It’s not enough to simply offer pension fund members a range of investment choices, finds Rachel Fixsen
Europe’s occupational defined contribution provision is growing up, and the industry is learning. Financial innovators may be excited to offer scheme members pension products with all the options they could surely want. But more often than not, those members simply don’t want to know.
“Members are often presented with investment choices,” says Daniel Morris, senior investment consultant at Towers Watson. “However, behavioural biases either deter them from making a choice - for fear of making a wrong one - or alternatively, even after making a decision they may not review their choices, due to inertia.”
This is why most schemes now offer a default fund option for members who are not financially savvy or find it an unnecessary burden, Morris says. It also makes it very important, he says, that the default fund is designed for the members of the scheme, and that due diligence has been carried as part of the design process.
Mercer typically sees 75-85% of members either choosing or defaulting into the default lifestyle fund option, according to Jenni Kirkwood, principal at the firm.
Towers Watson’s FTSE 100 DC pension scheme survey reveals a large number of schemes now offering a default fund option with some lifestyling within it.
“Whereas in the past, diversified funds were offered to members as a self-select option, more schemes are now introducing them as part of the growth phase within the default fund,” Morris says.
“Given the size and therefore importance of the default fund, this has diversified the investment risk exposure for a large population of members,” he says.
The investments underlying these funds consist of a range of asset classes, each with a different risk profile.
“In addition, schemes are introducing ethical and shariah-compliant products within this fund range,” he notes, although these are mainly offered as part of a self-select options for more engaged members to choose from.
There has been a lot of innovation within default funds, says Jamie Jenkins, head of workplace strategy at Standard Life, with more diversified portfolios, strategies to dampen volatility and more sophisticated lifestyling - for example, different periods and more dynamic switching or rebalancing.
“In addition,” he says, “we have seen more distinct offerings, such as NEST’s approach in using purpose-designed target date funds, with an initial low-risk strategy to avoid market shocks in the early years.”
In their early phases, individual DC pensions can be invested in a broader range of assets than simply equities, says Paul Black, investment partner at consultancy Lane Clark & Peacock. He also suggests diversified growth funds (DGFs) as a suitable investment.
“They may include assets such as commodities and high-yield bonds, and the key principle of these funds is that they aim to return cash plus 4-5%. So if the equities market falls 30%, they should be aiming not to fall,” he says.
Such investments give the scheme member’s savings less volatility along the way - something best avoided from a behavioural finance point of view.
“This is important if you’re trying to encourage members to have confidence in the scheme and continue contributing to it; large losses can cause members to form a negative opinion of pension saving,” says Black.
However, Rona Train, investment consultant at Hymans Roberston, questions the high level of attention given to DGFs in the DC market in the past couple of years.
They generally give members more diversified investment strategies than the more traditional strategies, she says, but adds that it often comes at a significant price in terms of a much higher annual management fee.
“Whilst we believe that DGFs do have a place in DC,” Train says, “we also believe that it is possible to create a diversified structure using more ‘traditional’ asset classes, often at a much lower overall management fee, which may be appropriate for those members wishing, or, indeed, needing, to take less risk with their pension investments.”
In Italy, DC scheme members generally have a choice between four main investment lines. These have become standard since 1993 legislation set the foundation for DC pension scheme investment.
The first three comprised a cash line, a balanced line investing 20-30% of assets in equity and a dynamic line including 50% of equity.
Following the 2007 law on TFR (trattamento di fine rapporto), or employee severance pay package, a fourth investment line was created for DC schemes. Its return replicates the TFR return of 1.5% with 0.75% of inflation. It is invested in cash, bonds and a maximum of 10% equity.
Andrea Canavesio, partner at Italian consultancy Mangusta Risk, notes that even though this guaranteed line was created later on, it has attracted high levels of investment across pension funds. “Now it has become pretty big because of the financial turmoil,” he explains.
Despite the solid democratic principle of letting employees choose how the money they have in an occupational pension scheme is invested, in reality people do not tend to be actively interested or skilled enough to manage their own pension investments, Canavesio says.
“I think it’s good to keep lots of choices, but it’s even better for the pension funds to keep full control. I don’t see how a member of Fonchim, for example, knows whether to be in the guaranteed line or the 50% equity line,” he says.
However, most pension funds do give members the choice, and at least one Italian pension scheme allows its members to switch investments every day.
One solution is to create lines based not on how much equity they contain, but on the life expectancy of the scheme member. Mangusta-Risk has introduced this in scheme design for several clients in the last five to six years, Canavesio says.
“Instead of investment risk, you have a 30-year horizon, a 20-year horizon and a 10-year horizon,” he says.
