With the Personal Accounts Delivery Authority launching its consultation into the investment process that the state-sponsored body will be adopting, default funds are set to take centre stage in the world of pensions.
There has even been a call to ditch the name ‘default’ altogether because it implies negativity. Axa head of corporate partnerships, Mark Rowland, who made the call, has a valid point. Default funds have long been associated with negativity. One reason is that most employees do not have the inclination or seemingly the will to take responsibility for their own pension provision. Instead they simply tick the default box giving the impression that it is second-best.
Default funds have also come under fire in the past for being poor performers. Before the days of lifestyle 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.
Lee Smythe at Killik says: “Unfortunately default funds tend to be the broadest fit, such as a balanced managed fund, but some schemes even elect for the cash fund so as not to force any investment risk on members who do not make an active choice.”
There are concerns that many employees are still stuck in these legacy funds and although there have been great strides to improve the default offerings many workers are not getting a piece of the improved action.
But who is ultimately responsible for default funds and their relative performance? Is it the provider, the consultant, the employer, the financial adviser or the employee?
Helen Dowsey, principal at Aon Consulting, says that when it comes to trustee-based schemes there is no doubt where the responsibility lies – it is with the trustees. “Trustees are responsible for the fund options and communications to employees. It is their duty to review and ensure the funds are fit for purpose – the regulator has said as much.”
John Foster at Hewitts Consultants agreed that trustees have the power to make those changes but questions how many do. “I think that where trustees are being active they are making the necessary changes but there is evidence that some do not due to time pressure.”
Not reviewing the default fund goes against the regulator’s wishes. Yet many schemes are failing to monitor their DC offerings. According to the latest PensionDCisions survey at least 10 per cent of plans had not reviewed their schemes for two years – flagrantly ignoring the guidelines laid down by the regulator in October.
It said that the stock market volatility and recession should be of ‘great concern’ to trustees, their sponsoring employers and scheme members. In the case of trust-based schemes it said that trustees may want to give careful consideration to their member communications at this time – ensuring that members have full knowledge of their options, are prompted to review their position in light of their circumstances and are directed to seek advice where appropriate.
In the GPP space the responsibility issue becomes less clear cut – the contract is between the provider and the member. Smythe says: “At the end of the day the responsibility really lies with the scheme sponsor, and in the case of a GPP, that would be the employer. For larger employers with GPP schemes I would encourage them to have a committee which mirrors to a large degree the trustees for an occupational scheme, including member-nominated representatives to ensure good governance. However, they will usually be taking advice, so you could argue it is the adviser who is ultimately responsible.”
Andrew Merricks at Skerritts Consultants reckons the IFA has a duty to respect their independent status and thoroughly review their recommendations. “In most instances they will be the first ones who should recognise lack of suitability if a default fund begins to waver from its stated objectives and they should be prepared to be proactive in the entire review process and continue to report to all interested parties without bias,” says Merricks. “But providers have a duty to see that their funds are managed as efficiently as possible within the parameters that are laid down for them.
Ian Buchan, business development manager at Standard Life, agrees that where an IFA has offered advice it is their responsibility to ensure that the funds on offer make the grade. “Providers have to be very careful because we cannot give advice, unless we are dealing direct with the employer. If an IFA has been involved they have to take responsibility.”
There is an argument that the employee has a responsibility – in legal terms a GPP contract is no different to a PP contract. But the reality is that many people will never have the inclination to make a decision – that is why four out of five employees simply tick the default box on their scheme’s application form. It is also the reason why advocates of the default funds (and their present strategies) argue that on the whole they do a decent job for workers.
“Not having a default option is the biggest hindrance to people signing up in the first place. A default fund has high equity content for those in their 20s and 30s and the lifestyle trigger helps to protect people as they approach retirement,” says Buchan. “There will be times when it does not suit everyone but you cannot underestimate the important role a default fund plays in getting people into a scheme in the first place.”
Despite the cloud of negativity that surrounds default funds, their performance of late is not as bad as perceived. The PensionDCisions survey suggests that employees have been neither worse nor better off by ticking the default box. In a year when most asset classes fell on hard times, the average default funds lost a quarter of value in the 12 months to the end of December 2008 – the average return was minus 23 per cent (the FTSE All-Share fell 29 per cent).
