Pada’s default dilemma

As Pada mulls industry responses to its investment consultation, advisers and providers reflect on how its default could change the market. Paul Farrow reports

The Personal Account Delivery Authority has closed the consultation on the investment discussion paper having received more than 60 submissions. It will not publish a summary of the responses for a month or so, but much of the consultation was on the default fund – for good reason.

Personal accounts will live or die by the performance of the default because the vast majority of employees will do as they always do – tick the default box. It is a trend the pension industry knows all too well and depending on which survey you believe around 80 to 90 per
cent of employees opt for the default.

Whether Pada likes it or not, the default will be viewed by many employers as the benchmark fund to use. If it is good enough for the Governmentbacked pension it’s good enough for us, will be their argument.

Roger Urwin at Watson Wyatt says: “This is mission critical for Pada. The default is crucial for any DC scheme success.” The pressure is on Pada to come up with the ideal default fund, although whether it can come up with a ground breaking blue print is debatable –some would question whether it is possible. “There is no such thing as a ‘perfect default’. The perfect position would be for every member to select something which matches their own personal circumstances,”says Helen Dowsey, head of DC at Aon Consulting.

Dowsey reckons that Pada will need to design the default based on the likely member demographic and taking into account what members will want most from the scheme, be that capital protection or growth.

“Pada’s analysis of the default and justification for its decisions will need to be thorough and robust – it cannot be ‘all things to all men’ so it must aim to be as close to most as possible,” she adds.

Pada has a tough job on its hands. Personal accounts have been clouded in controversy from day one. There has been cynicism aplenty on whether it can deliver a suitable default fund for such a broad group of people, even though the consultation period has barely finished and no decision on its design has been made.

But there are doubts whether the five-month consultation process will throw up anything different to what is on offer already to DC trustees across the country. If bookies were offering odds, a passive fund with exposure to equities and bonds at the core and a lifestyle mechanism would be favourite to be the design Pada comes up with.

The consultation paper is likely to have ruled out more than it will be ruling in. Certainly, the part that active management will play in the default looks likely to be small. Pada has made no secret that costs will have to be kept to a minimum and this will limit the use of active fund management.

Even Fidelity, one of the UK’s biggest fund managers and a staunch supporter of active fund management, has responded to the consultation paper with the suggestion that “funds should be managed on a passive basis to minimise costs and contain governance requirements”.

John Lawson, head of pension policy at Standard Life, admits that passive is almost a dead certainty. “The cost limits choice to passive investment. Overall though, passive shouldn’t be a constraint to asset class selection, which should have the biggest impact on performance. Stock selection is of the second order in considering investment performance. What the cost will constrain is the ability to use derivatives to hedge volatility – for example absolute return strategies.”

Laith Khalaf, pensions adviser at Hargreaves Lansdown, says: “I agree that the cost constraints and the spotlight on risk that inevitably influences the creation of a default fund favours a passive investment mandate. Pada seem to be suggesting the possibility of mixing active with passive funds, but data they present suggests there is actually little difference between the two.”

But given the phraseology used by Pada, you wonder whether it is unconvinced about the merits of active fund managers, irrespective of costs. It says that the risk of active fund management is ‘significant underperformance’ while simply stating that passive minimises the risk of underperformingthe benchmark index.

Pada has a point. It is true that active fund managers are able to deliver value and benchmark beating returns – but the number that do it consistently is small.

The best managers come at a cost and the Trustee Corporation will have the added task of being responsible for monitoring the performance of these active managers. This in itself brings another layer of risk to the table – not only are you trusting the manager investing in the assets, you are trusting the trustees to pick the best managers.

Khalaf adds: “The reason is that there are thousands of actively managed funds, but actually only a couple of hundred are actually worth holding. The rest are hampered by mediocre management and/or benchmark constraints that tie them to the index anyway. This is the kind of management personal accounts are likely to be able to afford if they go down the active route.”

Perhaps the trickiest problem for the default is asset split – again pension experts wonder whether constraints could see the default option being compromised despite the consultation paper wanting feedback on a plethora of asset classes, some less mainstream than others. Ros Altmann, the former government pensions adviser, argues that asset allocation is “absolutely vital” and a key challenge. Most experts agree that when it comes to long-term pension saving, diversification is desirable. Mark Fawcett, investment director at Pada, was recently reported as saying that the authority is already shying away from a default invested 100 per cent in equities and that a more balanced approach is appropriate.

Such a statement will hardly leave the industry open-jawed given that 100 per cent equities has been fiercely criticised by some in the pension industry for years. Diversification is a must – the question is whether the default can diversify to any great extent, even if it may be an ideal route to lower volatility and still deliver returns.

