Could an OFT price cap on auto-enrolment schemes change the types of default funds that are offered? Emma Wall investigates
The pensions industry is waiting with baited breath to see the Office of Fair Trading’s findings on whether a price cap is desirable for auto-enrolment pension schemes and how they might influence the DWP’s autumn consultation into the future of defined contribution schemes.
The OFT’s investigation aims to provide an insight into fees across schemes used for auto enrolment. The potential for a price cap has industry experts concerned. While work still needs to be done in the investment community to ensure fees and charges are as low-cost and transparent as possible, some stakeholders are concerned that prioritising cost above all else will stifle innovation.
Launched last October, auto-enrolment is expected to include up to eight million new members into pension schemes by 2020. According to government predictions this will equate to an increase in the value of annual pension contributions of £11bn. The majority of these new pension savers are expected to take no action, and therefore be enrolled into whatever default scheme is being offered by their employer.
But as so many of these scheme members will be new to retirement saving, and will have been nudged into investments without having actually asked to do so, scrutiny of pricing has increased .
Aegon regulatory strategy director Steven Cameron says: “We all have an interest in making sure individuals who are auto-enrolled and invested in a scheme’s default fund receive good value for money.”
But Cameron hopes the DWP will await the OFT’s findings to make sure its approach is proportionate and targeted at addressing outliers. “Price caps may have surface attractions but they can also lead to unintended consequences which can be to the detriment of consumers” he says.
“When stakeholder pensions were introduced, one unintended consequence was margins to pay for advice were squeezed, making it very difficult for individuals to get pensions advice. This time round it’s important we don’t unintentionally reduce consumer choice, therefore, any cap should be restricted to situations where an individual has been automatically enrolled into the scheme’s default fund.”
There are key differences between the proposed cap on default schemes now and the pricing pressure introduced with stakeholder pensions – most importantly that we are now starting from a lower level.
“Default funds currently are largely lifestyle or target date funds and of generally lower cost, as it is not considered appropriate to default someone into a higher cost fund when in most cases the member will be in the fund because they could not or would not make a decision for themselves and so they are relying upon someone else to look after them,” says Buck Consultants head of pensions policy Kevin LeGrand.
Schroders head of institutional defined contributions Steve Bowles says that while the rhetoric may talk about delivering better member outcomes and value for money, the message from a price cap in isolation will be ‘we want it done cheaply’.
“A price cap could place even further downward fee pressure on the investment component of the default,” he says. “This presents a challenge to the investment community and particularly the active investment community. Beta is cheap, alpha is not. Therefore in the absence of any other guidance the market response to a price cap could be to move to simpler and cheaper index relative solutions. However DC is an environment where it is real outcomes that matter, rather than relative performance.”
He argues that there is little evidence to support the view that passive investments were cheaper that alpha managers over the long term – or offered better outcomes for scheme members.
An Evercore Pan Asset white paper released last December, entitled Passive investing for pension fund trustees, highlighted that many defined contribution schemes newly set up to cater for auto-enrolment are targeting annual fees of just 0.5 per cent. Considering institutional fees on an actively managed portfolio can be more than that – especially if invested in alternative assets – and the pressure is on for scheme trustees to plump for passive.
Passive investments do have a place in pension portfolios – certain indices and commodities are better represented with passive exposure.
Many UK default funds are passive in the growth phase with active bond funds and cash introduced during the lifestyling stage, when workers approach retirement – these are by their nature low cost. But default schemes should be the option to invest in both passive and active holdings – on the basis of best in class, not cost, some argue.
State Street Global Advisors managing director, head of UK defined contribution Nigel Aston says: “The debate to date has tended to be framed in binary terms – active or passive. The world isn’t that black or white and we shouldn’t ignore the wealth of investment opportunities that lie between these two extremes: blending index and active; smart or alternative beta; tactical allocation to indexed components and so on,” he says.
Aston says one good thing that will come out of pricing pressure is the end of schemes that are simply closet trackers, portfolios that offer little more than fully indexed substitutes, but carry higher charges.
Aside from the active versus passive debate, Cameron warns that any extension of price capping to situations where consumers make active choices, for example on investments, could do more harm than good.
He continues: “This would stifle innovation and discourage member engagement, which we’ll need if we’re to build on auto-enrolment and deliver adequate income in retirement for many.”
