Industry Voice: Improving value in workplace DC pension schemes

clock • 4 min read
Industry Voice: Improving value in workplace DC pension schemes

Delivering good retirement outcomes for workplace defined contribution (DC) members might not necessarily correspond to the cheapest option.

A key component in value is offering properly diversified investments.

If you compare the Local Government Pension Scheme (LGPS) and workplace DC schemes, both are funded UK occupational pension schemes with high numbers of active members but there is noticeable difference between their invested assets.

Look at the range of funds offered by an LGPS pool such as Border to Coast and you will find both passive and active equity funds, corporate credit as well as a range of alternatives such as private equity and debt as well as infrastructure and real estate.

In contrast, a typical workplace DC scheme has a high proportion of passive equity and not much else.

A report commissioned by the Defined Contribution Investment Forum in 2017 explained the problem: "As principal defaults are the lowest-cost investment option, they are mainly invested in passive, market-capitalisation-weighted indices, even when more diversified."

Cost competition

To understand the reason for this divergence, let's take a closer look at how auto-enrolled pensions were developed.

When the Pension Commission built auto-enrolment policy, there was a concern smaller companies would struggle to find companies interested in providing workplace pensions as these organisations would struggle to make sufficient margin.

To combat this, a government-backed pension scheme - the National Employment Savings Trust - was developed to provide pensions for this segment of the market.

While Nest provides a valuable service - particularly to micro-employees - the Pension Commission failed to realise how attractive a business proposition mandated occupational pensions would become for insurance companies and master trusts.

Since the introduction of auto-enrolment in 2012, there has been a race to win market share among pension providers. The charge cap on default funds meant scale was the way to make this business profitable.

But while the charge cap might have put the focus on investment management expenses, it has been the race for market share which made cost the metric to beat.

As the Productive Working Finance Group said in its recent report: "Too often, charges are taken as a proxy for value with scheme selection decisions turning on a handful of basis points."

With pension schemes having to also include administrative expenses in their headline costs, this led to very low investment management budgets of only around 10-15 basis points.

With hardly any investment budget, investment universes have become highly constrained, resulting in an over-reliance on passive equities - the cheapest investment product available.

Long-term value

This cost constraint has raised concerns about whether DC pension schemes are sufficiently focused on creating long-term value. An over-reliance on passive equities can cause too much volatility due to a lack of diversification.

While a few larger master trusts - in particular Nest - have bucked the trend and built a diversified portfolio for their target date funds few others have done the same.

As the Productive Working Finance Group said in its recent report: "Trustees also act within a market context that has come to focus overly on charges, which limits trustees' freedom of action when they use their investment powers."

The report aims to help pension schemes to make a shift from cost to value and emphasises the role different stakeholders need to play in that journey.

For trustees, this means taking the time to understand whether a less liquid investment approach could be a valuable addition to the overall investment strategy of a default scheme.

An employer needs to shift their focus to understand value is about delivering good retirement outcomes for their employees which might not necessarily correspond to the cheapest option.

Pension providers, consultants and advisers need to ensure the impact of different approaches on long-term member outcomes is understood by key decision makers, the report adds.

The report also says it is important to understand members' investment time horizons are often more than 20 years.

"A long-term mindset can support greater appreciation of different potential sources of long-term returns, and opportunities to contribute to a more sustainable world through investment in climate solutions, or those opportunities addressing social needs," it adds.

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Issued by Franklin Templeton Investment Management Limited (FTIML). Registered office: Cannon Place, 78 Cannon Street, London EC4N 6HL. FTIML is authorised and regulated by the Financial Conduct Authority.

Investments entail risks, the value of investments can go down as well as up and investors should be aware they might not get back the full value invested.

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