Since the launch of auto-enrolment, the governance of DC pension schemes has become an increasingly prominent issue, with the Pensions Regulator, the FCA (formerly the FSA) and the Office of Fair Trading (OFT) all launching reviews concerning the way DC schemes are run and managed.
While the costs of scheme management and the quality of governance have been the focus of much of the regulatory attention, the oversight of investments offered to scheme members is also on their radar.
In January, when the OFT announced its review of the workplace pensions market, it estimated that auto-enrolment would increase the level of annual contributions to workplace pensions by £11bn. The OFT said it was keen to review not just the cost of pension provision for new and existing savers but, crucially, whether smaller firms struggle to make appropriate decisions for their employees and whether there is a lack of ongoing employer engagement with their pension schemes.
But the lack of oversight of DC investment strategies has also been highlighted by the Pensions Regulator. In January, the regulator published the results of a joint investigation with the Financial Services Authority into the quality of DC schemes. It pointed out that while 90 per cent of members are in their scheme default fund, the quality of default funds often falls short of the standards expected. In December 2012, Pensions Regulator chairman Michael O’Higgins warned employers about using substandard default funds. He said: “Workers should not be enrolled automatically into smaller schemes, which do not benefit from economies of scale, tend to be poorly run and do not deliver value for money in the charges they make to members.
“We also don’t want to see autoenrolment into legacy schemes operating on old administration platforms with higher charges and outmoded default funds; or into schemes that are themselves good, but that require a higher level of financial literacy.”
Over the years, many DC schemes have been established on a ‘set and forget’ basis but there is growing awareness that this approach will no longer stand up to the scrutiny of regulators.
Paul Bucksey, head of DC business development and client management at BlackRock, says: “The increased focus on governance will mean that sponsors and trustees will take another look at the best way to deliver that investment experience for members.”
Some fund managers say this attention on contract-based DC investments in particular is overdue as many of the existing investment options are not fit for purpose. Lifestyle investment strategies have come in for particular criticism.
Tim Banks, head of DC sales and client relations at Alliance Bernstein, says the list of what is wrong with many current default strategies goes on and on.
“We default people into pension plans, we then default them into the investment strategy and then we expect them to understand what a lifestyle strategy is, what it is doing and whether it is running to the right date,” he says.
But if the regulators appear to be dissatisfied with the existing approach to DC default investments funds, what is the answer?
A growing number of experts are pointing to the benefits of using target date funds not only to improve the governance oversight of DC default funds but also to improve scheme member outcomes.
First launched in the US in the early 1990s, target date funds have grown there very rapidly, to the point where more than 70 per cent of 401(k) plans have incorporated target date funds into their investment options.
The first fund was launched by Barclays Global Investors, now BlackRock, in 1993 and the company says the US experience shows that these funds can offer employers and employees something more than traditional DC investment options.
Simon Chinnery, head of UK defined contribution at JP Morgan, says: “Looking at the US experience, those using them are some of the most sophisticated institutions in the world. They are not going to adopt something unless they see real merit in it.”
These merits include the ability for a diversified investment strategy to be incorporated into a single fund, which is actively managed along its investment glide path to take account of market conditions.
This is in contrast to typical lifestyle investment strategies, which often have an inflexible asset allocation model that is difficult to monitor and hard to adapt to changes in market conditions.
“Some schemes have better governance than others but, on average, lifestyles are rarely changed. The trouble is, they are usually only changed after something has gone wrong.
“I think that would fail the most basic of tests, which is ‘what would members’ reasonable expectations be?’,” says Banks.
And even if schemes do decide to change their investment funds, the practicalities involved mean this can prove to be a costly and time-consuming exercise.
Banks says: “We could rebalance all our target date fund strategies tomorrow. One administrator told me that he thought it would take two years to change all the lifestyle funds in the UK.”
Julian Lyne at F&C says the conversation around default fund selection for DC schemes has already started to change.
He adds: “The debate has moved on. It is no longer about whether the default fund has a 95 per cent take-up – it is about whether the default fund is right.”
He says target date funds are not the silver bullet that some in the industry are portraying them to be, but he believes they can offer a number of advantages over lifestyle investing.
“Target date funds give you some governance benefits. For example, if they are run by a fiduciary, they can make allocations to different managers, different asset classes. There is an ability to take a more top-down approach to those types of issues.”
This can be particularly important during the years approaching the retirement date, when relying on an automated or mechanistic move out of risk assets and into gilts and cash can leave investors exposed to changes in investment markets.
Chinnery says: “Lifecycling is mechanistic. It is a very clunky system which doesn’t really take into consideration how you manage through the whole glide path. We don’t think it should be an artificial derisking, where on your birthday you are switched out of equities.”
Lyne says one drawback of target date funds is that scheme members could develop a sense of misplaced certainty about when they will be able to retire. “The one certainty we have is that we don’t know when we are going to retire,” he says.
But Buckley says this is fairly easy to deal with. Although members may start off with one retirement date in mind, if it becomes apparent that their financial plans are off course, it is easy to switch from one target date to another.
“If you will be 65 in 2030, you get defaulted into the 2030 fund, but if you decide you can’t afford to retire then and want to switch out into the 2033 or 2034 fund, it is pretty straightforward. The member decides when they want the money and leaves everything
to the manager.” Using a single manager to run the target date fund shows another of this investment strategy’s attractions.
Buckley says: “It is more straightforward for a member to understand. There is one fund, there is one factsheet and there is one performance number.