Bowles says that over the past couple of years the investment management community has begun to rise to the innovation challenge.
“It has been possible to produce innovative solutions that focus on delivering specific investment outcomes, in a price conscious environment,” he says.
“The ability of investment managers to maintain this innovation will depend on two key issues: firstly an environment that rewards value for money, rather than low absolute fee levels; and secondly those who govern DC schemes need to become more comfortable with new investment options and tools if they want to deliver better member outcomes.”
Nest – the government provided default pension scheme for auto enrolment – says it has proven it is possible to deliver a highly sophisticated, actively risk-managed default fund at low cost.
“Where automatic enrolment schemes have the right incentives, quality is not dependent on high charges,” says Nest head of investment policy Paul Todd. “Nest has a set of investment beliefs. One of those beliefs is that passive investment generally delivers better value for money. There is a large body of academic research discussing what proportion of investment returns can be attributed to asset allocation as opposed to security selection. Although definitive numbers cannot be agreed upon, there is agreement that asset allocation accounts for a significant proportion of investment. One thing that is certain is that active management is more expensive, and it is difficult to find active managers that consistently outperform the benchmark.”
Barclays Corporate & Employer Solutions investment consultant Lydia Fearn highlights the industry has already started to provide blended solutions to the price problem. She says that we have already seen diversified buckets of investments managed on a passive basis.
The investor is therefore benefiting from a strategic active allocation – but one which is implemented at a very low cost.
“We believe this is a better way to get active management into the default strategy and reduces the need for a high level of governance on the underlying assets,” she concludes.
There are certain types of investment that will be unobtainable if the price cap is set too low however – and it is these alternative holdings which provide a pension scheme with diversification.
Jupiter Asset Management institutional director Charlie Crole says that a price cap would make it less likely that default funds would contain new or original asset types or that DC members would get access to the same types of investments that are routinely available to defined benefit investors.
Many in the pensions industry are in agreement that there should be cost guidelines for default schemes – but that these should be part of a wider set of standards.
“There should be a minimum quality standard for auto enrolment schemes and price should be one component alongside other considerations set out in the Regulators Code of Practice,” says Aon Hewitt head of DC consulting Jan Burke.
“It should not be the sole consideration and should be set at a level to ensure providers want to participate in the market and advisers can continue to innovate to help members get the most from the scheme.”
She says that the fairest structure for a DC scheme should be individual to each employer.
“Pricing will vary depending on the scheme and will depend on factors such as the profile of the members, the contribution structure and the amount of help members get to support their decision making,” she says. “It is fair that members pay more for example in a scheme which provides generous employer contributions, best of breed investments and governance and high levels of support.”
Pensions minister Steve Webb has said that he did not have a pre-assumption as to what the OFT investigation would conclude, but he said that the aim would be to ensure the process was “streamlined, simple and able to engage people”.
The industry has already started to move towards this through competition – and a de facto cap of between 0.5 per cent and 0.75 per cent is already being achieved by many.
Aston says the challenge is simply a case of balancing risk, reward and cost. Schemes cannot achieve the highest return, the lowest risk and the smallest fees all at once, so compromises must be made.
As for the question of innovation and performance, Fearn says the key issue is how low the cap is set.
She admits that it is possible that a cap on the investment, if it is set too low, will stifle innovation. But a reasonably set cap should not hamper good ideas to be fed into default arrangements. As long as a cap on prices does not reduce the willingness for investment professionals to participate in its design, it would be a positive move, she argues.
Auto enrolment was introduced to plug the pensions deficit that exists in the UK – and ensure those working now will be able to sustain a comfortable standard of living in retirement. To this end, the industry should welcome the price cap – as a way of delivering a fairer product to scheme members.
“I think we’ve reached the point in DC now where we have to accept that trying to encourage employees to do the right thing is not the most efficient way of actually changing behaviour,” concluded Bowles. “Auto enrolment is the first step down that path to saving earlier and saving more. We certainly need to educate and inform members about their scheme, but ultimately we need to take the decision away from members.
“In an investment context we should aim for a solution that supports them and provides an environment where the best outcome can be obtained. Charges are important, but in the context of delivering value for money – it is the outcome that matters the most.”