Spoilt for choice

Members of defined contribution schemes are reluctant investors. This was one of the conclusions the Pensions Institute at Cass Business School drew in its recent report on DC investment innovation and governance. And there is plenty of evidence to support this assertion, not least the overwhelming proportion of members who opt for the default investment fund. The National Association of Pension Funds’ 2006 annual survey found that, on average, over 90pc of DC scheme members enter into the default, while the Pension Institute’s own survey yielded a figure of 82pc.

There is plenty of work being done in the area of communication and education, with a view to engaging members to take a more active role in deciding how their DC pots are invested. However, while this is undoubtedly a worthwhile endeavour, it is just as important – if not more so – to establish an appropriate default fund to cater for all the individuals who are either unable to self-select investments or simply don’t want to.

Establishing a default fund – or perhaps reviewing the current arrangement – is no mean feat. BlackRock’s investment director for its DC business Anne Swift summarises the challenge: “Having a default fund solves a lot of practical issues, but there is a danger that members will naturally believe it must be ‘right for them’ and that it comes with an automatic endorsement from the trustees.

“So, getting the default fund design right is crucial. Trustees need to think about the needs and objectives of their scheme members, as well as their attitude to risk.

“It’s particularly important to think about what a typical default fund member is likely to want. We believe that members who opt to go down the default fund route are by nature risk averse and don’t want any surprises when it comes to their pension investments.

“At the same time, the default fund should ideally take into account the member’s career path – younger members being able to afford more risk than members who are approaching retirement age.”

Russell Investments client executive Stephen Appleton offers a number of essential attributes for a successful default – boxes to be ticked, if you like.

- Opportunity for capital growth. The default fund should offer real growth potential over and above inflation over the long-term.
- Stability of returns. The default fund should not throw up any nasty surprises. Scheme members should reasonably expect the scheme’s default option not to expose their capital to significant losses, both relative to the market and in absolute terms.
- Value for money. The default fund should offer excellent value for money. If the default is passive, it should track the market index at minimal cost. If the default is active, trustees need to feel confident that the fund used can deliver meaningful after-fees returns, as well as feel comfortable that there will be no extended periods of significant underperformance (relative to an equivalent passive strategy).
- Easy to understand. The default fund’s strategy should be clear and easy to understand. Trustees should be able to present the scheme default to members and members should find the overall strategy easy to understand, certainly at a conceptual level.

So, how do trustees ensure the above issues are taken care of? The obvious answer is seek advice. This is certainly what JLT Benefit Solutions’ head of investment consulting Steve Barker counsels. And while you would expect an investment adviser to encourage trustees to seek advice, Barker urges that he is not being flippant.

He explains: “Trustees have recognised the need for consultation, particularly on the defined benefit side. We have seen a growth in the advice being sought and given, and you only have to look at the number of investment consultants – the individuals rather than the firms – to see that over the last five-10 years it has expanded hugely.

“But that’s mainly been on DB schemes. On DC schemes trustees have been a bit slower to seek advice. That might be a bit misguided. If you get your investment strategy wrong for a DB scheme, at least there is a company there that can bail it out in theory. But for a DC scheme, if you’ve got an inappropriate strategy or silly investments set up, it is going to be very difficult for an individual to recover from that – there is no one there to bail them out.

“So, in some ways, getting investment advice is probably more important for a DC scheme than for DB. And I think that is the direction things should be heading. Now, it’s difficult to give advice to individual members and that is costly and probably doesn’t make sense. The way that can work in practice is for there to be a default strategy that is sensible.”

Traditional lifestyle strategies
The traditional default approach has tended to be a lifestyle programme with investment in the early years into either a global equity or managed fund. The funds begin with a high equity content before a progressive switch to fixed interest and cash as the scheme’s retirement age approaches.

Many of today’s default funds are lifestyle funds because their automatic switching process ensures that members accumulate growth by taking on more risk early on their lives, before securing those returns with safe investments prior to drawing an annuity.

Alexander Forbes Financial Services client manager Jarrod Parker says: “As far as default funds are concerned, a lifestyle strategy is almost a failsafe way for companies and trustees to protect their position – in that at least they know as people are getting closer to retirement their funds are moving into safer forms of investment.

“So, often from a company or trustee perspective, if you are going to put members into a default, you have to have some sort of lifestyling in there.”

However, the traditional lifestyle format is coming under increasing criticism, one of the reasons being pensions simplication reforms and new age discrimination legislation which has brought about significant flexibility in the age at which benefits may be taken.

It is possible to argue now that planning to a specific age should be an individual choice and not a scheme-wide decision. This has massive implications for lifestyle strategies that have been designed with an annuity in mind as the end product.
Parker admits that from today’s members’ perspective, lifestyle strategies are not necessarily going to be ultimately beneficial.

