When did the pensions industry become so preoccupied with costs in defined contribution (DC) pension schemes?
Not that long ago our focus was mainly on encouraging members to save more and invest in assets that targeted a pension. Then came along auto-enrolment in 2012 and with that default charge caps. Low cost became good cost, bringing the rise of so-called ‘cheaper' DC solutions that leaned heavily on passive management. By 2015, it was all about how we flexibly spend our retirement savings. We then arguably got a bit cost fixated and started focussing more and more on things that matter less and less, e.g. transaction costs at 0.001%.
There's now a closed consultation in Driving Value for Money in DC Pensions from the Financial Conduct Authority (FCA), The Department of Work and Pensions (DWP) and The Pensions Regulator (TPR). With three of the most powerful pension regulators coming together, it's an impressive display of how important this issue has now become.
There's an argument that larger DC pension schemes, such as master trusts, not only deliver good value, but in fact deliver the best value. Maybe they do, but how do we know if that's true? It depends on what you mean by good value.
Value versus values
Before deciding if a DC arrangement offers good value, we need to have some understanding of what values matter. This will vary by the member, the investor, the company, the trustees or the government via the regulator. For our purposes, let's assume it's the member and focus on their DC pension scheme perceived value and identify the primary values that define it.
Members typically don't use cost-related pension terms involving transactions, out of market exposure, market timing, gross performance, administration service fees, or any other language that is familiar in the finance sector.
We therefore need to bring it back to the language of the member. Consider the following phrase: "I'd value something more if it was better quality, lasted longer or looked good…"
A member's assessment of perceived value can be complex and maybe even irrational - think of reassuringly expensive beer - but let's assume there are three primary values in the above phrase that trump all others, namely quality, longevity and appeal.
This is somewhat of a departure from the traditional definitions of value and is also slightly at odds with the direction of travel of the value for money consultation. However, if we accept these for now, then a good value DC pension scheme becomes defined as an arrangement that rates highly on the primary values of quality, longevity and appeal. The key of course, is what are the minimum values a member will tolerate before they flip from good to poor value? Let's look at each of these values in turn and what might make them good.
When we think of quality it tends to be a value judgement based on our prior knowledge or experience. In other words, quality is a backward-looking value assessment.
Despite past performance being limited or no guide to the future, it does tell us something about the quality of our investment experience. Assessed over a variety of time periods and importantly net of all member costs and charges including all costs paid by an employer to the pensions scheme or provider, we can easily determine out or under performance relative to benchmarks and targets in addition to absolute performance.
There are a number of other activities that are frequently discussed in relation to driving quality in DC pension schemes, for example governance, trusteeship, committees such as investment governance committees (IGCs), administration, accounting, legal and other services. These are clearly a cost to the employer, but they boost member returns.
So for example, if the employer pays for administration services on behalf of the member of say 0.3% of assets then this will enhance their performance by 0.3% and vice versa. In some cases, the employer might also pick up investment manager fees to the benefit of the member.
Importantly, by reporting everything net of all member cost and charges including any costs met by the employer, it doesn't matter and the value that's added or detracted will simply be reflected in the quality of the overall investment performance.
Without overly complicating things, if the fully cost-loaded performance doesn't keep up with the consumer prices index (CPI) then the member is effectively losing money and subsequently getting poor quality.
There is no hard science behind setting long-term performance targets, or if there is they tend to be quite complicated. So, to illustrate the point, the following might help with understanding, even if the actual numbers and timeframes may need finessed:
Where relative performance (RP) - absolute difference might also work, but either is fine - is net of all member costs and charges including costs paid by the employer over, say a three, five or ten year period. Consistency is what matters.
Longevity is a more forward-looking value. It's what underscores the long-term nature of pension saving. For most people, their pension needs to last a lifetime.
When we think about long term in pension schemes, we generally focus on investment strategies. We know these strategies can vary from one default to another in line with specific pension scheme investment objectives, possibly designed with the membership in mind.
Should investment objectives and associated strategies be compared across pension schemes in the pursuit of good value? It just doesn't make sense, given there are too many variables and differences in approach.
Far better is to consider what actions the trustees or providers have taken to support good value in the future. A sustainable future that is increasingly influenced by social, planetary and climate concerns.
Good long-term value can be measured by considering immediate or in-plan interventions aimed at making the DC pension scheme ready for a sustainable future; including for example, evidence of improvement of their ESG credentials, measurement or reporting of climate metrics, credible transition plan to reduce CO2, actions on diversity, impact investments that are impactful, investment in ‘long-term' illiquid assets like venture capital and private equity or debt, ESG ratings of asset managers, stewardship of the assets and evidence of voting, documented natural capital policies etc.
Creating long-term value is not a tick the box exercise. It's about delivering sustainable outcomes for the member they will gain value from now and for many years to come.
Pension schemes with appeal does sound a bit like an oxymoron for many, and yet trustees and pension providers have invested significantly in platforms, websites and communications in order to improve the members' pension experience. They believe that look and feel is of value when it comes to engagement with members.
Quantifying what appeals is challenging, but there are a number of factors that are worth considering; including but not limited to, is it easy to interact and transact, are communications getting good engagement scores, are queries being answered on time, how many hits does the pensions website get and action taken, is there evidence of positive action by members following a communication campaign, are diverse groups being catered for, are all members taking matched contributions, what percentage of members don't have an expression of wish, is there subsidised advice etc.
Whatever approach is taken, members really value the personal touch and being able to feel well supported in a complex and confusing subject.
What about value for money?
It's not entirely obvious that value for money assessments comparing costs or critically reviewing past performance league tables will actually create good long-term value. History tells us it's much more likely to create benchmark herding and a drive to low cost is best cost.
Value for money is the backward-looking language of cost-focussed decision making and it's been debated at length for a reason. It's muddled, vague and confusing.
Unless we change the language back to what matters, we risk stifling innovation, targeting average outcomes and creating a world that only pays lip service to long-term sustainable goals.
A change for good
By concentrating on the primary values of quality, longevity and appeal we can determine if good value is being delivered for any DC pension scheme regardless of size, type or membership.
It's time to tackle the ambiguity, the nuances and the noise, instead let's make a bold statement, a DC pension scheme is either good value or it's not. It's time to change the narrative.
It's time to focus on sustainable pensions, people and value, not costs.
Brian Henderson is head of sustainable investments for UK, Europe & IMETA (India, the Middle East, Turkey and Africa) at Mercer