Value for money rather than cheap, passive but with dynamic asset allocation and paying more than lip-service to governance. Consensus on what default funds should look like is beginning to emerge, finds John Lappin
They hold the retirement hopes of an increasing proportion of the UK’s population, yet many default funds on legacy schemes remain unfit for purpose. So the pressure is on the industry to come up with something better, and while it need not be as cheap as Nest, the new pensions paradigm means price will remain important said delegates at the Corporate Adviser/HSBC Workplace Retirement Services forum Reshaping Default Funds For The Auto-enrolment World.
Delegates warned that whatever the rights and wrongs of the debate on price, it will always be a significant factor, particularly with the arrival of low-cost alternatives, including Nest, in the market, and the recent harsh words on charges from all sides of the political spectrum.
Jelf head of benefits strategy Steve Herbert said: “This is about perception. People say that cost should not be the main driver, but that getting the right result is the main driver. But if your default fund is perceived as more expensive than the standard Nest charges, you have a problem. There have to be lower costs certainly. But whether they have to be rock bottom is another matter.”
Some delegates felt strongly that the industry needed to challenge the idea that low price is always right and to emphasise value for money. In practice, they said, that meant making the case for looking at performance net of costs.
But Bluefin head of consultancy solutions Jonathan Phillips worried that the value argument simply wasn’t accepted in political circles.
Hymans Robertson senior investment consultant Anthony Ellis pointed out that the practical issue of a lack of engagement from members meant it was harder for them to understand what value for money actually means.
He said: “We are all agreed it should be performance net of fees. But the problem you have got is that a lack of member engagement means there is no governance there, so no one is going to change their default choices.”
But P-Solve director Damian Stancombe argued that savers wooed by Nest’s cautious foundation phase would come to appreciate value given time.
He said: “Initially they are going into a very safe fund. It may be low cost but if you explain that you could buy a loaf of bread with that money now, but, because of inflation, a year on you won’t be able to buy the same bread, then people will start to value the performance. The investment and the performance is crucial, but it may take a few years.”
He added that he had never encountered cost as a barrier to entry.
Herbert countered that he had come up against objections on cost. He also felt that initially Nest would be the benchmark until the industry could demonstrate value.
Stancombe replied that Nest was set at an artificial price because of the Government subsidy. He suggested that in a rush to compete with Nest’s price structure some other providers might be offering unviable rates long term.
“All these people rushing to go to 0.3 per cent – are they actually going to be in business if they don’t get the flows of money? That will be more damaging to the industry.”
Ellis suggested that Nest itself could fail due to the contributions cap putting off some employers, while others felt that it wouldn’t be allowed to fail and if that required the removal of the cap then politicians would remove it. However delegates also suggested that sabre rattling from insurers over European competition law could have prevented an early removal of the cap when it looked inevitable at one stage.
Delegates had mixed views on Nest’s positioning and appeal. Stancombe said that in conversations with big corporates he had seen very low interest. “Large corporates have pension schemes, smaller ones don’t. They should have been accessed into Nest first. It is all topsy-turvy.”
Herbert agreed. “It was there as safety net for those who couldn’t afford something else. It should never have been charged so low.”
But LCP head of DC investment Paul Black defended the scheme saying it has to act within several understandable constraints of which cost was one. “They also have a target market of people who do not want to lose money initially. We have to give those people confidence in pensions, even if it means giving them a very small return. If it is positive, that gives them confidence,” he added.
Ellis agreed that a low risk strategy was probably right for younger, lower earners.
Phillips said the situation was reminiscent of the arrival of stakeholder charges, with Nest bringing down prices everywhere. While they were likely to stay low, Phillips argued some providers’ plans were based on other firms falling away.
Herbert pointed out that the argument in favour of spending more for better fund management in default funds had been made more difficult by performance in the last ten years.
“The background is that as an industry we achieved pretty poor returns in the last 10 years because everything moved against us. Making that case to the media is going to be that much more difficult even if everything goes with us for the next few years.”
Stancombe argued that some of the problem arose from the fact that default funds had been 80 per cent in equity in the past. However he said some of the sophistication of defined benefit was moving into DC, partly facilitated by platforms and, gave the introduction of fiduciary DC as one example.
Delegates discussed how the shift from the ‘cult of equity’ might be reflected in practice within default funds. HSBC Workplace Retirement Services national business development manager Paul Budgen said: “It needs to be like a family car. It has to work for people who won’t service it, or put oil in it. It still has to work, no matter how it gets treated.”
Phillips said that default funds were less equity-biased than four or five years ago, driven by both auto-enrolment and markets generally.
Black suggested that DC pensions were mistakenly seen as just investment plans when they should be designed with the need to provide an income in retirement in mind. And static asset allocations could never last for ever, he argued.
“This orthodoxy that equities will perform over an economic cycle is just nonsense. We know that now. The people in these plans are people who don’t want to make a decision. We have to start by saying we have to control the risk. The member who in 2008 saw their equity based fund go down 30 per cent wanted to know who was looking after this,” he said.
It was suggested that the industry needed to look at absolute return funds or diversified growth funds, but Phillips added that it can be quite difficult for a member to understand.
Ellis said a default fund should include someone professional looking after the asset allocation, “so it is not just 100 per cent in equities until you get 10 years from retirement”.
