Flexible friend

Corporate Adviser/Standard Life round table : Is there such a thing as a perfect default?
Default funds are set to receive the contributions of millions of new savers. The only consensus is they will need to be able to adapt. Gregor Watt reports

It has been predicted that auto-enrolment will create between 5 million and 8 million new pension scheme members and with many of these new savers lacking the experience and knowledge to select their own investments with any confidence, the role of the DC default fund has taken on an even greater significance.

For employers and advisers, choosing an appropriate default fund presents a lot of challenges. These include new regulatory requirements under auto-enrolment, member communication and the cost of a default funds – all subjects that were tackled in detail in a roundtable held by Corporate Adviser last month which asked: Is there such a thing as the perfect default?

For Buck Consultants senior investment consultant Simon Hill the best way to try and answer this question is to go back to first principles and ask what the default fund is really for. Hill said: “What you define as a good solution for a default fund does depend on the reasons why people are doing it.”

Hill argued there are two reasons people end up in default funds. They either cannot or will not choose an investment fund or they assume that because it has been pre-selected as the default option it is the best or most appropriate option available and this should determine the type of fund that should be used.

If they are doing it because they are unengaged, you probably want to think of safety first. But if they are doing it because they think it is the best option avail-able, or they find it very hard to make a decision but that it seems like a reasonable option, then you need to think much more in terms of proactive governance and actually trying to make it the best available,” said Hill.

There was a widespread acceptance that one default fund is unlikely to ever satisfy the needs of all scheme members and employers and their advisers should instead find a fund which meets the needs of the largest number of their employees.

Mazars chief investment officer David Baker said: “With the best will in the world we will never get to a perfect default fund. The best we can aim for is the least worst option.”

While there may be the temptation to choose a fund that will maximise returns for the largest number of members, Standard Life head of workplace strategy Jamie Jenkins pointed out that as auto-enrolment has been specifically designed to allow people to be enrolled in a scheme without making any conscious decisions, a default fund surely has to adopt a safety first approach.

Auto-enrolment could involve people in no way at all making any decisions, so it does have to be a disengaged choice,” said Jenkins.

But even before getting to the choice of default fund, advisers face the problem that many employers do not consider the default fund to be a priority.

Broadstone Corporate Benefits investment consulting director Peter Dean said: “They are more worried about HR and getting all the software in place to make sure they are enrolling the right people and in my experience the default almost becomes an afterthought. ‘Right, we’ve got that sorted. Oh we need a default?’”

So how can employers ensure they get the process of default fund selection right? Jenkins argued it is not about selecting the one fund that is exactly right for a scheme’s membership but is about ensuring you have a well thought out and documented process for the selection process. The concept of ‘safe harbour’, where employers are protected from legal complaint in future, is something that has been in place in the US since the mid 1990s and would be welcomed by many employers in the UK.

Jenkins said to meet this standard employers will have to show they are following best practice: “If you can demonstrate you have made a good attempt at the process and you have either taken advice or you have gone through some steps to understand what you have put in place and why, I think that is how safe harbour is more likely to work.”

For those employers willing to take advice,
Baker said employers should let their advisers take the strain.

From an employer’s point of view it is absolutely correct that they should concentrate on compliance and on systems and it is right they should rely on their advisers for advice on the default fund. While it may be low down their priorities, I don’t think that represents a great risk as they should be able to rely on us to give the correct advice,” said Baker.

The industry is often keen to say DC scheme members are unable to get to grips with quite complex investments but Jenkins said we should not underestimate people’s ability to get to grips with investments: “If we assume people can’t understand risk and return, then we are doing everybody a disservice. People, rumour has it, can bring up children. That is quite a difficult task. Understanding risk and return isn’t as tough as that.”

This approach can also help to tackle the problem of people being enrolled in funds that will probably be too cautious to meet their long-term goals.

Jenkins said: “I don’t think default funds should be about a once and for all investment decision. It should be about how do we get people into the scheme without an obstacle called ‘choosing a fund’ and then thereafter there should be some engagement, because people’s lives will change.”

