A new benchmark

Personal accounts will move DC investment defaults firmly into public view. John Greenwood assesses how investment strategy and attitude to risk will be affected.


The advent of such a high profile competitor as personal accounts will create an unprecedented new benchmark in the workplace DC market that could put pressure on more expensive active management strategies.

Delegates at last month’s Corporate Adviser/AXA round table, DC pension investments: a time for change were divided at the extent to which the performance of the personal accounts default would enter the public consciousness, but agreed that the very presence of such a monolithic alternative would influence adviser, employer and media perspectives of what actually constitutes a decent default fund.

Experts present at the event felt the personal accounts default could ultimately become a benchmark in terms of performance, risk and regulatory structure.

Professor David Blake, director of the Pensions Institute, felt that the performance of the personal accounts default fund would become part of the personal finance furniture. In the same way that the FTSE100 is reported in the media on a regular basis, so too would the performance of the personal accounts default, putting pressure on private sector arrangements to demonstrate they are better.

Andy Cheseldine, a consultant at Hewitt Associates, pointed out that doing so would be complicated because personal accounts will comprise a multitude of different target date funds for people of different ages, with different investment horizons.

But Blake argued that the media would find a way to take some form of statistic out of the performance. He said: “We know what the monthly inflation rate is, we know what happens to interest rates, and we will know what is happening with personal accounts. There has not been such a big benchmark before now.”

The risk of killing off the project at birth means that personal accounts are likely to follow a risk averse investment strategy at least in the very early years. So what would happen if private sector defaults, invested in more risky assets, underperform personal accounts in the years after 2012? Will this influence investment teams in employee benefits consultancies to have an eye to this potential benchmark and err on the side of caution?

Cheseldine believes this will not present any new challenges to the industry. “This is an issue we already have with clients, deciding between better returns or managing risk. So of course any one scheme can always outperform another scheme but what we say to employers is ‘we had a conversation with you in advance about a risk structure that you want to go for and that is manageable. We are not saying it is always going to perform better’.”

Gary Smith, senior investment consultant at Watson Wyatt, said: “Members are wanting a high degree of certainly over outcomes and if I was to criticise one thing about potentially where the industry is at the moment it is that we haven’t historically considered enough about the risk consequences of investment strategies.

“There has been a bit too much focus on investing for long term growth without really understanding the risk. One thing we have learnt from the current economic turmoil is the need for much more focus around the individual risk and the consequences of that investment risk within the investment structure. We need more awareness and thought given to the point about what risk means to the individual.”

Will Allport, vice president and director, DC product strategy, UK & Ireland at AllianceBernstein, pointed out that the way scheme members are asked what their risk preferences are will affect their responses, and how intermediaries interpret those responses will influence what investments they ultimately make.

Allport said: “Inherently individuals are risk averse and within DC we have this unique situation with investments in that you do have a genuinely long term investment horizon. You don’t have liquidity until you are 55 for a start. Therefore taking account of an individual’s own sense of their risk tolerance is likely to come up with a sub-optimal investment design. Whereas in fact you want to look at their own capacity to sustain volatility and clearly a 25 year old has infinite capacity for volatility because he doesn’t get liquidity for 30 years.”

Cheseldine added that scheme members’ investment strategies are very much determined by the prevailing investment conditions at the time they join schemes.

“There is evidence that there is a cohort effect in where people have invested,” says Cheseldine. “If they are investing at the moment they are into managed funds or bonds. Three years ago they were in equities, and so on, and once they are in a particular fund they never change. If someone has changed jobs five times in the last 20 years on average they have probably quite a diverse portfolio because they never change it.”

Mark Rowlands, head of consultant relations at Axa Corporate Benefits, foresaw potential problems if personal accounts’ performance does receive a high media profile. “Will it form a benchmark? I think regrettably yes it will. But for the reasons Gary outlined I think that that is a danger. The press reporting it on a monthly basis would be horrific because it will get people to think about what it has done in the last month rather than actually thinking about a 40 year time horizon. So there could be some really interesting consumer reactions to it being publicised by the press and how the media reacted to it could have a powerful influence on how employers and employees perceive it. If the Sun and the Mirror come out and say it’s a good thing, you’ll get a lot of employee buy in and if they come out and say it’s a bad thing you might get a lots of unusual behaviour. If they start reacting to performance on a monthly basis you could end up with lots of knee-jerk performance chasing which would be a disaster.”

