Defined contribution may be taking over from defined benefit but it still has much to learn from its older sibling. Paul Farrow reports
The defined contribution takeover is gathering pace. Another month goes by, another defined benefit scheme bites the dust. And as the auto-enrolment programme soon becomes a reality for tens of thousands of employers the DC machine will continue to attract even more of the nation’s retirement savings.
Yet despite the scale of the migration to money purchase, the DC industry is still in relative infancy and, say critics, is far from a complete solution for the nation’s workers. So what lessons can the DC sector learn from DB to improve outcomes for members?
Trustees of DB schemes think of liabilities and work backwards. It is the key attraction of defined benefit schemes – members know what their pension income is going to be. The same cannot be said for defined contribution, which David Calfo, head of defined contribution strategy, BNY Mellon Asset Management describes as an “invest and hope for the best strategy”.
But even though it may sound contrary to everything money purchase stands for, experts suggest that it would be helpful for employers, trustees, advisers and members to think about DC in terms of liabilities, in a similar vein to DB.
Mark Jaffray at Hymans Robertson reckons that DC members do have ’liabilities’, they just don’t know about it. “Essentially, workers have a massive deficit and they will have a funding plan and you try to recoup that deficit.
“DC prefers having targets and targeting an income. If you think of DB managing asset allocation over time to better match those liabilities then you can translate some of those principles to DC.”
This is where liability-driven investment has a place and it is a strategy that is becoming more prevalent in the DC space as schemes evolve.
Viewing a pension as a target is an area that consultants such as Mercer and Aon are focusing on. Mercer, for instance, is examining ways of introducing core target models for individuals to use as a base for evaluating how much they should be saving.
Paul Macro, partner at Mercer, says: “Unlike a DB scheme the question with a DC scheme is always ’how much I’m I going to retire on?’ and you have no idea.
“You don’t have this ongoing targeting or reviewing with DC schemes,” he says.
“With DB there are questions of funding and there are reviews. In DC, generally speaking, we do not have those targets. It is something we are looking into at Mercer.”
Macro says that the issue is a complex area because no member will have the same target, but he said that his firm is looking at developing half a dozen case study models for members at various stages of their life and whose targets might be similar. For instance, a model could be a 30-year old worker who wants to retire at 65 on 30 per cent of his salary.
“Members will also need more information then they get at the moment if they are going to think of their pension as a target. It has to be looked at frequently to see if they are on target or not, and if not what they can do to get back on track,” adds Macro.
John Foster, benefits consultant at Aon Hewitt, says: “DC pensions need to be individual liability driven, based on outcomes the member is setting. DB thinking is helping us to examine this concept.”
Cut dealing costs through transition management
Keeping costs down with transition management is another strategy DC could borrow from DB. Defined benefit schemes have being employing transition managers to move assets around for some time. A transition manager, such as State Street, BlackRock or BNY Mellon, takes over a scheme for a short period of time to project manage an in specie transfer of assets in a cost-effective and transparent way.
The same cannot be said today in the DC sector. At the moment, if a DC scheme wants to change a fund manager, the underlying funds are sold into cash and then moved into a new fund.
“When asset pools are small that’s OK,” says Calfo. “But as asset pools grow, the trading costs become more expensive and that is where the use of a transition manager will be more cost-effective. It is more cost-effect to reregister the names of the holdings rather than, say, selling Vodafone and buying it back.”
If DC is to be successful, there must be decent contributions going in. Unfortunately, this message may take decades to bear fruit because of the current feeling, unfortunately held by far too many people, that pensions are a waste of time
Greater scrutiny of schemes in the aftermath of the financial crisis has triggered reviews of arrangements; it has led to questions over the balance of assets and whether managers are performing in line with expectations. But there are other reasons why a transition manager might be of use. More schemes are changing platform and more are switching from trust-based to contract-based. And auto-enrolment should be another trigger of growth as pension schemes examine whether better deals, based on value and suitability, can be found elsewhere.
Andrew Williams, head of transition management at Mercer, says that working groups at various consultants are being set up to see how they can embrace transition management in the DC space – his firm has already used them on a couple of occasions. He said: “Given the growing size of assets in five to 10 years’ time, there will be an imperative need to control costs when moving assets. Transition managers have the expertise and the skill which could be put to use in the DC environment.”
Look beyond bog-standard assets
DC could also learn from DB by looking beyond bog-standard assets for higher returns. Defined benefit schemes have a history of being more flexible with regard to investment strategies, and were dabbling in alternative assets such as private equity and hedge funds long before DC schemes took up the idea of diversified growth.
Julian Webb, head of DC at Fidelity, says: “DB schemes have in the past been more likely to adopt innovative investment approaches than DC because the sponsor has a clear financial incentive to do so, and also to take on the associated additional risk that may be involved. This has meant that DB schemes have accessed new asset classes ahead of DC schemes, and as a result have benefited from early investment in asset classes such as commodities.”
However, Webb says that the situation is improving for DC, with the growing adoption of blended funds which mirror the DB approach of having a diversified range of assets classes in a single fund.
“These blended funds can now incorporate asset classes previously untouched by DC, as DB fund managers make their funds DC-friendly and charge more competitive fees. By combining asset classes into a single fund DC members benefit from improved risk/return, and when used as a default fund provides them with an ’all-weather’ fund which can be changed to meet their future investment needs,” he says.