Delegates discussed the practicalities of governance arrangements surrounding default schemes and DC in general and how to describe the offering in terms understood by the public.
Budgen said: “I would like to see more open and transparent governance that sits around the fund, where the employers can see it, the employees can see it and where it is named the right thing. It is not absolute return or sleep at night, but it is something that describes the risk, in terms of outcomes. If you are open about what are doing, then you are starting off on a good footing.”
Stancombe said he believed ‘governed’ had to be included. There was some discussion about the term ‘managed’, but delegates feared it had become tarnished by ‘managed’ funds that had not been well managed and which had too high an equity content.
Phillips suggested some idea of a target would be valuable. He said: “You have to tell someone what it is intending to do. It needs to be fairly clear in the title. With more alternative asset classes, it is going to be even harder to understand what’s in a fund, so they have to understand what it is trying to do.”
Stancombe suggested this required education about the objective, though those who wanted to understand the assets in detail would have the option to click through and do so.
Delegates also mooted terms such as ‘supervised’ and ‘overseen’. Passive and active were regarded as pretty meaningless to most investors.
Herbert added: “Nest is too safe but the wording they use is quite clever, though we need to get more punch into it.”
Delegates then discussed how to incorporate members’ retirement aims into a default structure and what had gone wrong in the past.
Stancombe said: “I don’t think it is right to have a single objective. In a common default fund a 21-year-old and a 55-year-old are the same. There have to be objectives based on time to retirement.”
It was pointed out that the risk involved for different age groups with dramatically different amounts of assets was huge and yet had they had same asset allocation.
HSBC Workplace Retirement Services investment services manager Lorraine Fraser sought delegates views on whether auto-enrolment would produce a two-tier system, with the trust market offering a high level of governance and oversight with almost vanilla offerings from contract-based DC.
Delegates thought not, with Phillips arguing that some of the offerings in trust-based DC can be pretty appalling too. He added that with trust there often wasn’t enough choice for those who did want to take an active interest in their financial affairs and that GPPs could provide a better choice. However many delegates felt it would be better if contract schemes could change some things without having to speak to every member.
Delegates felt that contract- and trust-based schemes would converge to some extent driven by regulation.
Stancombe said many problems derived from the focus on DB, citing the example of £1bn DB scheme taking all the pension manager’s time, until it was pointed out it only had 500 members while the DC scheme attracting little oversight had 2,000 employees in it.
Engagement would grow in significance as the shift to DC continued, as savings objectives and outcomes would need to be more clearly understood in future, delegates believed.
Ellis said: “You need to change it to an outcomes-based approach, and not just what you lob into your pension scheme in terms of equities and bonds. What are you trying to do with this savings vehicle in terms of retirement? I am looking for ‘x’ amount. The investment strategy comes off the back of that. It is easier to get that with member engagement. You can ask them, perhaps on a pensions sign-up sheet, what you need to retire on.”
However Phillips argued that was going to be difficult under auto-enrolment. “These people aren’t going to touch any paper. They are reluctant investors, not used to investing in pensions. Getting them to engage is worthwhile, but a pointless exercise for the majority. It isn’t one size fits all. It has to be a size that doesn’t really badly fit anyone,” he said.
He said age was a useful indicator but no more than that given everyone’s widely different circumstances and attitudes.
It was suggested that better off investors, moving into retirement would probably sort themselves out in terms of advice.
However Black pointed out the majority in these default schemes will be low to medium earners.
Stancombe said: “DC is going to fail very badly for a generation. Some of those who you think will annuitise will stay on risk and work part-time.”
Delegates discussed DIFs and blended fund offerings. It was felt that due to scale issues only big players could operate successfully in the market. Herbert said: “I suspect EBCs will be the only ones left in this market.”
Fraser said: “You come back to the cost argument, the perceived value from a blended fund. If it is being governed, you have to have infrastructure around that. It should provide you with all the good things. Do you buy a simple fund or go for the full Monty? Gold? Hedging? There is a probably a middle ground.”
Phillips raised a couple of potential problems.
“With DIFs, we have to be very careful. If we start taking a lot of money out, the whole value argument we want to put together is lost. It only takes a few people doing stupid things on pricing for it to be discredited.”
He also asked what commercial pressure would there be on advisers not to recommend a change where their DIF underperformed.
Market timing of switches within defaults divided delegates at the event, with Stancombe the most in favour, Herbert and Phillips most sceptical and Black somewhere in between citing obvious market timing opportunities such as the risk spread on corporate bonds in 2009.
Delegates also reflected that the guarantees mooted by Pensions minister Steve Webb were far too expensive, particularly in a low inflation environment.
Stancombe said: “When we are seeing market stresses, we are not seeing 5 per cent but 30 per cent. The world has changed fundamentally. Market cycles are getting shorter and shorter. Guarantees would stumble and fall.”
Budgen pointed out that the industry was under pressure on default schemes because the DWP had threatened intervention if the industry got it wrong.
Stancombe hoped the industry would be given time to prove the value argument while Phillips felt some sort of intervention was inevitable given the weight of money involved though not for a few years. Fraser meanwhile said the Government was likely to introduce a safe harbour concept.
Whatever the Government does or does not do, the development of robust default funds that have the right blend of cost, risk and simplicity of message remains a top priority as auto-enrolment unfolds.