Last year Tesco replaced its DB scheme with a low cost DC arrangement targeting investment strategies that push the boundaries of typical DC funds. Stephanie Baxter explores why the award-winning scheme breaks the mould.
At a glance
- Tesco created a low cost, sophisticated DC scheme to replace DB
- It adopted a diversified default strategy while optimising net risk adjusted outcomes
- Monitoring the experience of members will be crucial to its development and success
Too often when defined benefit schemes (DB) are closed down, employers replace them with a bog standard defined contribution (DC) offering, further widening the gap between older and younger generations.
However, Tesco has gone against the grain after it hit the headlines last year when revealing plans to replace its career average DB scheme with DC to save on costs.
After increasing matching employer contributions to 7.5% following backlash from staff and unions, it developed a sophisticated, low-cost investment strategy to help members get the best possible retirement outcomes.
Not even a year old since launching last November, the Tesco Retirement Savings Plan has already won a string of awards this year, notably DC Scheme of the Year at PP's Scheme of the Year Awards.
A different approach
The supermarket's group pensions director Ruston Smith says the starting point was to understand people's needs throughout the whole of their journey as a plan member.
"Colleagues wanted flexibility to change the amount they saved and a suitable long-term investment strategy to provide adequate savings for their retirement.
"So our priority was to create a simple retirement savings plan, that our colleagues understood, provided flexibility and choice around contributions, with an intelligent diversified default investment strategy aiming to optimise net risk adjusted outcomes. While some people may like to make choices, many are too busy or not confident enough to do so."
The scheme is split into three different stages (see boxout at end of article). 'Far to go' is for employees more than 15 years away from retirement, 'Middle distance' for those with between five and 15 years to go and 'Nearly there' for those less than five years away.
For each point in the lifecycle where member tolerance for risk was assumed, the aim was to optimise, which is to get the best return for the lowest fee at that point.
"Some plans' main focus may be on low charges; however, we thought about outcomes net of charges," says Smith. "It's incredibly important to think about the level of charges, as part of value for money. But we wanted to be pragmatic and think about what's really important for members - and consider more expensive asset classes where they could improve members' net outcomes."
It wanted to embrace investment strategies that were pushing the boundaries of typical DC schemes. This involved looking at alternative assets, including active strategies, but only if they genuinely improved the expected return for the given level of risk after fees.
Putting sophisticated strategies into DC is very challenging within the 0.75% default fund charge cap that came into force last April.
"We aimed to optimise the investment strategy by modelling it, and for each asset class, considering its contribution to return, its contribution to risk reduction, and the drag on charges," says Smith.
"Through that process you then either increase or decrease that allocation for each individual asset class within the default asset allocation. We then back tested the strategy through three decades - as well as forward testing it."
The result is a grown-up, low-cost investment strategy. Charges paid by members are just under 29 basis points including administration - which is very competitive particularly considering the wide range of assets in which the scheme invests.
For example, independent testing showed the 'Far to go' phase significantly outperforms a typical approach using passive equity and bonds, delivering a 25% improvement in net risk-adjusted outcomes. This stage has 70% equity-based exposure, and 30% in a diversification fund, which invests in growth assets such as infrastructure equity, private equity, property, and some high-returning assets in high yield and emerging market (EM) debt.
Hymans Robertson head of DC Mark Jaffray, who helped design the scheme, says they explored how to include illiquid assets to get diversification.
"We looked at whether we could get genuine illiquid unlisted alternatives into the portfolio, or listed proxies such as infrastructure shares. There is no point having them if they have the same properties as equities; they have to give true diversification. We found listed infrastructure doesn't give the same diversification as unlisted, but it does give some.
"When we looked at infrastructure indices we found there were some genuine diversification benefits from looking at those portfolios. But the intention is to at some point replace the listed vehicles with genuine illiquid vehicles - which will be step two of the process."
The scheme will look very closely at the investment strategy to identify any further opportunities, while acknowledging investments are long term, to see how it can be further optimised.
Monitoring member experience
For Smith, an important part is monitoring the actual experience of members. This is carried out by the Retirement Savings Plan Governance Committee to look through the lens of a member.
He explains: "We not only monitor how individual members' savings, in each phase of our lifestyle, change between quarters ('what they see') and monitor key messages from our helpline ('what they say'), we also monitor representative members' outcomes as they progress against 'expected' future outcomes within a range of risk parameters.
"This helps us answer the question, 'are those savings being invested and behaving in the way you'd expect?' Because if they're not it gives us the opportunity to look at what's fundamentally changed and take any action that may be necessary."
The feedback from the helpline teams can help it to have a more holistic view in supporting members.
Smith, whose best known phrase was 'junk the jargon' as chairman of the National Association of Pension Funds before stepping down last year, has put this at the very heart of the scheme's communications strategy.
"People don't always understand jargon - like DC - which is why we refer to the plan as 'your Retirement Savings Plan'. We also try to explain the real cost of their retirement savings.
"For example, for someone paying a contribution of £100 through our salary sacrifice arrangement, we simply explain how the members' take home pay reduces by £68 net cost while tax and national insurance savings, with Tesco's matching contribution, means £200 in total is paid into their savings plan."
Tesco made a series of short videos of three minutes or less on key questions members might ask such as 'why should I save' and 'how much do I save?', using the type of language employees would typically use.
This followed a realisation that while people value having a website with information because it is a point of reference, they are not always keen to use it as the main communication tool.
"This is because it takes time to read, digest and understand the information. Some found it more useful to watch a quick video or pick up the phone. Colleagues also say they value the ability to sit down and have a conversation, particularly those over the age of 50," says Smith.
"We had really good feedback to all our videos, particularly one explaining the state pension and how it changed from April."
While still early days as the scheme approaches its first birthday, it is clear much has already been achieved in a very short time.
Smith says: "We've had a really good response so far from our colleagues, with over 14,000 more colleagues saving for retirement than were saving in the DB scheme before it closed."
Tesco is a good example of why DB does not always have to be replaced with a bog standard DC arrangement. With enough thought and effort, it proves how DC can have a low cost but sophisticated investment strategy to ensure members get a good retirement outcome.
Tesco's three default phases
1) Far to go (more than 15 years from retirement)
Strategy: 70% equity-based exposure with 30% to a diversification fund which invests in growth assets such as infrastructure equity, private equity, property, and some high returning assets in high yield and emerging debt.
2) Middle distance (5-15 years from retirement)
Strategy: 50% exposure to equity, 30% to the diversified fund, and 20% to corporate bonds. Tesco looked at various ways of bringing the risk down by around a third to two thirds of the equity market risk. To achieve this, it looked at diversified growth funds and more alternative assets, but found the cheapest and easiest way was having 20% allocation to corporate bonds, which kept the fee low.
3) Nearly there (less than five years from retirement)
Strategy: 65% cash, 15% equities, and 20% bonds. Given the expectation that most members will take money as cash, certainly in the short term, the default is the cash option, but that will evolve over time. A drawdown option is available for higher earners, and also one that targets annuities and regular income.
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