Gary Smith consultant at Watson Wyatt said that the sheer weight of DC members in lifestyle default funds highlights the importance of getting their design right. “The lifestyle approach continues to be a robust answer to dealing with market turbulence, but if it is badly implemented through an over-simplistic investment design, poor switching mechanisms or excessive cost, then millions of members will be let down.”
The final phase, the “risk reduction” phase is also where much of the concern lies because this is where members are most likely to experience disappointment. “These concerns may be realised if the default arrangements are misaligned with members’ expectations and, more importantly, the risks associated with selecting a “one-size-fits-all” approach were not clearly explained,” says Brian Henderson, principal at Mercer. “In general, plan sponsors and trustees are acutely aware of the limitations of default funds and take great care to communicate thepurpose of the default arrangement.
But it is with contract-based schemes where the real danger lies. Tens of thousands of employees continue to be stuck in poor default funds because funds cannot be switched without members’ consent. This is an issue that the industry understands needs to be addressed”Despite enormous communication efforts, inertia is huge,” says Foster. “For one of our clients, all employees were informed on several occasions over a few months about the actions they should take to move into a new default fund, but two-thirds still remain in the original default fund.”
With the employer and employee ducking responsibility, white-labelled funds that are making headway in the trustee-based arena could be a solution. Three-quarters of trust-based schemes are now using an investment gateway (or platform) to deliver their investment strategy, of which over 40 per cent now use a scheme-specific ‘white-labelling’ structure to do so.
“White labelled default funds could be the answer for contract-based schemes because the underlying funds can be switched without the need for consent from employees,” says Dowsey.
Buchan adds: “There will be changes to default funds and the white-labelled approach will be one – be in no doubt.”
Providers, consultants and advisers will argue that default funds are wrongly accused of being inferior, but they admit that member inertia means that getting the right default in place is crucial. It is why all eyes will be on the eventual design of the Personal Account default proposition.
The Personal Account default fund will, in all likelihood, be perceived as ‘government sanctioned’ and adopted by many workplace schemes that fall outside the government initiative. Many schemes already simply opt for a lifestyle fund because it is too big a risk to stand out against the crowd for fear of getting it wrong. It is why target return and multi-asset strategies, which are being groomed as the successor to lifestyling, are finding the default market a tough nut to crack.
It also means that we can add another name to the list of those responsible for the performance and quality of default funds – Pada.
Default strategies that incorporate lifestyling will have helped cushion the blow for people on the cusp of getting their gold watch. All but one of the default equity based funds in the PensionDCisions survey was lifestyle which triggered a switch into lower risk investments between five and ten years to retirement.
The number crunchers at Standard Life have been looking at how lifestyling has worked. They assumed the high-risk, high-reward fund is the FTSE 100 and that the fund switches out of equities at the rate of one-fifth of the fund each year in the run up to retirement. Assuming retirement on 12th January 2009, 20 per cent is switched out on 12th January 2004 and each year until the final 20 per cent switch to cash/bonds on 12th January 2008.
The index values on January 12 over the five-year switch period were 4,449, 4,783, 5,735, 6,239 and 6,202(8). This means that a hypothetical DC saver would have sold units in a FTSE 100 fund at an average index value of 5,481. “It is not as good as leaving the fund on October 12 2007, when the FTSE peaked in its current cycle at 6,730. But it is also not that bad, considering an FTSE 100 index value of around 4,400 (and around 3,500 the lowest point so far in the current cycle),” adds Buchan.
But while lifestyling will have helped people within five years of retirement it may be very unhelpful to those investors who are about to be moved into lower-risk assets. The initial switches are likely to take place when equity prices are depressed and bond prices inflated.
Foster says: “Lifestyling has taken out some of the issues in the run up to retirement, but it could be refined further. It might not be the best time for those only five years from retirement to be going into bonds and cash given the recent events.”
Indeed, the Pensions Regulator offered its guidance in October by informing trustees that where lifestyling is ongoing, the value of assets being switched will in many cases be lower than they might have been a few months ago. In these circumstances trustees may want to remind members to keep their choices under review,” it said.
Lifestyling is not the panacea to successful default strategies – it’s an issue that trustees and sponsors need to be aware of.
Given the predicament many people five or so years from retirement now have, there is the argument that lifestyling fails to avoid a market timing issue. But Buchan points out: “The basic premise behind lifestyle funds is that they aim to avoid the investment timing issue altogether. Lifestyling is a mechanistic process designed for those that do not want to call the market, so why would they want to introduce market timing into their decision now?”