It’s been a period of upheaval in the pensions industry, with the introduction of auto-enrolment, the charge cap, and the freedom and choice agenda. Inevitably, funds have had to revisit the way their schemes are designed to take account of all these changes, as Charlotte Moore reports

It has been a tumultuous 18 months for the UK’s defined contribution pension industry, with two key changes in government policy radically re-shaping the investment strategy underpinning default funds.

In March 2014 the government announced that it would be imposing a 0.75% charge cap on investment strategies from 2015. But before the full impact of this policy could be absorbed, it was overshadowed by the government’s announcement that pensioners would no longer be required to purchase an annuity on retirement and could choose how to use their pension pot.

Multi-asset

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The combination of these two announcements has caused providers of DC schemes to radically re-think how they design the default fund. Before the changes, a consensus had emerged about the best way to design a default fund that would service both legacy members and new employees who were being auto-enrolled.

In recognition that most auto-enrolled scheme members were unfamiliar with investing and would be deeply spooked by any fall in the value of their pension, there had been a move away from investing into passive equities with a greater emphasis on multi-asset funds to provide diversification and less volatility.

The requirement to buy an annuity used to mean a straightforward investment strategy”

However, many of these diversified growth funds commanded fees higher than the charge cap imposed by the government, so the industry had to re-think its strategy.

The requirement to buy an annuity used to mean a straightforward investment strategy as the scheme member approached retirement. Risky assets simply needed to be transferred into a fixed income portfolio that could both lock in the value of the portfolio and match annuity pricing.

But the abolition of this requirement to purchase an annuity meant such simple solutions were no longer an option. Now scheme members can choose to take their pot as a cash lump sum, still use it to purchase an annuity or invest in an income drawdown product – and could well choose a combination of all or some of those options.

Meeting changing needs

Designing a default fund for so many different outcomes is far from straightforward. In order to narrow down the options, some consultants are taking a closer look at schemes’ membership.

James Smith, senior investment consultant at Buck Consultants, says: “For a number of our clients we have carried out a demographic review to determine the profile of the membership.”

We feed that data into a modeller to establish what the pot size is likely to be at retirement”

Key metrics examined to build up a better picture include age, salaries, current pot sizes and contribution levels. “We feed that data into a modeller to establish what the pot size is likely to be at retirement,” says Smith.

This analysis gives the scheme a picture of how much members are likely to have saved by the time they retire. Smith says: “Determining the final sizes gives us an idea over what choices people will have at retirement.”

If it is a small pot, the expectation is that members will withdraw it all as cash” 

Pot size is a good indicator of what options the scheme member will pursue. Skip McMullan, chair of trustees at the Bank of America UK Pension Plan, says: “If it is a small pot, the expectation is that members will withdraw it all as cash.” 

However if it’s larger, then after withdrawing some cash, they’ll keep the rest invested in income and return-producing assets, he adds.

Diverse needs and outcomes

In an ideal world, all the scheme members would coalesce around one pot size. But that is rarely the case as most workforces are quite diverse.

Smith says: “If there are a variety of sizes then we think the best option is a consolidation fund.”

The one-size-fits-all consolidation pot recommended by Buck gradually transfers assets out of equities into a less risky option, such as one that has only 40% of its assets invested in shares and the remainder in short to medium-term fixed income. 

Smith says: “This type of fund leaves all the options on the table.”

If there are a variety of sizes then we think the best option is a consolidation fund”

But while this fund design is a better solution than one that transfers all funds into fixed income, it is far from perfect. Smith says: “This will not be the best fund for many members but it will be the least-worst option for everyone.”

Other schemes are taking a slightly more targeted approach to the problem and are offering a number of options.

McMullan says: “We have designed an intranet site for our members that takes them through a series of questions to determine, based on the final pot size, which default fund suits them best.”

Those members with a smaller pot size will be directed to a fund which will provide them with cash on retirement. Those with a larger pot will be pointed towards to a fund which allows the member to withdraw their 25% in cash as well being invested in return-seeking assets, says McMullan.

A sharp devaluation in a member’s pension pot could be catastrophic at this point”

But rather than only using equities to provide returns, the scheme chooses to allocate to diversified growth funds (DGFs). Using a multi-asset fund provides diversification and should reduce the risk of the value of the pot falling too far if there is an equity market correction.

McMullan says: “A sharp devaluation in a member’s pension pot could be catastrophic at this point, as it will seriously undermine the quality of their retirement.”

Rona Train, senior investment consultant at Hymans Robertson, adds: “Once investment returns become more important than contributions, it is important to reduce the overall level of volatility in a default fund.” 

And that would mean switching some assets into multi-asset or absolute return funds, she adds.

The challenge is to be able to allocate enough assets to a DGF that will provide sufficient downside protection”

While it makes good investment sense to allocate a good portion of the default fund to a DGF or an absolute return fund, the charge cap can make this approach problematic, as these funds are more expensive.

Train says: “The challenge is to be able to allocate enough assets to a DGF that will provide sufficient downside protection but also meet the charge cap.”

The asset management industry has adapted to these new government requirements through the introduction of charge-cap friendly products with total expense ratios of less than 0.75%.

While these lower-cost funds help, it can still be hard to get the right investment strategy at the right cost. 

Train says: “We quite often have to blend some passive equity vehicles with actively managed funds in order to meet the charge cap requirements.”

The downside of the charge cap

There is a very real risk that scheme members are not getting the best outcomes because the charge cap is forcing scheme managers away from the better performing DGFs.

Jo Sharples, investment principal at Aon Hewitt, says: “During the recent market correction, many of the flagship multi-asset funds performed much better than the lower-cost alternatives.”

There is a danger that the investment strategy could be sub-optimal for some scheme members”

The challenges posed by the charge cap have been amplified by the introduction of pension freedoms, as scheme members now need to remain invested for longer.

Sharples says: “There is a danger that the investment strategy could be sub-optimal for some scheme members because the choice has been narrowed.” Some of those strategies with greater risk controls can no longer be used in the default fund, she adds.

One of the longer-term implications of the charge cap is that many active managers may decide to shun the DC market altogether, as it’s just too hard for them to gain market share. 

The charging constraints are making it almost impossible to extensively use active managers in the default fund”

Sharples says: “This could result in fewer market participants, which in turn will mean there’s less choice for scheme members.”

Steve Delo, chief executive of PAN Governance, says: “The charging constraints are making it almost impossible to extensively use active managers in the default fund.” 

He argues that under the current circumstances, the near future of DC is one where only passive funds are likely to be used.