The Value for Money framework within the Pension Schemes Act will reward top performers but could lead to ‘herding’ across the sector, advisers have warned.
Herding was one of several issues debated at a recent Corporate Adviser round table, hosted at the House of Lords. The Pension Schemes Act introduces VFM for DC schemes, requiring trustees and providers to evaluate schemes using a traffic-light system, which measures investment performance, charges and service quality. Schemes with consistent amber or red ratings face the loss of auto-enrolment contributions and scheme closure.
Lewis Daley, senior investment proposition manager at Royal London, weighed up the pros and cons of VFM in its current form: “Boiling something like this down to a forward-looking league table format is littered with the risk of hasty, uninformed decisions. What needs to occur is the demonstration of confidence on an ongoing basis that there’s been improvements [in a pension scheme], that you can provide conviction and confidence, as opposed to just presenting a really
good shiny number.”
The performance test has been scaled back when compared to the Australian version it is based on, but will still have an impact on provider selection. Before it became law an extra ‘colour’ was added to the traffic light system, with dark green for strong performance, light green for good value, amber for improvement, and red for poor value – making comparisons clear
and easy.
In a consultation response published in January of this year, the Financial Conduct Authority also confirmed the introduction of forward-looking metrics to be considered alongside backward-looking metrics in assessments.
Shabna Islam, head of DC provider relations at Hymans Robertson, explains how her own firm will approach VFM: “In our current assessment process, we place roughly equal weighting between backward-looking metrics and forward-looking metrics, so we have a modeller that looks forwards [to provide] a projected outcome, so that corporate working groups can make that informed decision.”
The government reasoning for introducing the VFM framework was to stop savers being “stuck” in underperforming schemes, and the numbers can be startling.
As shown in the most recently published Master Trust and GPP Defaults Report from Corporate Adviser, were the return differentials cited in the younger saver 10-year cumulative return to continue over 30 years, £10,000 in the 6.52 per cent annualised return fund would grow to just over £70,000. The same amount in the 12.76 per cent annualised return fund would grow to over £450,000.
More realistically, over a 40-year time horizon, a 6 per cent net return would grow a £10,000 pot to £110,000, while an 8 per cent net return would deliver £243,000.
Past performance does not necessarily equate to future returns however, and Callum Stewart, DC investment partner at XPS, breaks down how this may impact assessment within the VFM framework: “The backward lens is really important from that point of view, in terms of the learning, but in terms of trying to identify who’s going to be offering the best-performing default, I would place more emphasis on the forward look.
“It’s worth considering if there’s the appetite for the market to do the simplest thing overall, which is going to take the average or median of what the providers are saying and use that as a yardstick, and not allow gamification of VFM.”
While many pension providers have depended on the outperformance of global equities to sustain portfolios in recent years, recent dips within the asset class may point to some need for rotation, particularly if the investments are passive.
Rebecca Green, senior consultant at Lane Clark and Peacock, said: “What we’re seeing in markets, for instance with the recent conflict in Iran, shows that you need diversification. This is especially important when thinking about scale and VFM.”
If markets are unstable, it does beg the question of whether master trusts will attempt to match each other’s portfolios in a bid to ensure ‘safety’. She said this is similar to what occurred when such comparable value for money framework was introduced in Australia.
Richard Grover, strategic employee benefits consultant at Wingate Benefit Solutions, however argued
there is more nuance to what happened within the Australian system than is usually discussed.
When doing research on the ground in Australia, Wingate came to understand that this herding was between smaller superannuation funds which didn’t have the internal capabilities to access private assets or more innovative investment solutions, and effectively had to invest in line with benchmarks, causing the issue.
Private markets
Time will tell in the UK if the smaller master trusts can invest in such a way that does not cause a ‘race to the middle’, particularly within asset classes such as private markets.
The government has shown it is serious in its desire to get UK pension funds investing within private markets. Through the power of mandation introduced in the Pension Schemes Act, DC pension schemes must meet a government target of investing at least 10 per cent of their main default funds into private markets by 2030, with at least half of that allocated domestically, or they can be forced to do so.
This mandation clause caused huge controversy during the bill’s passage, and different DC schemes are still approaching private assets in very different ways.
Nicky Barker, principal and consulting team leader at Mercer Marsh Benefits, said: “All (DC schemes)
are adopting private markets in a different manner. Some of them are doing it more gently and stealthily, rather than through direct private equity investments, and they’re also upping their allocations at different rates. Some are quite high already at 15 to 20 per cent, while others haven’t started yet, they’re still just sort of drip feeding it in. This difference in approach may reduce some of that divergence that we’ve got in returns at the moment as private markets investment ramps up.”
As part of the scale test within the Pension Schemes Act, large defined contribution workplace providers and master trusts must have at least £25 billion within their default arrangements by 2030, or face the prospect of losing access to auto enrolment contributions.
Just as with VFM, the scale test could also revolutionise the pension industry approach to private markets.
Priti Ruparelia, head of DC and trustee director at Independent Governance Group, said: “A reason some smaller master trusts haven’t moved everything to one default is because of cost, especially in something such as private markets where the added value isn’t being seen yet in terms of those additional basis points.”
The proposal of the scale test did also lead to more conservatism in the buy-out space, as many schemes gravitated to the larger master trusts that had the greatest likelihood of survival.
Now the scale is official legislation, with more ways around it than originally thought such as through an innovation exception, Louise Wheeler, member of the DC product team at Aon, assessed its impact: “When selecting a master trust, the focus has now returned to private market expertise, global reach, innovation, and all the great things that it should be about. We lost a little bit of that while everybody was focusing on a number reaching scale.”
Investment in context
Intertwined with the ongoing discussion about the need to increase member engagement with their
portfolios, Mohammed Amin, employee benefits consultancy manager at Grant Thornton, noted that in his experience ordinary savers only paid close attention when the market was in a state of crisis.
“When the markets crashed during Covid in one week I had about 22 phone calls from people concerned about their pension. I actually told them to increase their contributions. When the markets recovered and everything rebounded, not one individual phoned me back again.”
A recent innovation within the pensions space that could change the conversation around engagement is the introduction of targeted support. This move looks to bridge the gap between factual guidance and full financial advice, and allows pension and investment providers to give ready-made suggestions tailored to pre-defined groups of consumers with shared characteristics. The Association of British Insurers has said targeted support could be “one of the most significant engagement shifts in pensions since auto-enrolment”.
On the engagement issue, Grover said: “Communicating to a member when the markets are up is an easy story. In a market downturn you have to answer how is this money invested? What’s it doing? You need to know how that information is presented, and how much detail you need, particularly for a lay person in a way that is necessary for them to understand.”
There are of course many elements to a pension scheme, and while Alison Hatcher, professional trustee and chief client officer at Vidett, underlined that she is aware of the importance of investment, she also frames it within a wider context: “Some of the master trusts have high conviction in their investments, because that’s what they’re trying to position themselves on. Others will have high conviction in
their tech or their service proposition, and that is really valued if your member population is ageing.
“From a trustee perspective, you never have a favourite master trust, because it depends on what it is that we need to achieve for members. You try to be open-minded coming into every discussion.”
