DC pensions are a timebomb waiting to explode when the next generation comes to retire, says Paul Farrow
The furore over public sector pensions has put the heat on their poor relations in the private sector too. It has raised the question of whether defined contribution schemes are up to scratch or whether they are a ticking time bomb for millions of workers set to retire 20 or more years down the line and crucially what that will mean for employers when the penny finally drops.
The phrase ’pension timebomb’ has been variously used to describe unfunded liabilities in DB, under-saving and increasing longevity. For today’s younger workers it means reliance on inferior DC alternatives. Younger workers will not have the back up of a defined benefit scheme to bolster their retirement income, unlike many workers retiring today. But the relative infancy of the DC market does not explain why the average retirement pot from DC schemes is a meagre £56,000.
The latest DC Tracker Index from Aon Hewitt shows the fragile nature of DC many private sector workers retiring today will be 18 per cent worse off in retirement than workers who retired three years ago because of falling annuity rates and volatile stock markets.
John Foster of Aon Hewitt says: “If the individual, aged 60, takes 25 per cent of this £56,000 as cash, it would leave around £42,000 to buy the pension. In 2008 this sum would have bought just over £1,400 a year, compared with just under £1,200 today. The underlying performance of the funds over that time would have been growth of 11.7pc.”
Aon adds that if someone three years ago had hung on and remained invested, the level of growth added to their pot would not have been enough to compensate for the fall in annuity rates. In other words they would have wasted their time, disproving the theory that working longer always gets you a bigger pension.
Plan members want funds where asset allocation is dynamically managed to take account of changing markets in an uncertain world
While public sector workers vent their anger at proposals to change from a final salary system, they have the comfort that the proposed alternative, a career average plan, will mean, crucially, that their pension income is still a defined benefit and still guaranteed by the taxpayer.
Tom McPhail of Hargreaves Lansdown says: “DC pensions are by their very nature unpredictable; investors can and will lose out as a result of unexpected movements in the prices of shares and bonds close to the point of retirement. Ironically, given the public sector protests, the least volatile and most predictable pension outcomes are provided not through final salary schemes but through career average arrangements, where the pre-retirement risk to members is effectively non-existent.”
Getting the message across
At the heart of the DC pension debate is the default fund. After all, survey after survey, year after year shows that four out of five workers simply opt for the default fund.
It looks set to remain so the image of commuters reading pension magazines on the tube or train on their way to work is a world away from reality.
Alasdair Buchanan at Scottish Life says: “The majority of people don’t have the knowledge, time or confidence to take personal control of investment decisions. Some may be willing to be educated, the majority are not.”
But not everyone is so pessimistic. After all, workers in the US have become more proactive with just 25 per cent of American workers choosing the default, according to the latest report by DCisions.
The difference between the DC market in the US and the UK is marked – 94pc of DC schemes in the US have a target date solution
compared to just 4pc in the UK
John Lawson at Standard Life says that employers face a battle, despite some recent improvements, to be innovative in their approaches towards communication.
“Communication is not just thick packs of paper these days. Changing the culture throughout the business with managers encouraging their staff to spend half an hour during the working day to review their own situation is an approach that works well,” says Lawson. “However, the truth is that people are not interested in pensions so employers, providers and advisers face an uphill battle to begin with.”
It would appear that many private sector workers are in the dark on the size of pension pot they need to generate a decent income, and are shocked to hear that a pension pot of half a million pounds will only buy them an annual income of £24,000 a year. They are just as surprised to hear that a £100,000 pension will buy people an income of only around £5,000 a year in retirement, depending on when and how they take it.
Little wonder the NAPF chairman Lindsay Tomlinson recently said: “Many workers think setting aside 5 per cent of their income will be sufficient to fund their retirement it will not. Retirement is much more expensive than many people realise.”
Although DC scheme contribution rates are higher than 5 per cent (average combined employer and employee contribution rates come in at around 12pc), the default rates are still half of the level of most defined benefit schemes. And given that many workers still do not sign up to their scheme, even though they are getting free money from their employer, it is easy to understand the difficulty in getting people to put even more into their pension.
The onus is on the industry to get the right default fund and give workers the tools to understand what they are getting into. If an asset manager can’t get it right, what hope is there for workers?
Nigel Aston, business development director at DCisions, reckons there is definitely going to be a generation disappointed with their pension pot.
“The industry has done a pretty poor job in getting people to engage. Around 50 per cent of workers do not join even when they are turning down free money. They are short termist and are reluctant to put their hands in their own pockets to get their employer contribution. One trick to get people to contribute more is to get them to commit to giving up future salary increases again that works in the US.”
The fault of the default?
