Massive market volatility has given investors a hair-raising ride over the past year and as yet there is no end in sight.
Massive market volatility has given investors a hair-raising ride over the past year and as yet there is no end in sight. This is particularly true for members of defined contribution (DC) and 401(k) schemes that have seen their fund values plummet in recent months. How people react to these stock market movements could have long term implications on the value of their fund. If people panic we could see a wholesale movement towards the safety of assets like cash which could result in people crystallising their losses. We could also see people choosing to slash pension contributions or even decide against saving into a pension scheme at all. Whatever happens scheme managers, trustees and providers will have to brace themselves over the coming months.
So far it would seem that while people are undoubtedly worried about the state of their pensions they haven’t yet started to panic. According to David Hodges, distribution director at Zurich Corporate Pensions many DC members in the UK remain “philosophical” about the situation and are taking the long term view. This is backed up by recent US research by Dr. Shlomo Benartzi, professor and co-chair of the Behavioural Decision Making Group at The Anderson School of UCLA. According to the research participation rates in 401(k) actually increased over the past year. At the end of 2007 they averaged 71.4% but had drifted up to 74% by the end of October 2008.
However, this veneer of calm could be shattered when annual benefit statements are issued over the coming weeks. While people can remain calm when speculating about losses how will they react when they see the cold hard facts set out in their benefit statements?
“It’s fair to say that when statements reach members there will be a shocked reaction to the fall in fund values. The FTSE was down 33% at year end so people are seeing real damage being done to their funds,” said David McCourt, policy adviser, investment and governance at the National Association of Pension Funds (NAPF) in the UK. “While those with some time to go before retirement still have time to make up their losses what about those who only have a couple of years? I think those coming up to retirement will have to look seriously at either delaying retirement or else working part time.”
When the facts have sunk in scheme managers will have to prepare themselves for a deluge of calls from members desperate for more information on their funds and it is important that managers are able to answer these questions in a reassuring way.
“Scheme managers are going to be inundated with queries about falling fund values and it is important that they reassure their members,” said Mark Rowlands, head of corporate partnerships at AXA. “People need to know how solid their pension scheme is and are asking for more information about the stability of providers and exactly what their investments comprise. As a result the most important thing the manager can do is be proactive in their communication strategies and give members regular updates.”
This move towards gaining more information has already started with Zurich’s Hodges reporting a big increase in UK DC members using the internet for more information.
“In terms of internet usage we have seen a 20% rise in the number of people going online for information when you compare the last three months of 2007 and 2008,” he said. “I think this demonstrates people’s interest has been dramatically heightened.”
Calls into T.Rowe Price US participant service centres increased an average of 30% in October, with an increase of 60% on October 11th following the previous day’s significant volatility according to Todd Ruppert, president and CEO of T. Rowe Price Global Investment Services.
However, while the need for information is dramatically heightened Ruppert is quick to say that people are not making rash decisions.
“Although phone assistance and web activity grew during the height of the volatility, most participants were only asking for guidance and not cashing out their retirement funds,” he said. “A majority of the questions were, “How do I invest my money more safely?” and “Are my 401(k) investments insured?” As a result of helping participants make more informed and thoughtful decisions, 97% of participants did not make any change at all to their accounts. Less than 2% of assets moved and those that did shifted to more conservative options.”
Martin Palmer, head of corporate pensions marketing, Friends Provident agreed that there had been no significant increase in switching but said it was the result of members not knowing where to invest. “Where can people invest seeing as all asset classes are doing badly,” he said. “The big issue is to get the information out to people to ensure they don’t make any rash investment decisions. They need to think about if they are in the right fund but they also need to take a long term view and look at the effects of pound/cost averaging for instance. People need reassurance and we may see a growth in the use of lifestyle and target dated funds which can provide this.”
While we are not seeing any significant amount of fund switching we are seeing a huge decrease in the amount of money people are saving. According to Hodges many members are choosing to make significant reductions to pension contributions as they cope with rising fuel bills and paying off debt.
“When comparing the final six months of 2007 and 2008 we saw the number of people looking to reduce contributions by at least 25% grow from 7% to 12.1%,” he said.
This is backed up by Benartzi’s report which also reported that savings rates into 401(k) plans had dropped from a peak of 8.14% at the end of 2007 to 7.76% by the end of October 2008. However, the report pointed out that this decline could also be due to the increased popularity of auto enrolment plans which often have default rates of 3%.
So as people allocate less money to their DC and 401(k) plans they will need to work much harder if they are to provide people with a decent income in retirement. This means that extra attention needs to be paid to the make-up of the default fund going forward.
“We have to accept that the vast majority of people are never going to be engaged enough to make their own investment decisions so we need to have really good default funds,” said AXA’s Rowlands. “The scheme needs to do its best to look after the interests of its members. It tends to be the case that the more you leave to the individual then the more likely it is that inappropriate decisions will be made and I think we will see huge innovation in scheme design in the next 18 months.”
In recent years, the “lifestyle” approach has been popular, particularly in the UK. This approach automatically moves a client’s asset allocation from equities to bonds the closer they come to retirement. This approach enables clients to gain from being largely invested in equities in the early part of their working life but then protect their fund values by moving into bonds later on.
However, the lifestyling approach has received its fair share of criticism with Julian Webb, executive director of DC business development at Fidelity International highlighting the need for a different approach. Webb advocates the use of target dated funds. These funds also aim to routinely rebalance a member’s portfolio as they approach retirement. However, this rebalancing is done at the investment manager’s discretion rather than automatically.
“In the main lifestyling products are not good,” he said. “This is because they are automated programmes that automatically move a client’s portfolio according to their age. However, this doesn’t take into account anything about the client’s circumstances. We advocate the use of target dated funds which use the manager’s discretion when changing asset allocation. They also have diversification built in. Target dated funds are used widely in the US and we already have one for retail customers in the UK. However, it is an idea that we are looking to expand on for our DC offering.”
David Harris, managing director of TOR Financial Consulting, also advocated the target date fund approach describing it at “almost a plug and play approach.”
“The issues we are having with some people are that they are getting to within two years of retirement and finding out their pot has plunged by 30%,” he said. “This shouldn’t happen with target dated funds as they carry out a structured rebalancing of funds so by the time you are two years from retirement you are likely to be largely invested in bonds.”
So as the DC market prepares itself to cope with the current financial crisis it is important to keep members informed of any changes that may occur. Keeping messages regular, clear and simple will be key in reassuring members and keeping them engaged with their pension plans whatever the circumstances.
“Times of high market volatility are stressful for participants. Plan sponsors should work to control emotions and not fuel panic,” said Ruppert. Plan sponsors should reinforce a “stay the course” message with participants. Plan sponsors should also work with providers to keep participants informed so that they can make thoughtful decisions based on facts not fears.”
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