The DC Debate – improving retirement income
This quarter's debate sees experts discuss the gender gap, decumulation and illiquidity, as schemes strive to attain the best outcome for members close to retirement age.
What is the best defined contribution strategy that can be designed within a 0.75 per cent total expense ratio or annual management charge?
Laith Khalaf: A cap on either measure will restrict default fund design where administration costs are not paid by the employer. All but the biggest employers will find themselves without the option of an active default fund. There is nothing wrong with passive investment but it is important to have appropriate expectations: if a passive fund is working properly it will slightly underperform the index each year, because of charges. While these charges are small, over time they compound.
Giles Payne: Controlling expenses is important and increased fees do not necessarily bring increased returns. Trustees need to consider where active management can realistically add value and only use it in these areas. There are more alternative index solutions being developed so schemes could also consider these. A diversified portfolio of growth assets, including illiquid assets, is likely to provide the
best balance.
The risk of auto-enrolment is it creates a nation of pension zombies who do not know how much they are saving
Paul Bucksey: The best DC investment strategies are easy to understand and aim for long-term growth when each member’s human capital and risk capacity is highest, and then invest in a variety of assets to preserve capital as retirement approaches. The strategy will invest in a variety of assets and be managed dynamically. This can be done within a total expense ratio of 0.75 per cent, particularly if the majority of the underlying building blocks are managed passively.
Gail Philippart: The best default investment strategy is the one that is most appropriate for the majority of the members of the scheme. [You are looking for] something that balances risk and return appropriate for proximity to retirement. Within these charging limits it is possible for most arrangements to access both active and passive equity options, reasonable-quality diversified growth funds and annuity protection funds.
Stephen Bowles: We firmly believe it is possible to deliver a high quality multi-asset solution within either of these cost parameters. However, the implementation of an arbitrary charge cap could stifle investment innovation. The two-tier ‘comply or explain’ cap would allow scope for investment solutions that add value, but it remains to be seen how these would be monitored and who would determine the criteria by which schemes are judged.
Tim Banks: We offer flexible target date funds as the default investment strategy within the proposed overall price cap. The investment charge is often a very small proportion of the overall charge to members. One potential consequence of introducing a price cap is that poor quality investment default strategies will be locked in or become even worse over time. The investment performance for the money actually paid in is critical to achieving good outcomes.
There is a widening retirement gap between men and women. How can schemes help female members gain a decent retirement income?
Banks: There is clearly a need to help all members achieve a decent retirement income. At face value the evidence of a widening gap is clear, and we need further analysis to understand the key drivers for this. Once we have this we can debate what can be done looking specifically at the DC model. For the majority of retirees today retirement income is planned on the basis of couples and it will be important to understand these trends in the future.
Bucksey: Of course the introduction of auto-enrolment should lead to an increase in the number of women in UK pension schemes. The reality is that the earnings threshold means a significant number of women will not be auto-enrolled. Keeping the threshold level low would mean more women in workplace pension schemes. A good scheme will employ sophisticated but relevant and easy-to-use tools and encourage female members to use them to think about the type of retirement they want for themselves, where they are now, and the action they need to take to reach it.
Khalaf: The risk of auto-enrolment is it creates a nation of pension zombies, who do not know how much they are saving, or why. There is only so far you can go using inertia, beyond that you need to encourage workers to think about their savings, and make some decisions themselves.
Payne: Frequently the problem is due to career breaks and the associated break in contributions. The only way these contributions can be made up is through increased contributions at a later date. The employer is limited in what they can do beyond communication due to the requirement to treat people equally. Communication needs to draw attention to the ways in which members can increase contributions and the associated benefits of such increases.
Philippart: A combination of fragmented careers and lower levels of pay means many women simply do not have the spare income to save for a pension. Schemes should consider a relatively low starting contribution level. They should also consider paying employee contributions during maternity leave based on pre-maternity salary. Finally, they should ensure the scheme communication material resonates and is relevant to women.
