Rewriting the book on defaults

The Chancellor’s budget pension changes mean default fund textbooks should be thrown out of the window. Emma Wall investigates what should replace them

In the Investment Environment module of the Investment Management Certificate, wannabe advisers, fund managers and analysts learn by rote the difference in liquidity, liabilities and asset choice between a young pension fund and a mature pension fund.

A mature pension fund, we are told, invests in bonds and has nominal liabilities, prioritising capital preservation as it will soon be required to pay out the entirety of its members’ accrued savings.

But all this will change next April, when the syllabus will have to be rewritten to match the pension reforms that will offer workplace pension scheme members much greater flexibility on how they access their retirement savings.

When George Osborne scrapped annuities for all in March’s budget speech he was lauded for granting the general public pension freedom – allowing the grown-ups fair access to their own cash. But behind the scenes the pension industry was thrown into turmoil, evident immediately in the stock market as share prices for the mega-insurers insurers tumbled.

Doing away with annuities not only hits certain insurers’ revenue streams but it also asks new questions of the suitability of lifestyle funds, the home of the retirement hopes of around 90 per cent of defined contribution savers. The outcome-based solutions currently offered will be null and void in eight months. While defaults are currently targeting gilts for annuity purchase, this will have to change.

And investment managers will no longer have the simple task of tapering risk towards retirement age as scheme members may not want to drawdown their funds until 10 years after retirement; meaning they will want a decade longer invested in growth assets.

Nest chief executive Tim Jones admits that the new rules posted a challenge for pension providers. “For the Nest Retirement Date Funds, our Foundation and Growth phases are likely to remain unchanged by the recent announcements,” he says.

“However, we will be reviewing our approaches in the Consolidation phase to ensure how we manage members’ money in that phase best matches a member’s planned method of taking retirement benefits.”

With investment assumptions based on age no longer applicable, a single default approach designed to match an annuity purchase at retirement becomes a much more difficult decision for trustees. Pressure will be on both trustees and investment managers to match an appropriate replacement level of income in retirement, whenever members choose to require it.

Schroders head of UK institutional business development group Neil Walton predicts that trustees and governance committees will need to consider the profile of the membership and design a series of options which manage the risks associated with the different choices members now have.

“Trustees will still have to select one option as the default and will probably be reliant on their advisers in making this choice,” he says. “This is a real opportunity for innovation to provide solutions that provide wealth preservation that bridge the period from accumulation into retirement, alongside approaches aimed at annuitisation.”

Communicating with participants will have to happen in mid-career, over the different paths that can be chosen, he concludes, as it will be too late to do this when they are at the point of retiring.

Suggestions have been made to do away with the consolidation stage of pension fund management entirely – instead keeping DC members in the growth stage of investment indefinitely, although this means scheme members accepting a much higher level of volatility.

Broadening the range of assets held in pension funds could be the answer. Income generating investments such as infrastructure and commodity based instruments such as royalties could help to diversify equity risk. These instruments often come with higher charges however, something that will prove tricky once the pension charge cap is introduced next April.

Increased flexibility within portfolios is a must, says Mercer partner and UK DC savings leader Brian Henderson. “People will need different ‘run in’ assets depending on what they do with their funds at retirement. For example gilts and bonds for those who still intend to buy an annuity, cash or some inflation linked asset for those who want to take cash, and lower growth assets for those who want to drawdown,” he says. “Much work is going on to get the right asset mix for these situations and more sophisticated approaches will emerge.”

What is clear is there will be no longer be one strategy that fits all perfectly, which was the idea behind a default fund. Greater communication with scheme members may help investment managers make their decisions, placing the responsibility with the individual rather than the pensions industry.

But this may be an uphill task according to a recent survey by AllianceBernstein. It revealed that three-quarters of DC members had either ‘no idea’ or only a ‘vague idea’ of the date they would retire. Even in the over-55 age group, more than half said they were still unsure of their final retirement date.

“It is not unreasonable to assume that they are also unsure what they will do with their pension pot and clearly require a flexible solution to meet the demands of the modern working environment,” adds Tim Banks, managing director of the provider’s pensions strategy group.

