L&Q segments DC scheme to hone outcomes

DC schemes have been urged to put greater focus on members’ retirement outcomes by the Pensions Regulator as well as interventions from the government and, most recently, the Office of Fair Trading.

L&Q decided last year to begin a review of its £12m DC scheme, segmenting its membership into quartiles based on earnings, and calculating their likely future pension incomes.

“We found that different quartiles were in different places relative to their replacement income ratio,” said Richard Butcher, independent chair of the trustee board, and managing director at independent trustee company PTL. “Some were fairly close, others further away.”

As a result, the scheme has decided against a discussed switch from a passively managed default to a diversified growth fund, deciding it had broadly the right level of risk and cost. It has also refined its communication strategy to suit its members’ needs.

• The top quartile were projected to get close to their 50 per cent replacement ratio – based on government targets – but this still represented a relatively big income hit, so the communication effort is focused on informing them of this and the actions they can take to address it.

• The bottom quartile were close to their target 70 per cent but the modelling highlighted the impact of taking a cash sum at retirement. "This had a disproportionate and of course negative impact, thus we were able to conclude that there should be comms around the sensible use of cash at retirement," said Butcher.

Ryan Taylor, senior DC investment consultant at Aon Hewitt, said the consultancy encourages its clients to consider segmentation as a method of understanding the impact of different strategies and contribution rates.

The industry needed to put into practice its convictions in this area, he added. “Everyone is talking about focusing on member outcomes,” he said. “I don’t see much evidence of that being done.”

But other DC experts feel segmentation only makes sense as a member reaches retirement, whereas earlier on, schemes should be focused on increasing members’ pension pots

“If we were being very true to ourselves, what we are saying is everyone in the pension scheme needs return,” said Damian Stancombe, head of the employee benefits and DC team at Barnett Waddingham.

He added: “Segmentation for me comes at 50 onwards and [that] is segmenting the routes into retirement and mirroring the investment accordingly.”

How L&G segmented its membership

The scheme took the following methodology to segment its membership:

1. It split its membership into quartiles by earnings.

2. Then it worked out the average contributions in each segment.

3. Its investment consultant calculated a best investment return for the default.

4. The scheme then calculated a final retirement pot.

5. Using an annuity rate, adjusted for longevity improvements, it calculated a retirement income taking into account state pension changes.

6. Finally it worked out the replacement ratio for each quartile using the average earnings figure and compared to government ratios.

"This was the first time this exercise had been carried out and the results were shared with the company,” said Butcher. “They were, therefore, able to see what sort of impact their contribution strategy had on the members and so, again, allowing them to make an informed decision on its appropriateness.”

Carol Perry, director at independent trustee company ITS, said segmentation was an area of innovation in DC. “What we have seen is… where you have got people who are more financially astute, you might offer them a broader range of choices,” she added.

The interaction between state and workplace benefits can mean lower earners have less to do to meet a target of two-thirds of salary in retirement, she added – as demonstrated by the L&Q case.

“If you are looking at overall retirement income, for the lower-paid the state benefits make up a high proportion,” Perry said, adding it was more of “a hill to climb” for high earners.

Stratifying the scheme membership for communication purposes has become more common at schemes.

“Segmentation in communications is incredibly powerful as it really improves your ability to engage a member with what you see as being the most relevant decision [facing] them,” said Nico Aspinall, senior investment consultant at Towers Watson.

In written communication, this can be much more expensive than one-size-fits-all correspondence, but online can be cheaper.

“We have released a front page to our administration portal which is different for every member depending on their age, contribution rate, investment decisions [and] recent activity,” Aspinall added.