He explains: “Certainly, for people who are going to have sizeable funds when they reach retirement age, a lifestyle fund will probably not achieve their needs, because it will start moving them out of equities and moving them into gilts and fixed interest long before they actually need the funds to annuitise.

“Another problem is if people decide to retire five years earlier than originally anticipated. Then you have the problem that they are still in equities at the point at which they want to start to retire.”

Swift is similarly sceptical of lifestyle formula. She says: “For members who are likely to take their retirement benefits in a pre-determined form (annuity and lump sum) and at a known future retirement date, lifestyle certainly does a good job at managing the risks associated with annuity conversion and market volatility in the run up to retirement.

“However, with much more flexibility now allowed when it comes to retirement – both in terms of when benefits are taken and in what form – it is questionable whether such a blunt and mechanistic tool really can deliver the optimum solution for the 21st century retiree.”

Furthermore, during the growth stage of a lifestyle strategy, the traditional approach has been to invest members’ money in 50/50 global equity funds (50pc UK equities, 50pc overseas equities) or balanced managed funds (often 50-80pc equities, with the remainder in fixed interest and cash).

JPMorgan Asset Management head of UK institutional Peter Ball explains: “Virtually every fund has either a global equity or a balanced fund, and balanced funds are 83pc equity, so to all extents and purposes they are pretty much the same kind of thing.

“Everybody, as a result, is in the same boat. They are all in an equity fund which is typically, very heavily UK-weighted.”
A large number of DC scheme default funds are balanced managed funds. Lipper’s latest Life Office Asset Allocation Analysis report reveals that, in June, 2007, approximately £121bn worth of pensions contributions was invested in 147 funds in the balanced managed sector.

Ball believes that the increasing inflows of DC money into these sorts of funds has the potential to cause much disappointment and concern for members in the future. Passive investments with high equity weightings are likely to suffer during a bear market.

When this occurred at during the early part of the new millennium, DC pots were relatively modest; next time the markets enter a similar phase, there may be more money at stake.

Ball warns: “When the market went down for three years or so, people didn’t have very much in their DC accounts. People were affected, but weren’t really hurt that much.

“When the next bear market arrives, people are likely to have some very sizeable pots. There are going to be a lot more DC plans and a lot more members of DC plans, and so there is going to be a lot more noise from members.”

Target date funds
If swathes of DC members are being unnecessarily exposed to the volatility of equity markets, what can be done? The seemingly obvious solution can be summed up in one word: diversification.

Trustees of DB schemes are well versed in the benefits of spreading risk by extending asset allocation to alternatives such as property, infrastructure, currency, commodities, private equity and hedge funds. However, these sorts of investment classes have in the past been seen as inaccessible or too sophisticated for individual DC investors.

A number of alternative strategies have emerged in the market that offer the capability to actively manage default funds and diversify assets so as to reduce exposure to equity volatility.

Target date funds, which work on a similar principle to conventional lifestyling, can be included. Target date funds allow members to select, from a number of funds, one that is nearest to their planned retirement date – for example, someone expecting to retire in 2040 would choose the 2040 Fund.

The fund still switches from a high yielding growth phase to a safer consolidation period, but it can do this with the specific target date in mind, allowing an active manager to perform the switch at what he believes is the best possible moment and utilising a wider choice of assets.

Webb explains: “These funds are actively managed which means the manager is deciding on the weighting between equities and fixed interest and cash. They also choose something very important, which most members don’t achieve: diversification.

“The funds will invest across the global markets and generally hold much higher levels of individual stocks than your average balanced fund. They are actively managed and the fund manager is deciding the most appropriate time to split your investments between equities and fixed interest and cash.”

And target-date funds may also be easier for members to understand, because they focus the member on the final outcome rather than on shorter-term performance. They are also flexible and enable members to phase retirement by investing in more than one fund, or to change the retirement date by switching to a different fund.

Diversified growth
However, Webb also believes more can be done to increase diversification in DC default funds, specifically through the use of “diversified growth”. Rather than employing just active equities during the growth phase, diversified growth funds are run by managers who are able to allocate relatively heavily to alternative investments, such as hedge funds and commodities.

He continues: “We know that a lot of DC members are reluctant investors and that even those who are not reluctant can be somewhat cautious. Therefore, we feel that placing them into a DGF default fund automatically gives them the exposure to these higher-risk, yet higher-potential-return asset classes, which they wouldn’t ordinarily self-select.

“The market needs to look at these products and adopt them as the growth strategy within a lifestyle or default fund. I would expect that within the next two to three years we would see DGFs replacing traditional default funds.”