Default funds have also come under fire in the past for being poor performers. Before the days of lifestyle and multi-asset strategies, many were bog standard balanced managed funds offered by the big insurers. These enormous funds frequently lagged their benchmarks and were regularly outed as poor performers in pension surveys.
Fraser Smart, managing director (UK) at Buck Consultants, fears that millions of workers are going to end up with less money than they imagine and not just because contributions are being paid in at a lower rate than many members realise. “The most common thing I hear is ’I have a pension’ with no idea of the likely payout at a retirement despite numerous illustrations being issued,” said Smart. “When default funds are not regularly monitored there is clearly a danger that they underperform if the money is invested in actively managed funds.”
The NAPF has upped the ante on governance and has developed new standards with its Pension Quality Mark, while the DWP recently published guidance on offering a default fund in DC schemes used for auto-enrolment. And there have been changes the likes of Aegon and Scottish Widows have revamped their GPP ranges so they take a more hands-on approach to asset allocation, while Scottish Life launched its Governed Range.
As Fidelity points out, if a default fund is well designed, well funded, well communicated and regularly reviewed then there is no reason why members should end up with less money at retirement. “The real challenge is those plans which are not regularly monitored and reviewed, particularly those which are in legacy insurance contracts with high fees and poorly performing in-house funds as the default,” says Daniel Smith, director of DC business development at Fidelity.
The question is whether defaults are being regularly looked at. If Mercer’s 2009 Global DC Survey is anything to go by, they are not 47 per cent of the 354 companies polled in the UK didn’t have any formal DC governance policies in place for their DC plans.
There is evidence that a change in default selection by some is afoot. The past few years of markets have brought the limitations of passive investment to the fore and there has been a move to diversify portfolios into a multitude of assets beyond the limitations of simple equities and bonds.
Lane Clark & Peacock has moved to use diversified growth as too has Mercer. Last year Mercer went on a push to get schemes to look at general issues surrounding investment and governance, and every scheme it has met has subsequently changed their default to a diversified approach.
The industry may have evolved, but it continues to be a slow burn. Lifestyle strategies are commonplace, and the move by Nest to offer target date return funds could be the catalyst to see its growth in the UK. Again the difference between the DC market in the US and the UK is marked 94pc of DC schemes in the US have a target date solution compared to just 4pc in the UK.
But perhaps the biggest worry is that the majority of funds still have a bias towards equities. This leaves pensions susceptible to big swings in performance and members who receive their annual statement to learn their pension fund value has fallen in value may act. If Nest’s research has shown us one fact, it is that people react to volatility and more people stop making contributions when markets go awry.
Aston says: “The onus is on the industry to get the right default fund and give workers the tools to understand what they are getting into. If an asset manager can’t get it right, what hope is there for workers? There is evidence that enlightened scheme providers and consultants have moved on to diversified strategies I’m not saying they are good or bad but at least it’s showing innovation and if they can deliver equity-like performance with fixed income volatility that would be good for scheme members.”
Can this pensions timebomb be defused?
Talk to the industry insiders and they believe they are making strides that will avert a pensions disaster. They believe that some companies have radically rethought their approach to default funds to the extent that risk will be significantly mitigated.
Buchanan says: “Increasingly, leading companies have been developing a risk-based portfolio approach to default options, rather than having a single fund. This is evidenced by Corporate Adviser’s “Ultimate Default Fund” now having a clear majority of portfolios in its shortlist. The best of these provide comprehensive ongoing governance at no extra cost.”
Others claim they have reacted to trustees and plan sponsors’ displeasure at the volatility members have been exposed to over the last few years. “There has been a move away from global equities as the growth component of a default to a more multi-asset strategy, which includes property, commodities, equities and fixed income,” says Smith. “Plan members want funds where asset allocation is dynamically managed to take account of changing markets in an uncertain world. This message is getting through and we see evidence that change is happening.”
Some providers have built risk-graded portfolios and are actively using risk questionnaires. Lawson says: “We also need to survey members of schemes as a group of employees to find out what the attitudes and aims of employees, particularly the non-choosers, are. This must be the starting point in the future for default fund design and investment approach generally rather than the current ’we know best’ approach. This is something which must happen because the DWP and FSA demand it and will happen in the run up to auto-enrolment.”
The DC industry is in its infancy and it is making progress, slowly but the British public are apathetic at best and they will need their hands holding. The pension industry is conservative by nature and many workplace pension schemes dislike change.
Aston’s company has been monitoring the DC industry for the past five years. Asked what the biggest improvement he has seen in this period he says: “We have seen much more interest in having an objective benchmark and the industry is looking at how things might develop, but you couldn’t look at it and say there has been massive change with default funds.”
With Nest biting at the industry’s heels, the pace of change will need to speed up if a truly differentiated proposition is to be offered.