Education can also help play a part in ensuring that companies have covered their regulatory responsibilities under auto-enrolment.

Dean said: “We try to communicate to all members of all DC schemes about the choice of their fund for, particularly if they are not targeting to retire at 65, 66, 67 or 68, because we know they are aiming at a much longer horizon and they shouldn’t be going into bonds. So it is all about education and we try to cover both our backs, and the employers’ backs, by making certain the employee is aware of what they should be looking at and what they should be doing.”

To date the most common one-size-fits-all solution the industry has come up with is the lifestyle fund which aims to switch out of higher risk assets as the scheme member approaches retirement. But this approach is not without its drawbacks.

Baker said: “My preference would be for a lifestyle approach but we can see at the moment that it is extremely precarious for someone approaching retirement now. You only have to look back at what happened in June when the Fed indicated it was going to cease QE, the impact that had on gilt and bond values lost 6, 7 or 8 per cent over a period of less than a month.”

Another problem that DC pension schemes have encountered is how changes to investment markets or investment management trends can leave default funds looking out of date.

Hill said: “If you go back about 10 years you will find a body of quite significant academic research which suggests the whole idea of lifestyling doesn’t work. That in fact you should be increasing risk towards the end of a DC plan. But a lot of it depends on the fact that 10 years ago equity returns looked much higher and risks looked much lower than current thinking. We’ve gone on through the next 10 years to have very strong bond returns and very poor equity returns, so as you do the modelling it shows bonds look a good option. They give you a high return and low risk. It looks fantastic doesn’t it until in another 10 years time it is going to look like the most inappropriate conclusion that could ever have been drawn.”

Lifestyle funds, particularly when used as part of a contract-based scheme, can also suffer from a lack of flexibility if investment conditions change, not least because of the hoops that must be gone through in many situations to change investment strategy.

Barclays Corporate & Employer Solutions investment consultant Lydia Fearn said the laborious process of getting members to agree changes to contract based schemes makes changes very difficult.

In terms of flexibility, in trustee world you are quite lucky and can change things around. It has been a shame that in the past few years gone by, corporates haven’t been able to make those changes as openly as trustees can. It is quite an effort to get members to sign forms,” said Fearn.

Another problem for default fund selection that has cropped up more recently is the question of whether the traditional lifestyle approach to DC investments will continue to be appropriate for scheme members retiring 20 or 30 years or more from today.

As the size of DC assets grow, more and more people will find that drawdown is potentially more appropriate than a standard annuity and so moving into low risk assets in the final years before retirement could become very inappropriate for many scheme members.

Fearn said: “Is that the right target? Or should we be looking ahead and thinking in 20 or 30 years time, are annuities going to be the right answer for them?”

An alternative to life-styled default funds is the option of target date funds. Although this type of fund is in the early stages of its emergence in the UK, they have been available in the US for many years, tailoring investments to a specific retirement date, rather than a broad range of dates and they often allow fund managers a greater degree of investment flexibility.

LEBC consultant Chris Brown said: “I am a fan of target date funds provided they are sufficiently structured for your particular target date. If you go back to the old SunLife days with five year target dates, you could be five years out on your own particular retirement and could be switching into the wrong things at the wrong time. But in terms of their flexibility, they give the investment manager more flexibility to move into safer funds at a different time, compared to lifestyling, which is prescriptive.”

It is not just providers that are learning lessons for auto-enrolment. The problem of suitable default funds involves employers and employees also understanding the roles they will have to play.

Standard Life head of investment solutions Jenny Holt said: “I think it is important that everyone understands where different responsibilities sit. Employers have got the responsibility to offer a default solution and do some work to gain comfort it is appropriate for their scheme and their membership.”

And increasing levels of employee understanding and awareness will also iron out many of the problems with auto-enrolment, and default funds in particular.

If we can get across to people the fact the buck stops with them as to what their pension income is going to be and if people understand that and engage with that it is much more likely that they will seek advice throughout their working life and part of that advice will be around a suitable investment proposition for them.” n