Today, 3.6 million people are building benefits in workplace defined contribution pensions, both trust and contract-based. The transition from DB to DC pension schemes has brought with it the realisation that employees are ill-prepared to make vital investment decisions affecting their retirement income.
In the UK there is a wide variation in the number of funds offered on DC schemes with a split between trust and contracted-based schemes. In general, trust-based schemes offer fewer funds with the trustees taking responsibility for the appropriateness and performance of the funds. Contract-based schemes tend to offer more fund choice and sometimes offer in excess of 15 funds despite the fact that research shows that participation rates deteriorate when the amount of investment choice increases.
Behavioural finance experts have given us a lexicon of descriptions for employee investing traits, such as inertia, anchoring, overconfidence and sunk cost fallacy.
In simple terms, the investment choice creates a number of issues. Too many investment choices acts as a deterrent for employees joining the scheme, although auto-enrolment should address this issue.
Having made the investment choice on joining, employee engagement is low and hence the investment choice and the level of contributions are rarely reviewed.
Where the employee has no access to advice, the investment choice often results in the employee choosing funds that are too low risk and therefore creates little chance of the fund growing to an adequate size to fund for retirement.
And on contract-based schemes, the performance and suitability of the investment funds may not be reviewed.
There is a growing wave of opinion towards genuine pension simplification and the aggregation of the small schemes into a much smaller and better managed number along the lines of the Australian ’Super’ experience
On the basis that employees suffer from these issues and are not ’rational agents’, to use the jargon, then what sort of investment tool can really assist them make the right investment choice?
The US market is several years ahead of the UK in this respect and employers there feel both a moral and fiduciary responsibility to offer their workers some form of planning tools to assist them in making an informed choice, especially within 401 (k) plans. It is useful to look at some of the financial tools that have been successful in the US market in order to form an opinion on what may happen in our corporate platform space as it develops.
Back in 1998, Financial Engines became the pioneer of online investment advice in the US with the launch of the first independent online advice platform. Co-founded by Nobel prize-winner, Professor Bill Sharpe, Financial Engines is now used by 131 of the Fortune 500 firms and 8 of the leading retirement plan providers in the US including giants, Fidelity, JP Morgan and Vanguard. Importantly, employers using the Financial Engine tools may obtain one or more fiduciary safe harbours including liability protection. Financial Engine offers a full-service as well as self-service option to employees that meet US standards, the Department of Labor’s Qualified Default Investment Alternative (QDIA) criteria. It is the only type of QDIA that can offer full safe harbour protection to those plans that include company stock, which has grown in attraction in the post-Enron environment.
In the UK, the introduction of auto enrolment will formalise the requirement for a default investment option. There is also a growing wave of opinion towards genuine pension simplification and the aggregation of the small schemes into a much smaller and better managed number along the lines of the Australian ’Super’ experience. The NAPF supporting the introduction of Super trusts or industry-wide schemes as a vehicle for better DC pension provision, and the appearance of ATP of Denmark as a provider in the UK market are evidence of this trend. In ATP’s Denmark offering there is no fund choice, just a single default. In a similar way, the US safe harbour funds aim to encourage employer and employee confidence.
Perhaps as a consequence of the recent market turmoil, employees are crying out for greater certainty of investment returns. Recent experience has also shown that focussing on investment performance is not enough as it is the income that the pension fund will generate that matters. If the industry responds to the needs of the employees, a spate of new innovative funds may emerge that offer some form of certainty of income generated while still retaining the simplicity that is needed.