Smith argued that the private sector will differentiate itself from personal accounts by offering more than a one-size fit’s all solution. “You can’t say there is one investment strategy for 4,000 people in an organisation, it’s impossible,” said Smith. “We need to be encouraging a significant number of people to start to personalise their portfolio along the lines of risk. That is not making them investment experts, or getting them to make investment decisions based on investment knowledge, but using more subtle tools to help individuals understand how much volatility they are prepared to accept in life and make sensible decisions to vary and personalise their investment strategy within a framework.”

Blake argued that the visibility of a low-cost alternative such as personal accounts would bring the issue of charges into sharper focus. “Charges are key and net performance after charges is critical,” he said. “It is the performance benchmark that is the key and all the studies show that the costs are critical to outcomes and that is going to become very transparent. More so than previously.”

Katharine Photiou, principal at Mercer, said: “We need to know what the providers and investment houses are going to come out with. We saw it with stakeholder – all those years ago we were talking about the 1 per cent world and how everyone was going to struggle and then lo and behold where are we now? Defaults at 30 basis points. I think inevitably what you will see is innovation will come in the private sector but they will have to have one eye on the charges. It will be difficult to demonstrate real value at triple the charge of the state-sponsored offering.”

But views differed over Blake’s assertion that passive vehicles are the only realistic way forward for private sector workplace pension solutions.

Smith said: “So why do people choose active management when passive management is cheaper? Because they believe they can achieve an enhanced return.”

Blake said: “But all the academic evidence from all countries shows that you can’t. Active management is a negative value-added industry.”

Smith argued that that does not mean that it is not possible to find better performance and Blake countered that it is possible to find star fund managers, but it usually takes you 20 years to do so.

Cheseldine said: “It depends whether you’re sticking with one fund manager all of the time of whether you are actively managing the active managers. And it also depends on whether you are looking at active allocation or perhaps currency hedging. Where personal accounts has its advantage is the sheer size. If they get this £6 billion per year of contribution, that gives them a lot of negotiation clout.”

So are the industry’s current solutions up to the job? Cheseldine argued that the lifestyled solutions around today have stood up well to the market shocks of recent years. “To the end of last year and end of first quarter this year anyone who had retired after being in a lifestyle scheme, whether a five year switch or 10 year switch had seen quarter on quarter increases in their fund value for the previous five years. Taking the point that the fund value is almost irrelevant, it has also protected the value of the income because we have also looked at what annuity rates have been doing at the same time,” said Cheseldine.

“Lifestyling has worked. We started the exercise trying to find evidence that it hadn’t worked so we could go out and sell lots of new products, but it did work. But trustees can develop and improve their lifestyle to a position of strength and although we say it works there are ways of improving it,” he added.

Rowlands felt the industry should have more confidence about default being the right approach to investment allocation, decumulation and lifestyle. Could that mean a greater role for insurance company defaults with some form of asset allocation decisions being made on behalf of members, rather than static trackers?

“Defaults are absolutely the right thing for the vast majority of membership, in most cases more than 80 per cent of members. But industry media tend to say we should educate people to opt out and do their own thing and that is the worst possible scenario. Someone should have a professional duty of care over the asset allocation and that is probably what we need to work to in terms of the investment engine that delivers the investment return,” he said.

Photiou summed up the controversial role defaults are likely to have post-2012 as creating an ideal stimulus for the nation to start on the steep learning curve of better understanding of defaults and risk. “All of this debate is long-term positive, because what we are all doing, the press, providers and intermediaries, is talking about pensions, talking about investing and talking about saving for retirement and that has got to be positive. Overall, yes personal accounts will provide some form of better benchmark, but hopefully there will be some kind of positive outcome from that.”