Bowles: Schemes are really limited to increased or improved communication methods to raise awareness of the impact on pension provision of periods of missed contributions. It might be helpful if an easement in legislation permitted contributions to be made on behalf of a non-working partner. However, in most cases the absence from work means it is unlikely there would be the financial scope for additional contributions to be made even if this facility existed.
What is the best way to manage a DC member’s decumulation phase, limiting their losses and getting good performance up to retirement?
Banks: In designing and managing the default strategy it is important to understand the investment objective. What we do know is most members are unengaged, and that precise assumptions made on their behalf are likely to be wrong. In targeting income the manager should use a series of fixed income components that are proactively managed against the income objective.
Bucksey: It is important to give members an easy-to-understand description of how their investment journey is going to be managed, and they also need to be clear it works to a specific retirement date and if the date changes they need to inform their provider. A well-designed communications programme will keep this front of mind. Increased diversification, managed dynamically with a focus on capital preservation, will mean a member’s savings will be better protected against losses in the run-up to retirement.
Philippart: The key for me is engaging people at the right time. A scheme could have the best decumulation strategy but if people don’t use it or if their actual retirement date differs from the age they have selected, the positive impact of the design is potentially lost. Schemes have to understand when their members do retire, they move into funds that better match annuity prices and keep an eye on the future to see if alternatives are required, eg for drawdown.
Bowles: Members require real returns but these need to be balanced with appropriate risk levels at each stage. As the member’s pot grows during later years, measures need to be put in place to manage downside risk.
If this is done effectively then decumulation can be delayed to maximise growth potential. During decumulation the focus needs to be on protecting the member’s purchasing power against annuity rates through better matching assets.
Payne: A default approach is designed to meet the needs of an average member and is therefore not going to be the ideal solution for a proportion of the scheme members. For this reason, a switch from growth assets to a combination of fixed interest and index-linked assets is likely to meet the requirements of the majority of members. However, it is important to design a communications strategy that enables engaged members to consider requirements well in advance of retirement.
Khalaf: Scheme members have different attitudes to risk, can take their pension at any age from 55, and can do so using an increasing variety of options. Looking forward 10 or 20 years there will probably be even more options. A one-size-fits-all default strategy cannot cater for all of these different needs – that is an indisputable fact. Member communication and engagement is therefore essential.
How can DC members gain exposure to illiquid assets such as property and infrastructure?
Payne: These assets are particularly suitable to DC members. They provide a stream of income that can be very useful in planning during the decumulation phase. The problem is the illiquidity and large lot sizes. This means the most effective way to introduce them is in a pooled fund that has scale and contains a mix of liquid and illiquid investments.
Philippart: Many DC scheme members are already exposed to illiquid assets through DGFs. An expansion of investment is probably undesirable. These assets’ very nature means, at present, they will not see a huge inflow of money. If we consider pot-follows-member is due to be introduced next year, the nature of these assets could make DC arrangements, and the transfer of assets, much more complex.
Increased diversification will mean a member’s savings will be better protected against losses in the run-up to retirement
Bowles: No asset class should be off-limits for DC but how members access these assets is the question. DGFs are becoming more common and these allow relatively easy access to alternative assets for DC members, but care needs to be taken as more illiquid assets tend to come at a higher cost.
Bucksey: Putting contributions in is the easy bit; getting money out will be difficult if the fund has no liquidity and it needs to sell an asset to raise the cash. DC members considering investing into property need to be aware of the potential restrictions, although a DC property fund can minimise risk by investing in more than one property sub-fund.
Banks: A TDF construct naturally lends itself to the inclusion of illiquid assets, such as property, infrastructure or private equity. These can be easily included; the challenge is usually for the client to decide what a fair price is for members who trade daily in instruments that are not priced that frequently.
Khalaf: These assets are very difficult to access for funds that provide members with daily dealing. There are shortcuts, such as listed vehicles and real estate investment trusts, but these are much more correlated to equity markets and probably don’t achieve the diversification intended. Costs are also a big issue: over the past 20 years UK property has trebled in value, but the UK commercial property market has quintupled in value. The difference is down to the high costs of investing in this area.