Ball explains that DGFs were originally developed for DB plans in the main, although they are equally applicable for DC.
He says: “For the first time really, members can gain access to a range of asset classes all bundled up in one fund, which gets away from all the liquidity issues.

“Admittedly, they are little bit more complicated to explain to members, because it is a combination of equities and an array of other products. But intellectually it is the right kind of product, because it will give the same kind of growth returns but will actually dampen down the volatility of those returns in a 100pc equity fund.

“So, they are right for a default fund, but care is needed to make sure they are properly communicated.”

Threadneedle Investments’ head of UK institutional Madeline Forrester agrees: “Very few DC investors have the skill or the inclination to invest directly in alternative asset classes, but if they are used within a fund structure, as part of an overall asset allocation strategy, run by professional investment managers, then DC investors can receive the benefit without having 100pc exposure to alternatives.

“This type of structure is one of the ways we are seeing innovation within the DC investment industry and there is a strong argument to ask why DC investors shouldn’t benefit from fund management techniques that have previously only been available to DB schemes?

“Many DB trustees have spent a lot of time, money and energy on selecting the right managers and techniques for their DB schemes, and welcome an opportunity to use these ideas within a fund suitable for DC members.”

As well as potential difficulties in explaining such arrangements to members, there are concerns relating to management fees. DGFs contain a number of specialist areas where management fees are typically high.

Forrester adds: “Allowing access to certain alternative investment vehicles clearly increases the cost of the overall fund.”

Total return
An alternative to diversified growth funds is the total return fund, which shares the ability to exploit alternative asset classes to increase diversification and reduce volatility. However, it also aims to deliver consistently positive returns relative to a cash benchmark, rather than a stock market index.

This means total return funds are potentially easier to convey conceptually to members, who can envisage a retirement outcome relative to something they understand – cash.

Ball says: “They are simple to understand from a member’s perspective. Clearly, if they are long way from retirement, they need to be taking risk, but are members comfortable with all that volatility?

“We would argue they are not risk-averse, but rather loss-averse; members think about the returns on their account not relative to some benchmark, but actually relative to cash. In other words, they want to know: ‘Is my account going up each year?’. That is not the same as: ‘Is my account performing greater than some composite equity benchmark?’ which they don’t understand.”

Total return funds can target, for example, cash plus 5pc per annum during an accumulation phase and cash plus 3pc per annum during a latter consolidation phase.

Ball continues: “If we tell them their fund is targeting cash plus 5pc, they can understand roughly what the rate of cash is, can add 5pc to it and for the first time get a good handle on what their fund is likely to return for them. So, I think it will get members more interested.”

Forrester agrees: “Total return funds aim to produce a decent level of return but with reduced volatility through allocation not only to the traditional asset classes of equities – bonds and cash, but also to alternative asset classes such as property, commodities, hedge funds and private equity.

“Given that DC investors generally dislike volatility, more particularly when prices are moving downwards, then a product that can offer increased stability of returns is likely to be welcomed.

“They give members increased focus on the end result of investing – that is, the pension they will receive when they retire. This is good news as most DC members have little idea of what they can expect to get in retirement or how much they have to save in order to achieve a decent income in retirement.

In defence of lifestyle
There certainly is evidence to suggest that traditional lifestyle strategies have their deficiencies. However, is it wise for trustees to migrate en masse to new alternative offerings in the market when they are very much untried products compared to the well-tested lifestyle model?

Legal & General Investment Management’s head of DC strategy Ian Richards is certainly cautious of the new pretenders to lifestyle’s throne.

He says: “While it is possible to put forward arguments for both target driven and total return funds, such funds still have to prove themselves over the longer-term.

“There is a danger with such funds that the cost of providing the inferred guarantees (which in practice they are not) will result in a lower return over the longer-term compared to the traditional lifestyle strategy. Members will have paid for short-term protection from volatility that they don’t need.

“The only issue with the traditional lifestyle is flexibility around the time when benefits are to be taken. The reality is that no-one can be certain what their requirements might be in five years, let alone 20 or more, in today’s fast-changing world. Whether you target an age or a date, there is every chance that it will not be appropriate.

“Provided that member’s monies move from more volatile equities to less volatile alternatives in the five year period before they might want to start taking benefits, trying to get greater precision does not seem to have much point.”

Richards also points out that the member apathy – the principal driver behind default funds – often subsides as individuals move closer to retirement and it becomes a more imminent concern.

He continues: “It is worth noting that when members start to approach retirement, they do want to start to engage. They are much more aware of what their requirements might be, and, provided that they are given appropriate communication sufficiently in advance, many of the problems of the current lifestyle could be overcome through members making individual choices.”