Moving on from this, the next step would be to oblige the member to go into a particular line, and a third step would be to have a single line available for all individuals entering the market. This could consist of 50% equities, decreasing later on, he says.
In the UK, too, choice within DC plans can be the enemy - even discouraging members from participating at all.
“We mustn’t give people too much choice but if we are going to give choice, we must find ways of helping them make those choices and make it obvious where they can go for help,” says Louise Barrie, head of DC client service at Legal & General Investment Management.
Even schemes for staff working in the financial sector find that a similar small proportion of members actually take active control of their investments, Black observes.
“In the main, we think you should offer members some choice, but it’s making sure that choice is not overwhelming,” he says. Six to 10 investment options are typically enough for the average DC scheme, he finds.
Scheme communication during the investment phase is a big area of focus in the UK, but some say it could be better.
“One area trustees can focus on too much is trying to educate on things like investment, rather than concentrating on issues such as what do these employees expect to live on in retirement,” Black finds.
“Sometimes they can go straight into the detail, rather than thinking about what the member wants from the scheme. They need to try to find ways to take advantage of inertia and controlling natural biases.”
A careful aim is important, according to Kirkwood. “It is a case of ‘know your audience’ and being committed to ongoing education,” she says.
“Targeted communications with information which is relevant is more likely to be read and understood. However, communication has to be ongoing. A one-off communication when the scheme options are reviewed, with no further updates, will not encourage engagement.”
Mercer has found that employers that actively encourage member participation and engagement have the highest level of member understanding.
In Italy, the effectiveness of communication with members varies widely, and depends largely on the labour association managing the pension fund, Canavesio says.
“Some have members across the country in thousands of different companies,” he says. Sending letters out to individual members is a costly business, amounting to a bill of around €2m for three letters a year, depending on the number of members in a particular scheme.
Web-based and email communications can be efficient, but do not ensure contact with all members, he says.
Fondenergia, for example, has a hit rate for communications of around 80%, because between 70% and 80% of its members are staff at the energy company ENI, making contact more straightforward.
But other pension funds, whose members are spread across employers and geographical regions, can have a hit rate as low as 20%.
There are ways of tackling this problem. Chemicals industry fund Fonchim, whose membership is widely diversified, sends advisers out to different parts of the country to facilitate member contact, Canavesio says.
“The other thing is the resources. If you have a high level of AUM, then you have more to spend on [communication]” he says.
Most pension schemes find members reticent about making active investment choices. But when it changed from with-profits to unit-linked, Denmark’s Industriens Pension took the view that practically none of its members would want to be burdened with different financial options.
The scheme is set to complete its transformation in June by becoming a simple life-cycle product for all members, with no choice of risk profiles.
The board of trustees at the pension scheme - made up of employee representatives - decided that members, who are blue-collar workers in the industrial sector, would not want to make investment choices themselves.
Most Danish pension schemes are incorporated as insurance companies. Steen Jørgensen, managing director of Finanssektorens Pensionskasse (FSP), sees the additional protection schemes offer as a crucial part of the investment phase of a DC scheme.
“Investment returns are decisive for the annuity that the pension fund will be able to pay when you retire,” he says.
“During the years of saving, it is important to provide the necessary safety net against the risks of disability and death before retirement.”
The FSP scheme, which covers employees in the financial services industry, runs both with-profits and unit-linked plans. Underlying investment in the traditional with-profits product aims for very broad risk diversification, Jørgensen says.
The main change to investments over the last few years has been to curb risk. “The introduction of additional risk restrictions by the Danish FSA in recent years has reduced the allocation to risky assets, ie, equities, private equity, high yield bonds and emerging markets bonds,” Jørgensen notes.
Target-date funds (TDFs) - funds designed with a certain retirement date in mind and invested accordingly - are a widely used tool in the US for pension provision.
Despite the widely publicised problems in this area in the US - the high equity weightings of these funds led to large-scale losses in 2008 - could this approach translate well into the European pensions environment?
“It may well work in Europe, now that we are moving towards a pension which will target a specific date for payment,” says Barrie.
“The one thing is that target-date funds should always be reviewed by the owner to make sure that the target date for retirement is still correct, and that the owner hasn’t decided on a newer or later date to retire,” she says.
“This was one of the downfalls in the US, because people had left their TDFs to run and hadn’t reviewed them and they were invested in the wrong place at the wrong time.”
In the UK, Kirkwood sees more change ahead for investment in the DC market. With the advent of auto-enrolment, the emphasis on pension provision will only increase in the UK, Kirkwood notes.
She sees more development of products tailored to meet members’ needs as DC assets grow in size. “Some of these will be good, some of them will be over-priced gimmicks,” she warns. “Trustees and employers will need to review what they invest in carefully.”