Schemes need a greater understanding of their members since the new freedoms have come into force, argues Jenny Swift, DC consultant, Aon Hewitt
The last few years have proved tumultuous for DC pensions. Increased scrutiny from the Pensions Regulator, the introduction of the charge cap and ‘Freedom and Choice’ have restructured the landscape. We need to ensure our DC investment strategies move with the times.
The new flexibilities effective from April mean there is no longer a one-size-fits-all DC strategy – different members are going to want and need different approaches depending on the form in which they expect to take their benefits. The introduction of the charge cap has also led many schemes to question how they can achieve value for money without compromising investment design.
How can we meet those challenges?
Setting investment strategy for a DC scheme starts with the members – who are they and what are their objectives? What benefits are they likely to want at retirement ?
In the old world, the vast majority of members targeted the same type of benefit – an annuity. But not anymore. After 2014’s Budget Aon Hewitt, in conjunction with the Cass Business School, carried out a survey of DC pension scheme members’ attitudes towards the new freedoms and asked them how they thought they would take their benefits at retirement.
Setting investment strategy for a DC scheme starts with the members”
Our research enabled us to categorise members into different behavioural groups, and has shown that we have a number of types of members to think about. This includes a reasonable proportion of members, 35%, who we identify as ‘Certainty Seekers’ who are most likely to buy an annuity. An equal proportion are categorised as ‘Steady Spenders’, i.e. most likely to retain their investment through into retirement and draw income from it. Other members are identified as ‘Early Spenders’, being more likely to spend their money as cash over a short time frame.
Given these differences in likely spending patterns at retirement, it is clear that each category will also need a different approach to how they invest their DC savings before they reach retirement.
What will your members do?
Our survey looked across a broad spectrum of the UK population, but we think it is important to consider specific characteristics of your own membership. For example, you could survey them to understand their retirement aspirations.
An alternative would be to take a more quantitative view. One way of providing an indication of what members might do at retirement is to look at how large their DC funds are likely to be.
It is important to consider specific characteristics of your own membership”
For example, in a typical immature scheme there are relatively few members in the older age groups and most of them will have low projected fund values. Many of these older members have DB benefits accrued with the same employer. So the older group could be classified in the ‘Early Spenders’ group – more likely to take their DC benefits as cash over a short time frame, and to rely on other sources of pension for their long term income.
The younger group of members are much more likely to rely on their DC pension to fund their retirement. Average projected pot sizes are large. So this group could well consider a drawdown solution – these are perhaps the ‘Steady Spenders’ of our groupings.
What might the new strategies look like?
The key is to provide some level of consistency in how these strategies are designed until around five years before retirement. This means that members are not required to take decisions before they are ready to do so and also reflects the consistency of objectives in the early years between the different groups.
Prior to that five year point, we have two phases; first, the Growth phase – primarily equity based funds, possibly with allocations to other growth-oriented assets, and then a Transition phase, where we start to bring in other asset classes to provide diversification and - potentially - to meet other objectives such as inflation protection.
From five years the strategies will diverge. The drawdown strategy will de-risk towards a well-diversified portfolio at retirement. The cash and annuity strategies follow more traditional paths: the annuity strategy ends up with 75% in an annuity-matching fund and 25% in cash, and the cash strategy goes into 100% cash.
In reality we do not yet know what members will do in this new environment, and investment products are still developing. So DC investment strategies need to be sufficiently flexible to adapt as real life experience starts to come through and as the market develops.
In reality we do not yet know what members will do in this new environment”
Further, the strategies will only be appropriate if members understand them and their application. Trustees and employers will need to raise their game at the five year point to help members determine which option is right for them.
Jenny Swift is a DC consultant at Aon Hewitt
Jenny Swift will be speaking at Workplace Pensions Live 2015 in a session looking at how to ensure members get the most out of their investments. To book your place click here.