It is now less than six months until D-day – or should that be C-day – when the charge cap on defined contribution default pension funds is initiated. When the cap was first proposed the pensions industry was up in arms; the City boys threw their toys out of the pram, vowing the cap would result in ineffectual solution for pension scheme members.
As it became evident that Steve Webb and his Department of Work & Pensions colleagues were not budging on their price promise to pension savers, most schemes have come around and accepted they will have to adapt to survive. And for some this may mean slashing big mandates with expensive active managers.
Even with wiggle room afforded by industrial scale there is no getting around the fact that active management costs more than passive funds. A recent report from Hymans Robertson into the role passive funds within local government pension schemes recommended trustees opt for wholly passive portfolios.
The report admits that there are some active funds that performed consistently well relative to their peers, but found that for the local government pension scheme taken in aggregate, equity performance before fees for most geographical regions had been no better than the index.
“This outcome is consistent with wider international evidence which suggests that any additional performance generated by active investment managers relative to passively invested benchmark indices, is, on average, insufficient to overcome the additional costs of active management,” it concludes.
If trustees are unable to secure lower charges from active fund managers they could end up forced to adopt this model. Downward pressure from both retail and institutional investors in recent years, as well as the surge in popularity in passive strategies has reduced costs, but not all active managers are willing or able to bring their charges in line with the new cap – placing between a rock and a hard place.
In particular, some big mandates may have more expensive strategies in their glidepath, most typically Dynamic Growth Funds (DGF), which may have push them over the cap.
Standard Life head of workplace strategy Jamie Jenkins says it would be a concern if objectives like managing volatility were eliminated because of the need to meet the cap.
“There seems to be a plethora of opinions from consultants about what the end of a glidepath should look like and many trustees seem to be sitting on their hands,” adds JP Morgan Asset Management head of UK defined contribution Simon Chinnery.
“Perceived, lower cost investment strategies such as passives may be increased within a glidepath to meet the charge cap, however this can hold additional risks. These include; reduced likelihood of passing the retirement finishing line and volatility risk, where levels have historically increased post periods of rate hikes.”
Some providers are offering more automated attempts at controlling volatility which may improve member outcomes when well-designed. Others are advised to adopt a Target Date Fund (TDF) structure with a single fee for all members, making monitoring the cost of investment much easier. TDFs allow the investment fee to be spread across the life of the member, so smoothing out any fee peaks and troughs.
“Typical approaches to managing volatility include a traditional lifestyle mechanism, reducing asset risk as the member moves closer to and beyond retirement, or similarly through a target date fund structure where the approach can be managed more dynamically, or through simple diversification,” said Client Account Manager for Legal & General Investment Management, Richard Skipsey.
“Where a specific investment fund aims to manage volatility through the explicit use of derivatives, there is no reason why these tools cannot be incorporated within the new charges cap.”
Skipsey said that at LGIM, they have many such cases where derivatives had been used to manage volatility at rates considerably lower than the proposed cap.
While some providers may change their investment strategy as a result of the cap; implementing the use of blended passive portfolios, more active-like smart beta ETFs and single fee TDFs, some may decide that they simply do pack enough clout to bring down costs sufficiently.
“Ultimately, DC pensions are a scale game. As a large provider, with over one million members, we’re relatively well placed to keep down costs down for the benefit of scheme members,” says Darren Philp, Director of Policy and Market Engagement at The People’s Pension.
“As the charge cap starts to bite, we expect to see more consolidation in the marketplace, and you can see a world emerging with fewer, but larger schemes.”
Contract Schemes Feel the Brunt
While some big schemes are being forced into reviewing their investments, affected schemes are most likely to be contract based schemes set up by smaller companies, according to Nico Aspinall, Senior Consultant at Towers Watson.
“Unless trusts are both using active diversified growth funds and charging members for administration costs, they won’t be affected,” he said. “Instead, it is the smaller contract based schemes who will have to make changes.”
Within a contract-based environment, member record keeping or administration is incorporated within the overall charge, reduces the amount that can be spent on the investment proposition. An estimated member record keeping charge of around 0.25 per cent leaves just 0.5 per cent to pay for the investment solution.
On top of this increased pricing restriction, many contract-based schemes face opposing pressures from members in medium and small contract based market, who are invested in passive equities and would prefer more active management of their asset allocation.
Director DC Business Development at Fidelity Worldwide Investment, Dan Smith says this causes pricing considerations as there is premium attached to delivering the asset allocation versus passive investment.
“However good value investment solutions – which include active asset allocation and dynamic roll-down strategies – are available within the charge cap,” he offers.
There is also the reduced governance to consider. Savers in contract based scheme do not have trustees and advisers ultimately ensuring that any price based investment decisions are not made at the expense of member outcomes.
Instead, the responsibility lies solely with the provider, raising concerns that the charge cap will result in in a cheaper substitute product being used within the investment modelling process, which may lead to a perceived inferior solution for the underlying members.
“In reality however, a savvy contract-based provider will work closely with those in the industry who make the decisions to ensure that their proposition is attractive and saleable,” says Skipsey.
“In addition, providers are setting up improved governance committees to ensure that their default investment propositions remain appropriate in an ever-changing DC market.”
Down with the default?
There is of course a simple way to circumvent all these strategy challenges. The cap only applies to default pension schemes – so will we see the more switched on savers execute a mass exodus from these restricted portfolios?
Head of Corporate Solutions, Buck Consultants at Xerox John Deacon says that the debate should be about educating all scheme members to make the right decision for their personal needs, and calls for greater communication between providers and members – and the work of an impartial third party.
“Opting out of default funds should be carefully considered and arguably only with the help of an adviser, where the member’s retirement savings strategy is not aligned with that of the default fund,” he suggests.
Smith predicts that over time members will start taking more interest in their investments but this will be as a result of the new retirement flexibility, rather than any impact of the charge cap.
“The majority of members will still want investment solutions packaged but more for their circumstances rather than choosing and building their own portfolios,” he says.
The difficulty with this line of argument is that the new pension freedoms being introduced at the same time as the charge cap next April are almost certainly going to require more complex retirement saving solutions – which will cost more money.
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 five, 10 or 20 years after retirement. This lack of certainty will require new solutions – annuity-like products for those require income in retirement, drawdown products, and longevity insurance.
“These innovations will inevitably come at a price,” concludes Skipsey. “It would be a major concern to the industry if, having brought the member to a point where they can afford to retire, they are not then in a position to deliver a superior post-retirement product purely due to charge constraints.”
