It is well known that commercial pilots don’t actually need to fly their planes thanks to fly-by-wire software. Even so, the presence of skilled pilots throughout any flight is essential. No-one would step onto a plane otherwise.
In the same way that commercial airliners now use fly-by-wire technology, finance and pensions in particular have moved a long way since paper securities were stored in filing cabinets.
Defined contribution (DC) pensions have experienced several iterations. First, they were a poor cousin to defined benefit (DB), in the UK often conceived as additional voluntary contribution schemes embedded in insurance contracts with high fees and opaque or limited investment options. A second iteration saw an abundance of investment choice, often too much for a typical investor and usually without guidance. Now, with auto enrolment, there is a welcome focus on default funds and a limited number of target outcomes and investment options.
Pensions freedoms in the UK mean individuals are no longer obliged to purchase an annuity by age 75. This has led to a welcome outbreak of clarity with three broad choices for members. The first is to target income security through annuity purchase at retirement. The second is income drawdown from retirement age onwards and the third is to target a cash lump sum.
Clarity on outcomes allows trustees to focus on the journey – in other words, the investment options and default strategy that are required. Targeting cash or an annuity means derisking close to the desired retirement age. But given that members will increasingly target a drawdown approach, trustees will need to ensure they maintain an appropriate level of investment risk up to and into retirement.
A useful case study is the US target-date fund industry, which faced scrutiny in 2009 when the relatively high equity allocations for older plan members came to light. The sophistication or otherwise of those allocations is another matter. The point is that members needed to hold their investments through the market turbulence to stay on course.
The UK DC market is clearly experiencing growing pains and there is work to be done to develop intelligent default investment options. Here the challenge is two-fold: the first is in investment strategy, while the second is to tailor the risk level appropriately to the member and their age. NEST’s target-date fund approach looks sensible but its individual per-year strategies would be too granular for most other schemes.
NEST’s approach has also allowed it to design an internal market for illiquid assets which essentially passes these assets down to younger cohorts as older cohorts mature and divest. This highlights an overall design flaw in the regulatory architecture of UK DC in the requirement for daily liquidity. Overcoming this regulatory headwind should help improve member outcomes by allowing investment in long-term, illiquid asset classes.
The new world of UK DC pensions makes the trustees and providers the designers of a pensions-by-wire system. As such, they will play a crucial role in ensuring individuals end up with an investment strategy that is appropriate to their needs. That means getting the default option right in the first place, but also actively reviewing it to ensure that it remains right.
As pilots of their own plane, members will need every help to remind them to stay on course and not change destination part way through the journey or to lurch over to grab the controls when the journey gets rough. Good communication will be essential.
Clearly there is much to be done before UK DC members can set off on their journey on full autopilot. At least there is greater awareness of the direction of travel.