“In our view, the open market option should be the default for all schemes”
The UK Pensions Regulator’s recent consultation on member outcomes in work-based pensions sought views from the industry on how we could ensure good member outcomes. The first question that this threw up for us was: what is good? The second question was: do fiduciaries actually understand what their members might get from their current arrangements? So where can schemes start?
The first stage is to develop clear objectives for your scheme. We examined the Investment Governance Group’s (IGG) investment principles for defined contribution (DC) schemes at a recent seminar and only a handful of attendees claimed to have set clear objectives for their schemes. To judge the success of any scheme - and to determine whether it is providing good member outcomes - it is important to know what ‘good’ means.
Although investments and contributions will be critical to this exercise, aspects such as high-quality administration are also important to members achieving a good result. Indeed, at a recent focus group we carried out, problems with logging on to the provider’s website were rife. This had actively discouraged members from viewing and taking action on their pension investments.
Ultimately, achieving good outcomes in retirement is about investing the right amount in the right fund in the growth phase, de-risking to the right strategy at retirement and choosing the right retirement option. But what should members be aiming to achieve with their pension saving?
A good place to start is to look at the two-thirds of final salary that many defined benefit (DB)schemes used to offer. Members on a median salary (£25,000, €28,477) may expect to receive a replacement ratio of around 30% of their final salary from state benefits. For a higher earner (£35,000 ), this figure falls to around 20%. This suggests that higher earners need to target a higher level of replacement from their private pension than lower earners (although realistically, they are also likely to have other investments).
In our experience, the majority of fiduciaries of DC schemes do not know what outcomes their members might expect. The IGG’s principles refer to the need for fiduciaries to spend the majority of their time designing and reviewing the ‘default’ fund and developing an understanding of the likely outcomes. Many schemes have work to do here.
It has also become increasingly clear to us that one size does not fit all in relation to default funds. Here are some examples of the differing member behaviour and contribution structures we have come across in the clients we have been advising:
• A scheme where over 50% of the membership was paying a total contribution rate of 20% or more. The median expected outcome, based on the existing default strategy and 20% contribution rate, was 76% of final salary;
• A scheme where all the membership was paying a total of 7.5% with very little additional voluntary contritbutions being paid. The median expected outcome based on the existing default strategy was 30% of final salary;
• A scheme where the vast majority of members were paying only 5% total contribution - this was the rate they got if they paid nothing into the scheme themselves. However, quite generous matching contributions were available above this rate. This was in a company where one might have expected to have found a reasonably high level of financial sophistication.
In some of these cases, we have found that members may be taking too much risk in order to achieve their target level of income at retirement. In the first case, for example, we were able to model the outcomes based on a lower risk strategy (with around 40% in equities and the balance in lower risk assets). This allowed members to achieve a median expected outcome of 60% of salary - still perhaps allowing for an early retirement - but with a much narrower range of outcomes (ie, less volatility).
And don’t forget self-selectors. Although fiduciaries have no legal obligation to contact members who are making what may be considered anomalous fund choices, many trustees, in particular, will want to consider some form of contact - although they must be clear not to give individual advice. Creating a policy on when you will contact members (if at all) is helpful from everyone’s point of view.
The accumulation phase of any investment is critical to the level of pension a person might expect at retirement. But two other aspects are also important - how a member de-risks (including the period of de-risking) and what they do when they retire. For example, if a member plans to drawdown all or part of their pension at retirement, it makes little sense for them to sell equities and buy bonds and cash for five or 10 years, simply to buy back into equities and other income-producing assets when they retire. Equally, for those who do buy an annuity, providing - and promoting - the open market option (OMO) can lead to improvements of up to 20% in the amount a member may take home in pension. In our view, the OMO should be the default for all schemes.
The final piece of the jigsaw - and arguably the one without which the rest is merely interesting - is good quality communication. We regularly carry out focus groups with members of the DC pension schemes we advise. The feedback is often genuinely concerning. We all know that it is difficult to get members engaged in pensions. But we owe it to them to try our best and use all the tools available to us. This is not just sending an annual statement with an SMPI illustration - do you read yours? - but using a suite of communication tools ranging from web-based solutions and modellers to paper-based information. Remember, you will have some scheme members who will not like new ways of communicating. It’s often hard for fiduciaries to see the benefits of communications and this is why is it also important to set clear success measures and regularly speak to your members. Member feedback will certainly help you to determine whether you are providing good outcomes.
In the future, concentration on outcomes will be critical to the success of DC schemes. DC is challenging - there is no doubt about it. But it is incumbent on us all to gain as much understanding of our membership as we can, have a clear idea of what outcome they might expect at retirement and provide a range of fund options and communication tools that really help members engage with their long-term savings.