Analysts who published the 2007 Barclays Equity Gilt Study compared a multi-asset market portfolio (made up of equities from developed markets, bonds, property, private equity, commodities, infrastructure and emerging market equities and emerging market debt) to a portfolio consisting of equities from developed markets only.

Between 1991 and 2006 the cumulative returns between the two portfolios were much the same, but the multiasset portfolio experienced far less volatility. Returns showed a steady rise throughout the dotcom boom in the run-up to 2000, while equities enjoyed sharp spike. Shares fell steeply between 2000 and 2003 after the bubble burst, while returns from the multiasset portfolio were relatively flat.

But while a spread of different assets is beneficial, the audience for personal accounts is unlikely to be familiar with asset classes such as hedge funds, infrastructure and private equity, all of which are thrown into the mix by Pada in the consultation document.

Communication is going to be key and discussing the merits of securitised lending and counter-party risk is likely to be a stumbling block for many alternative assets.

Richard Parkin, at Fidelity, says: “Given the audience, the personal accounts default cannot be an overtly complex cutting edge idea so I think it will be more of a vanilla offering.”

Parkin says that personal accounts are not about making millionaires out of employees, but providing a basic level of subsistence of 15 per cent of the income target. He doesn’t believe that a narrow asset spread will be detrimental. “My suspicion suggests that it could be bond orientated. They talk of other assets but you can go an awful long way with a bond and equity split,” he adds.

Lawson agrees that asset allocation is the main driver of performance. “Unfortunately for the default fund, asset allocation choices may be significantly constrained by the risk of appetite of the target group and by political influence.”

If personal accounts embraces an active management strategy to any extent at all it will be not with the underlying funds, but with having a flexible asset allocation strategy.

The consultation document states the Trustee Corporation will need to determine the levels of risk and return required to achieve the investment objective. But such asset allocation decisions are likely to be strategic rather than tactical (decisions that aim to benefit from short-term market movements).

There are two main reasons why Pada is likely to keep tactical asset allocation (TAA) at arms length – cost and risk. Parkin adds: “It is not without its risks or expense, nor is there any clear cut argument that it actually adds value. Implementing a TAA strategy would very likely require a derivativebased technique, which exposes trustees to additional, and potentially unacceptable, levels of risk.”

The role trustees play is going to be vital, but whether they will be better equipped to make decisions on behalf of members is debatable. “I’m sure the Trustee Corporation will be a mix of consumer organisations representative, trade union representatives, lawyers, investment specialists, government representatives and one or two others from the pensions industry,”says Lawson. “It won’t be any more adept at designing a default fund than any other body of trustees – it will be faced with the same choices, but arguably more constraints.”

Some have questioned whether decisions made by trustees will be influenced by politics. Will Government debt see the fund full-to-the-brim with index linked gilts, was a question raised by one cynical fund manager.

There certainly will be pressure not to damage the fund’s reputation in the early years with significant losses, which adds kudos to those that favour an ample helping of bonds in the asset mix.

“This is a real and important issue. Trustee boards of pension schemes have been far too influenced by ‘groupthink’, which led them all to follow the wrong strategy,” says Altmann. “It is to be hoped that the Board would be made up of independent thinkers, but at the end of the day we all know that investment is not an exact science and there can be good and bad investment decisions. That is reflected in risk. Choosing good and successful investment professionals does not guarantee future success, but it should help.”

Pada says it does not feel under pressure, but it has an unforgiving task ahead. It is starting with a blank piece of paper and has asked the industry to come up with its best ideas and suggestions. Some are tried and tested and others are not. The DC sector is in its infancy too, and providers are still very much in the innovation stage.

The authority has the opportunity to come up with a default fund that breaks new ground, but that does not come without risks attached. It also comes with a number of constraints that do not impact ordinary DC schemes. It is why many industry experts are not holding their breath.

“I do not think the default will be very different to what we see already,” says Urwin. “I suspect we will end up with a lifestyle arrangement, that is on the cautious side of the line because of the members’ demographics.” Lawson adds: “It is more likely to be a 40:60 or 30:70 fund, but I don’t expect it to be ground-breaking.”

Despite these concerns Pada is confident that its default fund will cut the mustard. Jennie Drake, its acting chair, stresses that she and her team are passionate about the new scheme and they are leaving no stone unturned – hence the lengthy consultation process.

Drake dismisses any idea that means testing will be a barrier and that changes to the State pension will make a huge difference to people’s expected retirement fund when their personal account is taken into the equation. She enthuses about asset allocation and trustee flexibility that could make a difference to many of the current bog standard default funds that are offered to workers.

Drake says she “promises” to deliver a successful pension saving vehicle for the masses – it’s a promise that workers will need her to keep.