Tim Banks of AllianceBernstein Defined Contribution Investments looks at the changes facing DC schemes and discusses how best to tackle them
Anyone who remains to be convinced that defined contribution (DC) is the new normal in occupational pensions should look at the recent 2009 Occupational Pension Schemes Survey issued by the Office for National Statistics.
This confirmed that active members of DC schemes are now in rough balance with active members of defined benefit schemes – and the latter are falling fast. Little wonder then that both government and regulators are increasingly fixing their gaze on this area of the market.
Some of the most far-reaching changes that DC providers need to face up to are the forthcoming relaxation of the compulsory annuitisation rules and the launch of NEST, the national workplace scheme. This changing landscape offers an enormous challenge to existing DC schemes. But it also offers a huge opportunity to make workplace pension schemes much more attractive to a membership which is often disengaged from the process.
Positive change
The key to embracing this new environment will be flexibility. Any DC scheme that is fit for purpose must first and foremost be able to cope with the inevitable changes which the industry constantly faces. It should also be able to adapt to the needs of its members as they age, without exposing them to unnecessary risks or upheaval. And of course, it should not put too much burden on the scheme sponsor, whether in terms of costs, risks, or management time.
In terms of investment options, we believe this means building flexibility into the design of a scheme’s default fund and then delegating day-to-day implementation of the agreed asset allocation to a professional asset manager. Lifestyle funds are clearly one way to go. They sensibly take the responsibility of adjusting the asset allocation of pension pots away from a typically unengaged and unprepared membership.
However, we think there is significant room for improvement. Often investments are overly concentrated in a particular asset class or fund manager, which exposes members to unnecessary risk. We believe it is important to spread those risks, both among different asset classes and among a range of managers. Where the expertise is available, the long-term asset allocation should be dynamically managed at the overall default fund level to reduce volatility and “smooth the ride” for members.
But we also think that some schemes can go further. Lifestyle approaches may be good at reducing risks immediately before retirement, but they are often less able to manage the investment opportunity at earlier stages in a member’s life. And because the asset allocation changes are often effected through a number of funds held directly by the individual, they can be inflexible in their operation. Thus, they are end-point sensitive, tending to be designed around the aim of buying an annuity on a fixed date. This may lock the member into an unsuitable asset allocation.
A target date approach, where all the asset allocation changes take place within a single fund, offers much more flexibility. All the member sees in his or her pension account is their ownership of that one fund. This permits the use of age-appropriate diversified growth funds that progressively de-risk through time, using a combination of best-in-class fund managers (see display).
Changes to the underlying structure, asset allocation or managers and administrators can be made seamlessly and at low cost. By contrast, we are aware of many relatively minor lifestyle fund changes that have taken over 12 months to achieve. A flexible target date structure can achieve this in days at a fraction of the cost. This offers huge savings in terms of money, administration and risks while allowing much easier communication with the individual.
Just as crucially, the flexible target date construct makes it much easier to change the strategic asset allocation across the entire range of funds as the environment changes. In the future, the ability to be nimble and take advantage of opportunities will be more important than ever in helping members achieve optimal outcomes. That same flexibility allows the member to adjust more easily to changes in their expected retirement date or retirement income.
What will make this a compelling proposition for members is if, as well as cutting long-term risks, year-by-year volatility can also be reduced. Here, we believe the ideal is a target date approach overseen by a manager who not only takes responsibility for the tactical asset allocation, but is also able to dynamically manage it to achieve the best outcomes.
The result should be similar returns with less risk for both member and provider and a more robust default, with the flexibility to take change in its stride. It is why we have just broadened our range of open-architecture bespoke and packaged DC default funds, which are now designed to be flexible enough to meet the needs of any client.
Tim Banks, director, sales and client relations, AllianceBernstein Defined Contribution Investments
