The DC Debate – ensuring value for new savers in 2014

How can DC default strategies be set up to maximise growth?

Richard Butcher: DC default strategies must be appropriate for that population of members. By appropriate I mean they must be research-based, ie you need to know about the member, and have an intent – what are you trying to achieve? For that reason, a strategy may not be about out-and-out growth. It may be about consolidation and protection. It may be about achieving a particular rate of return in order to achieve a specific end goal.

Nigel Aston: Success is not necessarily measured by maximum growth achieved. Trying to shoot the lights out leads to considerable variation in what different members receive. A lucky few get the ‘lottery win’, but many will be at the opposite end of the distribution. Similarly, scheme sponsors and trustees desire consistency; maintaining a high-median, risk-adjusted net return, while compressing the range of outcomes, is good for everyone. To achieve this you need to be in the right asset classes at the right time, therefore the full universe of exposures should be accessible.

Andrew Dickson: It is not enough simply to maximise growth for members – we must at the same time seek to manage investment risk effectively. This is vitally important for DC members who, unlike their defined benefit counterparts, bear all of the investment risk. The importance of genuine diversification as an effective way of providing lower-risk growth cannot be overemphasised. Efforts to diversify must go beyond simple reliance on equities, bonds and real estate, all of which depend on economic growth.

Tim Banks: The critical role in relation to the DC default strategy is in determining the investment objective. Clients generally seek to maximise returns within the identified risk budget, with risk usually defined in relation to the remaining investment horizon. This is usually expressed as a glide path, against which the strategy is managed.

Ian McQuade: An effective DC default strategy should be designed to work for the vast majority of members in a scheme. In diverse organisations, that might mean multiple defaults are required to meet members’ needs. The default should aim to help a member grow their DC pot over the period that they are a member of the scheme, and protect the pension buying power of the pot in the run up to retirement. This may not maximise the growth, but should actually provide a better risk-adjusted outcome and more predictability. What actual asset class or strategy is used will depend on the scheme’s governance appetite and budget.

If 2014 ends with good asset performance and low volatility, what would have been the best approach to risk management?

Banks: The DC investment default strategy should be proactively managed to maximise returns within the defined risk budget. Trustees and plan sponsors want both the strategic and tactical asset allocation managed within their parameters. It is important to control volatility while maintaining broad market exposure aimed at meeting the performance target.

Butcher: It is always possible to determine the perfect investment strategy with the benefit of hindsight and, regrettably, it is usually in short supply until it is too late. That said, investment risk is only absolutely a negative at the point of payment, or close to it – in orther words, risk can only be measured relative to something. Those that can be managed include concentration, cost and manager risk.

McQuade: Hindsight is a wonderful thing. If we knew how 2014 was going to develop, we would invest in the highest performing asset class. Investing needs to have a longer-term focus depending on the age of the member, their appetite for risk and their short-term plans. Someone early in their career should be looking for long-term growth, whereas someone approaching retirement needs to manage the annuity risk that is likely to be more immediate.

Aston: While guiding workplace savers to a good retirement savings destination is essential, we also need to manage the savings journey. Our primary research leads us strongly to believe that members hate seeing large losses and sometimes react negatively. We aim for more predictability. This gives members the freedom to concentrate on the inputs they feel comfortable with – deciding how much to save and for how long.

Barry Parr: In the recovery we can expect a faster pace of change – in corporate growth and investment, production meeting capacity constraints, and consumption. Inflation, interest rate and currency exchange rates will likely all exhibit unequal rates of change across geographies and asset classes. Therefore it is likely that our DC funds will respond to an increased rate of investment adjustment – that is dynamic management.

Dickson: An active manager will continually assess economic and market developments and aim to position the fund accordingly. However, trying to predict market behaviour over the short term is hazardous – managers risk being distracted by short-term market volatility, which can cost dearly in performance. Taking a longer-term view allows the manager to benefit from market inefficiencies.

How can members be encouraged to give more than the minimum?

Aston: The biggest challenge for the pensions industry and DC is not the construct itself, but the lower saving levels compared with DB. Our research indicates that people may be happy to save at a higher level than we usually give them credit for. However, what they need is help. This can come from their employer, from powerful communication and engagement methods or from features such as auto-escalation.

Dickson: Ideally, all employees should be encouraged to pay higher contributions but in reality many cannot afford to do so. This makes it all the more imperative that their pension savings are invested well. Only through delivering good and consistent investment performance can we expect to promote member confidence and engagement, and give greater credence to calls for minimum contributions to rise.

Parr: With the amount of work needed to absorb auto-enrolment it is rational that government should not pursue more changes concurrently. It is near certain that minimum rates will not deliver an adequate outcome. So yes, employees should be encouraged to contribute above the minimum, but aided by a range of employer-led initiatives.

Banks: It is clear that individuals in DC schemes will need to contribute more, but we agree that the immediate imperative is to get people to commence saving. We expect to see lots of innovation in how to get the adequacy message across, and expect that contributions will rise over time on either a ‘push’ or ‘pull’ basis.

McQuade: Educating members on the link between the level of contributions being paid into the scheme and the expected outcome needs to continue. For many established schemes this process is already in place, and showing the impact of paying additional contributions – especially where the structure includes employer matching – is making a difference. For new schemes and members there is a lot more to do.

Butcher: Many low-paid employees will receive a high proportion of their retirement income from the state and so may not need to contribute more. Others may not be able to afford more, no matter what we think. Good governance is partly about providing an environment where members can make informed decisions.

What can be done to ensure members get good value at retirement?

Parr: It is already clear that members should be informed about the open market option and also impaired health annuities – and increasingly this appears to be the norm. The sponsor or scheme may consider covering the cost of annuity broker quotes.

Dickson: Employers and schemes can best serve their members by delivering as large a pension pot as possible, through steady, solid investment growth. During retirement itself, investment managers can make a valuable contribution in managing wealth. Products are needed that can provide a dependable source of regular income, while also preserving capital in real terms.

Aston: People desire the absolute security an annuity delivers, but also want the liquidity and flexibility that drawdown provides. It is an outcome that is just not possible, but that does not mean we cannot consider products that take something from both worlds. Instead of offering a binary choice, the new generation of schemes we envisage will transition people from saving to flexible retirement income in an intuitive way.

Banks: The question needs to be asked whether a member should be rushed into buying an annuity – which will typically be written on a non-redeemable single-life level basis – at such an early age. They are buying insurance they do not need and would not want if they were fully aware of both the risks and the alternatives.

Butcher: The annuity market is dysfunctional because there is too little choice and not enough competition. The industry, policymakers and regulators need to encourage innovation to find new ways of paying income through retirement. Schemes can help by encouraging advice, actively promoting the open market option and making sure members are aware of products such as impaired life annuities.

McQuade: All retiring members should be given information about the main options available to them, including drawdown and annuitisation. Those who wish to annuitise should receive information that allows them to look at the whole market, and to consider whether they might be eligible for an impaired life annuity, so as to ensure they maximise their income in retirement.