Banks sees a much greater role for proactively managed solutions that allow for quick and easy changes as well as early or late retirement and says he “expects a dramatic shift toward strategies such as target date funds”.

JP Morgan Asset Management head of UK defined contribution Simon Chinnery agrees that TDFs dynamic glide paths allow investment managers the freedom to change or adapt the types of investments or their weightings in the latter years to make a smooth transition into eventual drawdown.

Chinnery says that the UK could learn from the US model, where less than 10 per cent of the market buys an annuity.

“Target date funds are more than 20 years old in the US and as they continue to build a track record and assets – more than  $650 billion according to Morningstar – it is clear they are offering more flexibility than other defined contribution products, which is winning over companies and investors,” he explains.

But First Actuarial director Henry Tapper does not believe TDFs have an exclusive hold on the future of defaults in the post-budget world. He says: “I don’t buy the fact that target date funds are the only solution. I don’t buy this idea of having a single line of best fit. This is too important to take the approach that ‘this solution is good for seven out of 10 cats’. There is no short cut here – you can’t just sort this out with algorithms.

“There is no reason why three different lifestyle funds couldn’t do the job just as well. The real issue is getting people to make the right choice and that is all about education and engagement.“

 With so much money to be channelled into default funds in the coming years, this is clearly a debate that is set to run and run. Whichever school of thought wins the day, it is clear that today’s lifestyle funds targeting annuities are no longer fit for a significant proportion of the people saving into them.

What Would a Post-Retirement Default Strategy Look Like?

Last year, 350,000 annuities were sold by ABI members in the UK and analysts predict this market will drop by two thirds following the implementation of the pension reforms. With hundreds of thousands of scheme members predicted to stay invested after retirement, what will a post-retirement default fund look like?

Guidance from the Department for Work and Pensions outlines that in terms of its investment strategy and asset allocation, the default option should, as far as is reasonable, take account of the likely characteristics and needs of employees who will be automatically enrolled into it. Post-retirement these needs are far ranging – some members may opt for several lump sums evenly spaced throughout retirement, while others will want all their cash at 70.

In markets where DC schemes are more established, such as the US, Canada and Australia, pension schemes offer members more control of their own savings.

State Street Global Advisers head of UK DC Nigel Aston says: “Scheme members seem to want an at-retirement product that allows them to control their assets and which provides a predictable income with a very high probability that the income will be sustainable over the long term”.

As was Osborne’s want, the responsibility for post-retirement solutions will have to be placed in the hands of the scheme members.

JP Morgan Asset Management head of UK defined contribution Simon Chinnery explains: “It’s not possible to have multiple default funds. By their very nature a default is designed for people who do not want to make any investment decisions. Options at-retirement, however, require engagement with scheme members.”

For those who wish to engage with their provider, options could be provided in the run up to retirement age. Those who wish to buy an annuity will be de-risked in fixed income assets, and those who wish to keep their cash invested could be provided with a choice between two or more multi-asset strategies – such as an annuity-proxy income portfolio or a growth fund.

Unlike annuities however, these strategies will have the flexibility to receive top-ups for those who wish to continue working in some capacity. According to the recent Retirement Readiness Study from Aegon, four in 10 British workers expect that they will continue to work past the age of 65, with a further 14 per cent predicting they will have some form of part-time employment so this feature is an essential development.

Rather than fall to the responsibility of the pension provider, this strategy decision may provide an opportunity for the financial advice sector, and be incorporated into the free advice on retirement outlined by the Chancellor in March’s Budget.

“Early consumer surveys suggest that roughly 32 per cent of DC assets will be money-in-motion, either entering drawdown wrappers, Isas or going into annuities which are not overseen by the pension scheme or trustees,” says JP Morgan head of retail Jasper Berens. “Advisers will have to raise their expertise to meet a newly opened market, requiring them to gather significant context across capital markets, investment strategies, and financial planning – not to mention no single client will have the same set of circumstances as the next individual.”