The PPI has unveiled a policy paper outlining current considerations and policy debates relevant to DC scheme default strategies. Kim Kaveh explores some of its views.
As the majority of defined contribution (DC) members are saving into their scheme's default fund, trustee and provider decisions on how to structure these strategies will have a significant impact on outcomes.
According to the Pensions Policy Institute's (PPI) second of two briefing notes on DC scheme default strategies - unveiled earlier this month - since Freedom and Choice in 2015 and the surge in new savers who have been automatically enrolled - the considerations which need to be taken into account when constructing default strategies have changed.
The paper outlines that some strategies such as investing in illiquid and alternative assets could benefit default strategies. According to the PPI, "Illiquid and alternative assets generally provide a more stable rate of return, higher than those earned from bonds but generally lower than equities in the short term".
The report explains that DC contributions invested in these assets will not require the same level of de-risking in order to preserve capital, because illiquid assets and alternatives are less volatile than equities. Though, some level of de-risking may still be necessary for those who wish to start drawing an income from their pension savings.
Indeed, the Department for Work and Pensions (DWP) published a consultation last month putting forward a range of proposals that aim to expand defined contribution (DC) investment opportunities, which includes making it easier for schemes to invest in illiquid assets.
However, although these types of assets are likely to become more accessible to DC schemes, the proportion of funds which schemes can afford to invest in will generally be limited. As the PPI points out, this is because "schemes need to preserve a large proportion of liquid capital to fund daily costs and transfers/withdrawals out".
Meanwhile, another approach to meeting the varying needs of DC members could be by offering different strategies based on people's intended withdrawal methods.
For example, reductions in annuity purchases since the pension freedoms mean that lifestyling may no longer be the most appropriate default strategy for the average member.
The paper notes that for those who wish to reinvest DC savings into a drawdown product or another investment vehicle, a lifestyle strategy could result in missing out on returns which they would have otherwise been able to benefit from if their contributions had remained in more volatile assets.
Furthermore, retirement pathways could play an important role in default strategies. The use of these pathways are being considered to help people who cannot, or do not want to, make an active choice about accessing DC savings.
However, default pathways which are able to adapt to unexpected changes in needs during retirement may be tricky to design, the PPI says.
"Designing a default which can cope with multiple pots will be challenging". It adds: "Those with multiple pension pots also pose a design challenge to prevent different pots belonging to a single person being enrolled into conflicting retirement pathways."
It comes as The Financial Conduct Authority called for drawdown investment pathways to boost outcomes in its Retirement Outcomes Review, while the Pensions and Lifetime Savings Association's Hitting the Target report set out a blueprint for retirement income targets.
The PPI is also supportive of DC scheme consolidation, as it could "reduce charges and increase the accessibility of illiquid assets for default strategies". This is in line with the DWP's expectations set out in its consultation on investment innovation.
According to the PPI's report, consolidation could reduce administrative and/or investment costs and improve governance and practices on a scheme and funding level. It also notes that "smaller schemes are generally associated with poorer governance, higher charges and risk, and generally have less capacity to diversify portfolios".
However, consolidation reduces a scheme's ability to cater to the needs of a distinct membership group, the PPI says.
DC master trusts have been applying to The Pensions Regulator to be authorised, as part of a regime which kicked off last October. While some schemes have consolidated, it will not become apparent how many master trusts there will be in total until the regulator announces all those that have been authorised later on this year. If a master trust does not apply, or is not authorised, it will have to wind up and transfer its members to an authorised scheme. The deadline for authorisation is 31 March but it has granted extensions to some master trusts.
Environmental, social and governance (ESG) factors can also affect risk and returns. DC schemes that do not integrate ESG factors into their default strategy could face higher costs, legal difficulties and reduced returns, though consideration of ESG factors could involve increased implementation and assessment costs. It may also result in more long-term secure returns for investors, the report noted.
In September 2018, the DWP introduced regulations which require trustees to consider ESG factors as part of their investment processes, following a consultation in June. Meanwhile the FCA will, in the first quarter of this year, consult on a package of changes for independent governance committees, including reporting on stewardship and evaluation of ESG considerations such as climate change.
It is clear that having the right default strategy is essential to boost retirement pots for members. Nonetheless, challenges remain. It will be interesting to see how default strategies evolve, and how much consolidation will occur among master trusts.
Phoenix Group will launch an ESG defined contribution (DC) default solution for pension fund clients of its Standard Life Assurance business and their scheme members.
Newton’s Curt Custard considers the investment outlook for 2021 and the implications for DC schemes
Master trusts’ investment strategies have grown and become more sophisticated over the last three years, but “growing pains” are hindering progress, according to the Defined Contribution Investment Forum (DCIF).
More than half of BlackRock’s flagship UK defined contribution (DC) default fund’s assets will be invested in ESG strategies by June 2021.