Financial Adviser feature on structuring investment options for money purchase pensions
by Dr. Ros Altmann
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The last few years have witnessed a dramatic change in occupational pension provision for future UK workers. The majority of defined benefit pension schemes in the private sector are now closed to new members, many are closed to existing members too. Employers have been turning their backs on the open-ended liabilities which a final salary pension scheme entails and have been moving to defined contribution arrangements instead. Many commentators have lamented the movement away from defined benefit schemes, but there is nothing inherently wrong with money purchase arrangements. They certainly make much more sense for the employer, but also fit in much better with the realities of shorter job tenure and flexible retirement. Average job tenure is around 5 years now, so does it really make sense for the employer to be responsible for paying a pension, for decades in the future, to someone who was only with them for a short time?
The real problem with defined contribution in the UK at the moment, is that it is not working as well as it should. Apart from the fact that contribution levels are much lower in defined contribution schemes and the annuity purchase at the end may not be working well, I think that the design of the investment options for defined contribution schemes needs to be carefully thought through. Individuals should be offered appropriate choices and suitable default options, but this is not always happening.
Many trustees of occupational money purchase schemes have not focussed on the enormous responsibility they bear in terms of the investment options they offer to the members. Many trustees offer little or no choice. All that the members may be able to invest in is a balanced fund, a lifestyle fund or even just a with profits fund. This approach leaves the trustees exposed to a challenge from members, if the fund they are offered performs poorly. Trustees should bear in mind this possibility. Even if more than one fund is offered, there is often very limited choice. It is, of course, difficult to strike a balance between giving too much choice and too little, but it is easier to defend the former than the latter.
It is also important for trustees and providers to think about designing appropriate default options. At the moment, many schemes merely offer a ‘lifestyle’ default, but this one-size-fits-all approach is not really suitable. In addition, research from Invesco suggests that the majority of members who are in a lifestyle option do not understand what it is! Just investing in equities when young and then being switched automatically into bonds as retirement age approaches, will not be suitable for all members. Particularly as policy moves to encourage more flexible retirement, being 100% in bonds at a particular age is not always right. It will be important for each individual member to assess whether they want to carry on working, purchase an annuity with all or only part of the fund, perhaps even go into drawdown or ‘alternatively secured income’. This would require a more subtle change to low risk assets than the lifestyle approach entails.
So what could be done to improve the situation?
I think it is important to develop a more sophisticated approach to the design of defined contribution pension investment options. Many schemes are now introducing multi-manager platforms, which will ensure that members have access to a range of providers, rather than relying on just one (we don’t want another Equitable Life fiasco). In addition, this should give access to a wider range of investment choices too. At the moment, anyone who wishes to structure their own investment portfolio for their defined contribution pension may be unable to do so. Given that pension investments often last for decades, it is surely important to give the option to access a broadly diversified range of funds. I think these should include equities – both domestic and international, fixed income – both gilts and corporate, index-linked bonds, property, hedge funds and possibly even venture capital and commodities. Furthermore, it is vital that investors are able to use passive index funds, not just actively managed. Many schemes offer only actively managed funds, but the fee structure and performance characteristics of these funds may not be suitable for all portfolios. As long as members have access to a range of funds, they cannot complain that they were unable to satisfactorily structure a long term investment portfolio to suit their needs.
Beyond this, however, it is essential to carefully consider the design of sensible default options, which could cater for a range of circumstances. These options can be structured in a number of ways, but would need to be carefully explained to members. For example, there could be options to suit particular age ranges, or for those who do not own their own home there should be options that include property and there should be different ‘risk profiles’ for members to consider.
This leads on to one of the biggest problems with defined contribution investment options. Investment providers have not always understood how little most members understand about ‘risk’. Most people’s concept of risk is very different from that of ‘professional’ investors. To many individuals, the idea of risk means ‘will I lose money?’. It does not mean ‘how much money am I willing to lose?’ And, of course, when investment risk is explained to individuals in product literature, they are not presented with the loss scenarios. The projections they are shown are based on different levels of positive return. That is one of the reasons why pension scheme members have been so disillusioned with their investments. They were not really prepared to watch the value of their contributions fall. Without tax relief, of course, the situation would have been even worse! One possible conclusion from this is that, in order to restore confidence in pensions and long term savings, greater emphasis should be placed on ‘money-back guarantees’ and structured products. If investors are told that, at the very worst, they will at least get back what they put in, or only lose, say 5%, they might be able to live with this. But if they think that they risk ending up with much less than they invested, they may decide not to bother. The investment professionals may say that this is not an optimal long term investment strategy, but I do think it is important to consider what the members’ concept of risk. At the very least, it would be sensible for defined contribution investment options to include an equity related, capital guaranteed product. Even bond funds can fall in value, as can with-profits and balanced vehicles. This is something which has been a major factor in undermining confidence in long term savings. Offering capital guarantees, at least as an option for part of the members’ investments, could encourage more people to contribute and, once they start contributing again, perhaps they can be persuaded to be more adventurous.
This leads on to another important element of defined contribution pensions. Given that most people do not understand investment risk, or pensions, and most will simply not be able to choose a portfolio of funds for themselves, surely we need to consider how to enable members to access independent advice. Moving from a system where most employer pensions are defined benefit, to one in which most will be defined contribution, is a huge change for society. Workers who previously did not have to worry at all about investments or pensions are suddenly being put in a position whereby they need to make choices which they are ill-equipped to make. Surely, we cannot expect them to do this on their own. Members really need access to independent financial advice, to help them understand how much they need to save, what vehicles to invest in, what their portfolio choices should be and how to plan their income needs in later life. They also need advice on annuity purchase. Government should consider ways of delivering advice, for people without complicated financial circumstances, in a cheaper form, with the FSA authorising a lower-cost, specialist advice regime. The 6-hour full fact find is not necessary for most people and advice via the workplace could take advantage of the economies of scale which we so desperately need, in order to make personal pensions work better for the mass market.