Off-the-shelf diversified growth funds offered by the likes of Baillie Gifford, Standard Life. JPMorgan, BlackRock and Schroders are making headway but on the whole take up is slow. Persuading clients, who have been accustomed to straightforward passive equity funds, to adopt strategies that embrace private equity and emerging market debt has been far from easy.
Improve corporate governance
The Pension Regulator has long been concerned that not enough is being done in the area of corporate governance. Only last year TPR chief executive Bill Galvin said: “It goes without saying that all schemes should be designed and run in their members’ best interests, and be capable of delivering a good outcome. But at present DC standards are mixed with too many schemes providing poor value for money.”
Some within the pensions industry suggest that DC schemes should take a leaf out of DB’s book when it comes to governance.
After all, there have been hundreds of pages of legislation that attempt to ensure the protection of DB benefits.
“Trustee duties in DB schemes are arguably the most onerous because of the inherent complexity of DB schemes,” says Jamie Clark at Scottish Life. “As such, there is a high level of governance.”
Calfo suggests that the DB model works “pretty well” from a trustee perspective because trustees are actively engaged in investment management and liability management, and they have well-established advisers.
“DC schemes that have a trust arrangement tend to be subcommittees and they do not get anywhere near the same attention. Investment issues are often the last on the agenda,” he says.
Calfo is even more concerned with contract-based schemes, where responsibility is a grey but also growing area.
According to Spence Johnson’s latest DC Market Intelligence Report, of the 800 biggest schemes (with more than a 1,000 members) 380 are contract-based and 420 are trust-based. But by 2021 this will have changed significantly with 580 being contract-based.
“Where the fiduciary management lies with DC-contract schemes is questionable and we need to ensure that the individual member is looked after appropriately.”
Guarantees cost money – a lot of money. That’s why contributions by employers and members to DB schemes are higher on average than contributions to DC – and in particular to contract-based DC
Clark agrees that governance is an area where contract-based DC has been lacking and could, perhaps take a leaf out of DB’s book. Indeed, as it stands the Pensions Regulator does not directly regulate contract-based schemes. The Government has identified this as a gap exacerbated by the imminent introduction of automatic enrolment and so the Work and Pensions Committee has recently announced an inquiry in this area.
But many providers have moved to adopt a DB mentality on governance and it is one that is growing. Scottish Life is vocal about its “market leading” investment proposition to help advisers and employers with governance. It is not alone – the likes of Fidelity, Aegon and Scottish Widows offer similar solutions in the contract-based market too.
However, some experts question whether DC governance is an issue at all. John Lawson, head of pension policy at Standard Life, says: “Those from the large trust-based world, particularly the DB community, tend to view their DB governance and trust governance through rose-tinted spectacles. Contract-based schemes are seen as a governance vacuum, but this is not true.
“Contract-based schemes are subject to FSA regulation, specifically TCF. So, the provider must research the members to determine their needs even before they build the scheme – and how many trustees do that?”
The main advantage of defined benefit schemes is the guarantee – it is one of the reason they are deemed to be gold-plated. On the other hand, DC schemes are far from certain and have to deal with the vagaries of the stock market and annuity rates.
It is a challenge that Pensions Minister, Steve Webb is examining with his ’Defined Ambition’ plan. If it comes to fruition it would be a crossbred DB/DC trust-based scheme that will provide some form of guarantee, with the risk being shared between the member and the employer.
Launching the idea, Webb said: “The Government is looking to investigate options for a new model – the defined ambition pension – where the risks and uncertainties are more evenly shared between employer and employee.”
One example, he says, is a so-called “cash balance” scheme, where the firm guarantees to deliver a fixed pension pot on retirement, and the employee then bears the uncertainty as to how much pension that pot of money will buy. Another model is to share some of the uncertainties of rising life expectancies, so that firms pay a guaranteed pension but the date on which that pension is paid can change for future accruals if people live longer than expected.
Webb added: “There could be new models where younger workers are told that their pension could lie somewhere within a wide range but as they get older they are given more and more certainty about what their final pension will be,” he added.
“If we can get the framework right, we can make sure that final salary schemes are replaced by a model which offers greater flexibility to firms without loading all of the uncertainty on employees.”
However, Clark says it would be a big step to then extend the concept to contract-based schemes, which are likely to be the predominant type of workplace pension scheme going forward. “Guarantees cost money – a lot of money. That’s why contributions by employers and members to DB schemes are higher on average than contributions to DC – and in particular to contract-based DC.
“If DC is to be successful, there must be decent contributions going in, to provide a decent income in retirement. Government and the industry should work together to ensure people are aware of the consequences of not saving enough. Unfortunately, this message may take decades to bear fruit because of the current feeling, unfortunately held by far too many people, that pensions are a waste of time.”
Lawson wonders whether DC could evolve to become more like DB, by taking more risk away from the member with the market, rather than the employer bearing the risk. He says: “The employer could of course pay that risk premium as a defined contribution amount. For example, the employer pays 5 per cent pension contribution and another two per cent to hedge investment returns.”
DC is in a state of evolution. It will need to adopt best practice from across all parts of the industry if it is to improve.