A DC smörgåsbord
Simon Pearse recommends that UK pension trustees should use the Personal Accounts model as a benchmark for their own DC schemes
The discussion paper of the Personal Accounts Delivery Authority (PADA) Building Personal Accounts - Designing an Investment Approach - provides a timely update on the defined contribution (DC) investment market along with an insight into where it could be heading. It is a must-read for all current (and potential) DC trustees and sponsors, and others working in pensions.
While the discussion paper focuses on the investment design of personal accounts, it is useful as a reference document for trustees and sponsors to bring themselves up to speed on the DC market, how personal accounts could affect their own scheme and what they could do to update their own scheme. The research and discussion provides a framework against which other schemes could be compared.
The first section of the paper discusses the key characteristics of the expected membership of personal accounts, recognising the target workforce of “at risk” work groups identified by the DWP research. This provides the focus of the discussion of subsequent stages in the design. While the expected membership is not typical of existing DC schemes, there is some useful analysis that could be utilised by trustees/sponsors in understanding the membership of their scheme.
Membership of personal accounts is expected to be the low to medium-paid who, it is argued, would have a lower level of financial education or interest in pensions than the average population. Typically, they include temporary workers, those in unskilled jobs and young workers. For this group the focus is likely to be on simple and prescribed approaches to investment aiming to encourage members to remain enrolled and contributing to the scheme. Undoubtedly this is the most important factor of any DC scheme.
The default fund is likely to be a low cost, low risk fund as the potential membership is perceived to be risk averse. However, this will be subject to the return targeted to achieve the 15% replacement ratio identified by PADA, based on the prescribed 8% contributions and recognising that state benefits will make up the majority of the 45% combined replacement ratio for the expected membership. We would expect the membership of private schemes to focus on higher contributions and investment returns to accommodate higher salary expectations.
One of the most important objectives for DC trustees is to improve member understanding. PADA has provided a consistent focus on member behaviour throughout its paper, recognising that this is critical to investment design. The accompanying research paper referenced in the discussion paper provides a useful overview of the field of behavioural finance and how it relates to DC, and is an invaluable tool to assist trustees understand their members better. This understanding can be useful when communicating to members and in designing the investment options.
Before any investment options are considered it is essential that trustees have a clear understanding of what they are trying to achieve with their DC scheme. The discussion in this section sets out different ways in which the investment objectives can be set and how these objectives may affect different members.
It is important that trustees and sponsors take the time to discuss the objectives of their scheme alongside the expected membership profile and its development. Historically, DC has often not been afforded the necessary time or importance on the agenda, typically taken up with DB items, and without sufficient thought of the impact of the objectives on members. We recommend that trustees increase the time to review their objectives and time spent on DC as reflected in the section in the discussion paper.
The structure set out by PADA can easily be replicated by trustees and sponsors in their decision-making process, and even the questions asked could be applied to their own scheme. Discussions of different types of risk are also addressed in a similar vein to defined benefit schemes and there is no reason why a group of trustees of a private scheme, who are likely to have more experience of investments than most of their members, could not also consider how they can reduce risks for members and choose optimal investment strategies.
PADA looks at the opportunities available in alternative asset classes to equity, bonds and cash to both aid diversification and enhance returns over different stages of the market cycle. Alternative asset classes have become considerably more DC friendly in recent years, overcoming the usual constraints of illiquidity and pricing. Schemes of a moderate size can already access these asset classes but with its potential size personal accounts is likely to influence and accelerate the availability of these products. It is worth trustees looking at how their scheme could benefit from these asset classes within their current structure.
The active versus passive debate is once again raised, albeit with a slightly different angle, by considering the use of manager skill across asset classes rather than just within. This includes the opportunity to access manager views of market movements and take tactical decisions on whether to overweight or underweight particular asset classes. If trustees feel that managers should be better placed to understand the markets and anticipate its movements then they too could consider this approach.
Since the vast majority of UK DC schemes offer a lifestyle approach, which is typically utilised by most members, it is understandable that lifestyle would provide a good benchmark against which other methods can be compared. The discussion paper highlights the challenges to the lifestyle approach along with the positives of other approaches.
Mercer remains committed to the lifestyle concept and our research suggests that it is one strategy that has met its objectives in different market cycles despite the varying market conditions. However, we recognise that elements of the strategy can be improved and we have developed bespoke solutions with our clients to provide more efficient lifestyle strategies specific for their members.
The popularity of target date approach in the US, combining the elements of lifestyle and diversification within one fund, suggests that it could also be considered in the UK. One attraction is that a target retirement date rather than age could make administration easier. It can also provide greater flexibility in retirement, one of the aims of Pensions Act 2005 and ‘A-day’ simplification process, since members can choose more than one target retirement date from which to receive a payout.
Given the size of the personal account structure, a bespoke approach may be most beneficial where the investment strategy and selection of underlying funds could be carried out by the trustee rather than leaving all funds with one manager. For smaller schemes a packaged solution may be worth considering, although an existing lifestyle approach could be adapted to provide a similar result with greater flexibility for the trustees and sponsor in line with their members needs.
The importance of good governance in DC, as focused on by the Pensions Regulator (TPR) recently, is echoed in this section and provides an opportunity for improved performance both by trustees and the scheme investments. A diagram of the relationship between corporate governance and responsible investment helps clarify this commonly confusing area. We believe that the subsequent explanations provide necessary direction for trustees to confidently develop a more structured approach for corporate governance and become more actively involved in influencing UK plc, in which their members are prime investors.
The responsible investment section takes corporate governance to the next level, linking in with the common themes of sustainability and universal ownership. The terms socially responsible, ethical and responsible investment are explained and the paper considers how personal accounts could incorporate these elements within its objectives. We are fully supportive of this aim and encourage all DC schemes to consider the options available.
The paper turns back to the research on member behaviour and the fact that few members access funds offered to them. The research suggests that limited choice can help and this echoes our clients’ experience and that of our research. We advocate a structured approach to fund choice to accommodate the changing needs of members over their working lifetime.
There are a number of methods that can be used to facilitate progressive choice of funds by members, to counter the negative impact of their own behaviour on their fund performance and to allow them to utilise optimal investment strategies in line with their own circumstances. There is no reason why trustees could not utilise these factors in their own scheme.
PADA’s discussion paper is a timely reminder of the key issues that trustees and sponsors should be considering in relation to their own DC scheme. We strongly encourage trustees and sponsors to review the content and consider how they could use some of the ideas that raise similar questions of their own scheme.
Simon Pearse is a senior associate at Mercer in the UK