In contract we trust

Rumours of the slow death of contract-based pensions have been greatly exaggerated says Henry Cobbe, executive director of BirthStar

The Pensions Institute published its report last month on default funds, sponsored by Now: Pensions. While sponsored research is nothing new, the inclusion of some findings and the exclusion of some important data raises more questions than it answers.

The report made solid recommendations on two key aspects: legacy charges, and legacy default design.

According to the report, charges are the most important determinant of the final size of a pension pot. With Total Cost of Ownership on legacy contracts ranging from 0.5 per cent to 3.0 per cent, that is not surprising. Any legacy contract that is unjustifiably expensive should be rebroked, and employers, advisers and providers have a duty of care to see that they are.

Secondly, the report challenged the design of legacy default funds under historic contract-based schemes. This criticism is also valid, as fund design has moved on a long way since the early 1990s and legacy defaults such as tracker funds, or balanced funds with crude lifestyling, may not comply with the latest guidance on best practice, and are statistically less likely than modern alternatives to give robust and consistent outcomes to consumers. Again, it’s up to employers, advisers and providers to resolve this, and consider the more modern default funds available.

The more questionable parts of the report focused on a tacit call for the wholesale migration of contract-based schemes to trust-based schemes on the basis of long-term cost; and a notable exclusion of some quantitative results.

The report also suggests that employers with old contract-based schemes charging 2 to 3 per cent should move to multi-employer trusts. Well in fairness, shame on those employers, advisers and providers who have not reviewed such expensive schemes for so long. Contracts with high fee structures clearly need to be reviewed. But calling for the death of contract is misplaced. So long as contract-based schemes can offer suitable default options at an affordable price, there is no reason why they should not continue to flourish.

The main problem with the report is that it glosses over the inconvenient truth that for the target auto-enrolment market, new trust-based schemes are substantially more expensive than similarly-scaled contract-based schemes, for at least the first seven years, on our calculations. It’s only after seven years that new trust-based schemes charges become cheaper, and hence only after about fourteen-fifteen years, that the early year upfront costs are fully offset by subsequent benefits.

Time value of money dictates that we should rightly prefer guaranteed near-term cost benefits, compared to uncertain long-term cost benefits, particularly for those who plan to retire sooner rather than later.

For this reason, the Pensions Institute’s attempt to focus kite-marking on long-term eventual cost alone is short-sighted, as it ignores the much lower or comparable cost of contact-based schemes for the first seven to fifteen years, at a time when member engagement is key, and which may be more suited to those with shorter time horizons.

There is certainly a need for kite-marking both of default schemes and of default funds to enable the success of auto-enrolment, to help employers and advisers make sound choices. But in our view, any kite-mark should focus on governance, design, suitability and affordability. Affordability should be measured in near-term as well as long-term cost, for a more balanced approach.

“The suggestion of an industry kitemark, whilst attractive in theory, needs careful management by a credible and independent authority,” says Steve Gay of the ABI, “Trust based pensions can be more expensive in the shorter term than contract based schemes for employees. And its important to consider the comparative impact of charging structures over time.”

The final problem with the report, was about what was not there. Despite enrolling the input of more than 50 different entities, sending data off to Germany to be rigorously crunched, and describing in detail the 8 different default strategies that they would stress-test, the Pensions Institute was surprisingly coy about which strategy came out on top.

The report simply concluded that the modern multi-employer trusts were generally best but shed no light on which default strategies fared best. Was it diversified growth funds with lifestyling, or target date funds, or traditional balanced funds with lifestyling? This was perhaps the most interesting part of the report, so it was a great shame that on this point it became so inexplicably vague.

What is for certain is that the influx of new entrants, new strategies and new ideas in the pensions market guarantees interesting and competitive times ahead. And that’s no bad thing.