salary is £21,000. Some 95% of current pension scheme members are invested in the default fund.
BMI Healthcare has long operated a Friends Life defined contribution scheme for its 9,500-strong workforce, but the advent of auto-enrolment and the prospect of increased membership prompted the trustees to review its investment strategy in relation to the default fund.
Anne Woolcott, head of employee relations and HR compliance at BMI Healthcare, is mindful that the Department for Work and Pensions (DWP) guidance highlights the employer’s responsibility to consciously look at the default fund in the scheme. With the potential for 4,500 new members as a result of auto-enrolment, they were aware that the membership could suddenly grow significantly.
The trustees’ discussions resulted in moving away from traditional lifestyling starting at five years before retirement to Friends Life’s My Future investment programme. As well as aiming to provide a better return for members, My Future also aims to control the amount of risk to which members are exposed, recognising that big fluctuations can be harmful to pension funds.
This strategy has three stages, with different investments in each: a growth phase using a multi-asset fund for the early and middle years of the typical career; a consolidation phase, when, like lifestyling, any gains start to be locked in; and a pre-retirement phase, when the assets are moved over to bonds and cash to protect them from risk.
The key differences from the old arrangement are that the growth phase is based on a fund invested in a wider range of assets and is managed to a volatility target, so should protect against downside risk, and the introduction of a consolidation phase will start to lock in assets before the start of BMI’s traditional lifestyle option.
In addition, Friends Life’s investment managers have the flexibility to adapt to market conditions to ensure the My Future programme remains suitable for members.
“We needed to ensure the investments were right for our employee population,” says Woolcott. “What we have moved to is probably a better match because it encourages growth but has protection by holding different asset classes in the default fund.”