Understanding investment options can be key when explaining these to staff to ensure they don't simply play overly safe and plump for default funds, says Ceri Jones
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Defined contribution (DC) pension schemes are sometimes seen as a simple pensions option, but there is nothing straightforward about the decisions an employer must make regarding the number and nature of investment choices they should offer to members.
The big difficulty is that investment risk is highly subjective, and the terminology involved means different things to different people. To some employees, saying that an investment is high-risk implies there is a chance of losing a fraction of the original capital, while to others it indicates there is a chance the entire fund could go up in smoke.
If employees are asked whether their investment style is cautious or adventurous, most will say cautious. For a young person, choosing a low-risk deposit-based fund is usually a disastrous decision, however, because the return may not keep pace with inflation, so the investment's buying power will diminish over time. Even a few percentage points of additional return will grow into a surprising amount when compounded over years.
A good way to demonstrate asset class characteristics is to show members historical performance data such as that published annually by Barclays. In the long term, equities typically perform better than government bonds, or gilts, which offer no possibility of capital appreciation. The younger or wealthier an employee is, therefore, the greater proportion of their pension pot should be invested in equities where there is potential for profit.
According to Barclays, the likelihood of shares outperforming deposit accounts rises from 67% over two years to 93% over 10 years, so an employee will typically need to keep their pot in an equity fund for a decade to be sure of it doing better than a savings account.
The drawback of equities is that they can be volatile and more prone to plummet just before a member retires than other assets. A member should therefore reduce their exposure to equities and increase their allocation to cash as they approach retirement, because if markets slide just as their working life is coming to an end, there will be less time for the position to right itself.
In between cash and equities on the risk/return scale are corporate bonds, which are less risky than equities because they are paid out ahead of equities in the event of a business collapse. However, there is a huge disparity between a corporate bond issued by an AAA-rated company, and junk bonds or bonds issued in a less-regulated or developed market which entail greater risk and would be held only in specialist funds.
Generally, the variety of asset classes offered by DC scheme providers is not great. Most funds will be based on equities, bonds or cash, with only a few linked to commercial property, for example. Index funds, which track an entire stock market, are a good low-cost option, while at the other extreme, manager-of-manager funds, where a manager tries to pick the star funds from the entire universe of funds, tend to be expensive. Some specialist equity funds focus on a specific industrial sector or region, and will consequently exhibit a more exaggerated risk/reward profile.
A fund must also be nominated for the default option, which is usually a lifestyle fund that automatically shifts the allocation from equities to cash as the member approaches retirement. This can be one of the most thorny issues because, in practise, default funds tend to be relied on heavily.
Research by Aon Consulting last year showed that less than 25% of members had made an active investment decision. In some schemes, even more members (87%) had chosen the default fund.
Paul Macro, head of DC propositions at Aon, says: "There is a real problem with the practical use of default funds in DC schemes. In particular, how can one single fund (or funds, when set into a lifestyle matrix) be appropriate for 80%-90% of members, when their background, needs and attitudes to risk will be diverse?
"There can be a delusion with employees thinking everything is being looked after for them. They think that a default fund is the right choice for Mr Average, so it will be alright for them. We need to continue to educate members about the different asset classes, but on its own this will not be enough to give the vast majority the ability to make investment decisions, as they won't understand the consequences of each route."
The other consideration is that lifestyling will be less relevant in future, as employees choose not to retire at 65, and where members opt for drawdown over an annuity and therefore need to maintain higher equity exposure. Some consultants talk about dynamic design where allocation to bonds accelerates if there has been a bull run in the equity market, but this will be difficult to administer. Other solutions may be to offer a programme targeted at member-selected retirement ages, or to rebalance the growth element of funds on an annual basis.
Macro recommends that members are provided with some kind of modelling questionnaire which enables them to grasp their attitude to risk. This would then route them to an appropriate fund. They need not know or understand the nature of equities or gilts, for example, because the funds could simply be labelled Cautious or Adventurous with various gradations in between.
This whole process can be achieved without an employee knowing an equity from a bond, as long as their risk profile is established. It may be that members only need to understand what they are using the fund to do, like using a car to move from A to B with no need to understand how the engine works.
Often the temptation is to include quite esoteric funds. This may be fine for a City firm where staff are financially knowledgeable and will switch between funds on a regular basis, but most members are ill-equipped to judge market timing. More often than not, strong bull runs in a sector are directly followed by a bad patch, which can be difficult to make up later. An investment that falls by 50% needs to grow by 100% to get back to square one. In this respect, trustees must sometimes be careful not to let the desires of the most powerful executives in a company drive the choices given to other members.
Another consideration is how many fund choices to provide. All the evidence suggests that the greater the range, the fewer choices members make because it all becomes too confusing, and so they rely more heavily on the default fund.
Crispin Lace, senior consultant at Watson Wyatt, suggests that for certain employers, just two fund choices will do the job. "Financially-competent people who can make good decisions may want a wide range of funds to choose from. But if the [employer's] aim is to achieve a basic level of retirement income, they might want to restrict choice to one or two funds: one that creates diversified growth, and then a switch into a protected fund towards retirement."
Both sponsors and members are increasingly keen on index funds because it does away with the risk of choosing an active manager. There is also a growing awareness that choosing a tracker where the manager cannot underperform avoids the potential administrative burden of having to change options in the future, and reduces the risk of litigation.
Despite the general perception that DC schemes are low risk, there may be a real risk of a class action some way in the future by members who are dissatisfied with funds' performance. So a sponsor may put itself in a particularly uncomfortable position if it runs both a closed defined benefit and new entrant DC scheme, but concentrates on different investment strategies for each scheme.
Glossary
Annuity: A regular income stream paid to an individual from a lump sum investment. Typically, an annuity is set up with funds from a pension scheme to provide retirement income.
Bond: Loans to borrowers, which could include government and companies. In return, the borrower generally pays a pre-determined rate of interest for an agreed term.
Equity: A share investment or security that represents ownership in a company.
Gilts: Bonds issued by the UK government.
Index funds: An investment fund that holds a portfolio of investments that closely matches an established index (such as the FTSE 100). Also known as tracker funds.