The right amount of risk

Some risk is good for default funds. It is our job to make sure members get the right amount of it says JLT Employee Benefits chief executive Duncan Howorth

Duncan Howorth, JLT Benefit Solutions
Duncan Howorth, JLT Benefit Solutions

The debate about the nature of members’ default funds is building and looks set to run for some time. This in itself is strange as members have been contributing to DC schemes for over 20 years with little scrutiny. There seems to be some extreme views out there, with the pensions minister also now offering some suggestions on what “good “ might look like.

There are perhaps 3 fundamental questions being asked around the issue. Firstly, in the compulsory world of auto enrolment, how right is it to put these forced savings at risk of capital loss ? Should this apply to the employee, employer contribution or both?

Secondly, to what extent do members change their savings habits ( or stop saving at all ) if faced with a short term capital loss ?

And finally how important is it for schemes, advisers and fund managers to follow conventional wisdom and recommend/ commit contributions to equity based investments in a bid to beat inflation, but which carry volatility and the possibility of capital loss?

The fact that DC contributions will increase materially under auto enrolment should not change the need to put them to best use and seek to achieve the investment objectives of building the real value of retirement income. After all, those that are not happy with the returns can either self select or even opt out. Some commentators argue that capital loss events, however short term, drive people to cease savings or switch investments in a potentially ill-timed flight to safety. But is the alternative to commit savings to long term low levels of return just to avoid the risk of knee jerk reactions to a capital loss ? Would the bigger scandal be the failure to preserve real value of savings rather than the absolute value at any point in time ? Scheme sponsors and trustees need to have the long term interests of their members at heart when designing the Default Fund and related options. These interests should be focused on good member outcomes as the Pensions Regulator points out. Other participants, for example Nest, may have other interests to consider – that levels of opt out are not too high – in the short term this objective might override the delivery of long term member outcomes.

It is also wrong to say that reward cannot be delivered with an acceptable degree of risk. Whilst the industry has been slow to bring the more sophisticated investment techniques of DB to DC, they are coming now, and can be packaged to be made available for the small and mid-size scheme. For example, diversified growth funds have been proven to provide ‘growth-like’ returns but with significantly reduced volatility. These products are more expensive than passive equity funds, but they are very much in line with DC members’ needs. It is not all about cost.

The pensions minister has recently challenged us to produce guaranteed returns. While consistent with the desire for a defined ambition future, it is a big ask. Who will back the guarantee? Employers who have stood behind the DB promise for so long are heading for the hills. Banks are unlikely to be trusted and the cost of a guarantee to an insurance company has just risen – thanks to Solvency II.

It’s time that members were treated as individuals. With today’s technology, it should be possible for members to be taken through a risk profiling process, to help them understand risk in a long term savings context, and to identify their own risk appetite. Schemes should then be able to deliver an investment solution applicable to them – not deliver a ‘one size fits all’. In this way, members would have a better understanding of the risk that their money is being put in and the returns they might expect. To me, investors take flight when they experience the unexpected, not a simple capital loss.

How do we square the circle? After all, nothing stays the same for long, so a solution for today is unlikely to last too long. Just as investment fads come and go, so does risk appetite.. Schemes need default funds that meet the needs of their members, and a structure that allows these to move with the times and with clear monitoring and governance included as standard.

Most importantly, members expect us to do what is best for them, that is why they default to our expertise.