The company pension scheme is dead! Long live the company pension scheme! It’s an odd situation. Everyone in the pensions industry knows that the defined benefit (DB) scheme is bereft of life and the future lies in defined contribution (DC) schemes. Yet trustees still spend so much time managing the DB scheme that it would be easy to conclude that reports of its death have been much exaggerated. The industry, however, has recently woken up to the future and recognised that DC schemes pose their own, equally thorny problems, which need to be addressed.
“Over the next five years, we’ll see funds using interest-rate swaps to provide a better match for the type of asset an individual will buy at retirement.”
Jonathan Parker
The causes for this awakening are easy to pinpoint: the introduction of auto-enrolment has forced companies to review their current DC offering and the regulator starting to focus its attention on ensuring that companies have a fit for purpose scheme.
It’s not only trustees, human resources departments and regulators who have started to take DC scheme design much more seriously: the asset management industry realises that there is untapped opportunity in this market. Blackrock managing director, UK DC business development Paul Bucksey says: “According to our forecast, DC assets will overtake DB assets as soon as 2019. That’s proof, if needed, why asset managers need to start focusing more closely on this sector.”
DC schemes might have been a lower priority than DB over the last decade but some lessons have been learnt. Consultants and companies recognise there is little point in trying to teach individuals to think for themselves as around 90% of the member population will simply opt for the default fund. Much is often made of key differences between DB and DC schemes but both aim to generate long-term savings to help scheme members fund their retirement. And the truth is that many of the philosophies are transferrable, especially when it comes to the design of the default fund.
Mercer UK head of DC investment Brian Henderson says: “Over the last two years, 50 of our largest schemes have undergone a full strategic review of their DC offering. We’ve used various DB techniques to assess what the DC schemes should look like to ensure the best member outcomes.”
The need for a better solution
Not all that long ago, default funds tended to be made up of passive global equity funds. But the poor performance and the volatility of equity markets over the last decade made DC scheme trustees look for a better solution. As it happens, DB trustees were also often put off by the volatility of equity markets and were prepared to sacrifice some growth for more consistent returns. Enter the diversified growth fund (DGF). Pension consultants pushed the idea of diversifying a scheme’s assets away from the holy trinity of equities, cash and fixed income into alternative assets, such as commodities, infrastructure and property.
But transferring the DGF into the DC market was not that straightforward.
From an operational perspective, a DC scheme’s requirements are similar to the retail market: funds need be liquid, have to be able quote prices for small sums of money and be available on different platforms. Even more challenging than the operational constraints are the governance issues. One of the key reasons that passive equity funds were so popular is that it reduced the governance burden for the scheme. Active funds have to be monitored and exchanged once they start to under perform.
That can create a huge administrative burden, especially for contract-based schemes, because often each individual member needs to be contacted. The burden is even greater for group personal and stakeholder schemes: each member needs to give consent. A trust-based DC scheme, however, has more control over the structure of the plan. The development of white labelling and blended products has enabled trustees to introduce more active investment strategies like DGFs into the default fund. This allows the trustees to change the investments in the default fund without having to inform the members.
Henderson says: “A decade ago we could not use diversified growth funds because it was just too complicated to build them for DC schemes. Trustees had to get their heads round how to monitor, manage and maintain these kind of funds. And the asset managers had to figure out how to build these funds with the necessary operational requirements.”
Asset managers who have yet to develop a DGF for DC schemes should not despair: there is still room for innovation, although regulatory and operational hurdles have to be overcome.
Bucksey says: “At the moment it’s impossible to put certain asset classes into DC schemes, such as private equity, some commodity assets and exchange traded funds. Over time, we’d like to be able to include more of these assets.” Although both DB and DC schemes are designed to solve the same problem: generate enough savings to fund retirement, there is one very fundamental difference between the two plans. A member of a DB scheme knows what salary they will receive in retirement. For a DC scheme member, however, receiving their retirement income is a two-stage plan. First, they must build up a pot of money then they must use these funds to purchase an annuity.
This two-step process introduces two potentially catastrophic risks. Firstly, if financial markets tumble just before a DC scheme member crystallises the gains in the portfolio, this can wipe a substantial amount off the value. Secondly, annuity prices are very sensitive to interest rates. If interest rate are low when it is time to purchase an annuity, this can significantly reduce the member’s retirement income.
To minimise the impact of these two events, many schemes offer a lifestyle or target date fund. A traditional lifestyle fund operates by gradually transferring the assets across into a bonds, usually over a long period of time which both protects the capital value of the portfolio and aligns it with annuity pricing. But these funds are not efficient because the transfer is carried out mechanistically, without taking movements in market prices into account. There is no option to wait a few months for pricing to move in the favour of the scheme member.
Plan sponsors have recognised this fl aw and want more discretion to be used when the assets are transferred during the roll-down phase. Fidelity DC business development director Daniel Smith says: “We have developed a new dynamic roll-down strategy. The strategy operates within an upper and lower limit of risk based on a member’s term to retirement, but the manager has discretion within those limits.”
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