“The downside to a lifestyle option is that you could be invested in three or even four funds at one time – depending on where you are in the switching matrix – and that can be confusing because you are looking at four performance numbers, four fund fact sheets. What a target date fund does is package it up very simply and at the end of the year you are able to see how your fund performed. It is very simple to understand.” The focus on a single fund and a sin
gle date could also help DC schemes and scheme members get back to the central questions of what a pension scheme is for.
Rather than getting bogged down in the detail of the investment process, it should encourage employees and sponsoring employers to look at the fundamental questions of when the employee wants to retire and how much they wish to retire on.
“You need to focus on what is the purpose of the DC plan and it should be to get to a point where the member gets a target level of income replacement,” says Buckley.
Cost is a recurring issue for pension schemes and the OFT investigation means it will continue to be a factor in the selection of a pension scheme. Target date fund providers concede that the strategies are more expensive than a passive investment strategy with automatic lifestyling.
Packaged strategies tend to be cheaper than bespoke target date funds and Banks says that compared to some other common DC investment strategies, target date funds provide value for money.
“In terms of our packaged target date funds, we offer those at 35 basis points and below, and that is great value for money. One way of thinking of target date funds is that they are age appropriate diversified growth funds. It is just that they are about a third of the TER of a diversified growth fund.”
Lyne says that while cost is clearly important, the trend of picking the lowest-cost option available has been replaced by a more nuanced approach to fund selection.
“It is not a case of cheap is good or expensive is bad – it is a case of getting value for money for the most appropriate strategy,” says Lyne.
Getting the most appropriate strategy was of paramount importance to Nest when it chose to use target date funds as its default investment option for scheme members.
The scheme, which is likely to become the default pension scheme for a large number of small and medium employers for auto-enrolment, says target date funds make it easier to meet regulatory requirements, thanks to the combination of a simple-to-explain investment approach, low costs and ongoing management of the underlying investments.
A spokesman for Nest says: “All the evidence suggests that even the most experienced and financially knowledgeable savers often make poor decisions about their own pension saving because many people do not have the time or the right information to constantly monitor their portfolio at every stage of their savings career.
“Our target date fund structure and focus on risk management means that we can provide a highly diversified and actively risk managed portfolio that is designed for every stage of a saver’s life. Because of our expected scale we can provide this level of sophistication at a very low charge. We think this approach is suitable for most savers, whether they are engaged with their investments or not.”
The benefits of having what will shortly be the most high profile pension scheme in the UK signed up to a targeted date fund strategy are not lost on the managers currently operating in this market.
Banks says: “While governance committees, trust-based or contractbased, will not have to adopt the same construct as Nest, they will have to explain why what they do is better and different.”
With auto-enrolment set to bring in millions of new pension savers, the prize for cracking the default fund market is a sizeable one.
Chinnery suggests the initial interest will come from more engaged trustbased DC schemes as, spurred on by the regulation and the example of Nest, they start to increase the standard of the investments on offer.
“I think we will see some of the early adopters being among the more forward-looking trust-based plans that have the governance in place to get their heads round defaults and have the time to consider them with their consultants.”
Bucksey, in contrast, says the early demand for BlackRock’s UK bundled target date service is coming from contract-based schemes.
“It is a pretty attractive product if you want well-governed default funds for your members but you don’t want to be too involved as a sponsor in setting strategy and participating in the ongoing governance requirements,” says Bucksey.
There are currently only a small number of investment managers offering target date funds in the UK but if the experience of the US is any guide, the market is likely to be too tempting for other investment managers to resist for long.
Banks says: “We see a mainstream role for target date funds. By 2018 the OFT believes there will be about £11bn of new contribution flows into defined contribution plans.
“We firmly believe that at least 50 per cent of those flows will go into target date fund type strategies.”
Target date funds – the US experience
This year sees the 20th anniversary of the launch of the first target date fund. Launched by Barclays Global Investors, now BlackRock, in November 1993, target date funds grew out of a perceived need to provide a more sophisticated approach to investment for the members of occupational defined contribution schemes.
The adoption of target date funds was modest initially but a change in pension regulations in 2006 was partly responsible for their rapid growth in popularity.
In 2006, the US government brought in the Pension Protection Act to counter ‘reckless conservatism’ in the design of DC default funds, which had caused many scheme members to be invested in cash or near cash investments.
he act introduced safe harbour provisions that allowed companies to embed investment strategies that included more investment risk with no risk of being liable for the investment performance, and target date funds have taken off since then.
According to the Investment Company Institute, 72 per cent of 401(k) plans now offer members a target date investment option, up from 57 per cent in 2006.
The value of assets invested in target date funds was $12bn at the end of 2001 but this had soared to $503bn by January 2013.
Although the proportion of scheme members using target date funds is only 39 per cent, this figure is far higher among younger savers, with 51 per cent of new scheme members in their twenties opting for this type of investment.
The chairman of the ICI recently said that following regulatory changes, it expects to see growth in target date funds in the UK, Sweden and Hong Kong as regulatory changes tip these markets in their favour.
But it has not all been plain sailing for target date funds. Some near-dated funds showed exceptional volatility in the financial crisis of 2007 and 2008, because they were not as conservatively positioned as their name implied.
This volatility led to a joint hearing by the US Securities and Exchange Commission and the Department of Labor, which found that target date funds were generally welcome but that disclosure needed to be improved to make sure that investors understood the risk profile of the particular target date fund they were invested in.
