Defined Contribution: An innovation conundrum
The end to compulsory annuitisation poses questions. When and how will Britons save, invest and draw down their DC savings? Taha Lokhandwala finds an industry unwilling to invest in future plan design until it finds the answers
Defined contribution (DC) pensions are becoming increasingly important in the world of UK occupational pensions. Already a well-established industry, it was turned on its head in March 2014 when the government ended compulsory annuitisation. Thoughts immediately turned to how schemes would manage DC investments in the pre and post retirement phases.
The rules have now been in place for almost half a year. The Association of British Insurers (ABI) estimates that around £2bn (€2.8bn) was withdrawn from DC schemes in April and May 2015, almost half entirely as cash. Active membership in both trust and insurance schemes is now well over 5.5m, according to The Pensions Regulator. Growth will continue apace as auto-enrolment continues. Occupational DC assets were around £214bn at the beginning of 2014 and set to triple by 2023, according to the advisory firm Spence Johnson.
At a glance
• Budget reforms granting freedom to DC members have highlighted a need for innovation in the at-retirement market.
• Regulation and a lack of clarity about future demand is hampering investment in income drawdown and related strategies.
• Schemes, insurers and asset managers are waiting for each other to the take the lead on innovation.
This presents the pensions industry with a conundrum. With auto-enrolment targeting adequate retirement income, product innovation to match this ambition is an absolute necessity, both for commercial and social purposes. But there is a distinct lack of incentive to invest.
Until now, DC schemes have generally invested in growth assets for the bulk of a member’s working life, slowly de-risking into assets that match an annuity purchase. Given the lack of choice, this was largely done without member engagement. In a new world where annuity sales are likely to fall, pension schemes, insurers and asset managers all have to consider how, why and when members will save, invest, access assets and insure themselves in the future.
With assets set to grow, product innovation is most needed in areas like income drawdown.
It is still unclear who is responsible for developing retirement income methods that do not use conventional annuities, although the National Employment Savings Trust (NEST) recently set out its retirement phase blueprints. Responsibility for auto-enrolment lies with the employer but it is questionable whether trustee boards have the appetite to accept any kind of responsibility for the post-retirement phase. This means there is much to gain for providers who get this right.
Strategies like income drawdown rely heavily on sound and risk-aware investment processes. They already exist but are often expensive and a preserve of the wealthy.
Darren Philp, head of policy at the master trust provider B&CE, says he expects to see innovation from both insurers and asset managers but costs will need to be carefully weighed when it comes to the mass market.
“The asset management industry really needs to innovate and come up with products that deliver, but in a partnership approach,” says Philp. “They need some skin in the game. We will need continuous innovation to ensure costs are driven down, otherwise the sophisticated products will become the preserve of those with larger pots.”
The idea of collaboration is logical but requires someone to take the lead. If pension funds wait for insurers who await asset managers who, in turn, wait for demand from schemes, very little gets done.
Emma Douglas, head of DC distribution at Legal & General Investment Management (LGIM), says collaboration between provider and scheme is the only route to spur the necessary innovation.
“You cannot innovate on your own, otherwise you run the risk of designing something that seems great on paper, but that no-one actually wants to buy,” she says.
So the momentum needs to start somewhere. Philp points to the large single-employer DC trust schemes, where unique demographics should spur demand for bespoke solutions that requires innovation from providers. Trustees should play a leading role, he believes.
“I do not want to be in a world where people are developing solutions and trying to sell them. It has to come from the trustees articulating what products they want, in a virtuous circle,” Philp adds. “The more forward-thinking asset managers could be anticipating what their clients want. This is how innovation happens.”
The industry has time to ponder. With DC still in its infancy and many of those retiring still supported by DB entitlements, complex income drawdown products are not yet in demand. Regulation, however, is playing its part in stifling attempts to innovate.
The requirement to ensure scheme members fully understand the implications of their decisions not to annuitise seems reasonable. A review of the functionality of the at-retirement market by the Financial Conduct Authority will determine what providers can offer and, more importantly, what they feel comfortable offering.
“There is a tension between personal freedom and choice and what providers offer,” Philp adds. “Innovation will depend on where the regulator gets to in terms of requirements for interaction with members at retirement.”
A further concern is that insurers have faced unprecedented regulatory change in recent years, which makes investment unappealing.
Douglas says any investment in new product design today will only see a return far in the future. Most individuals’ DC assets are currently too small, and complex products too sparingly used, to warrant large-scale investment in the short term. “Providers do not want to spend too much up front. We cannot set anything in stone as we do not know how the market will evolve. There could be more [regulatory] change,” she says.
“You do not want to spend millions setting up an infrastructure that rapidly turns into the Betamax of the pension world,” she says. “One of the constraints of an evolving regulatory environment is that providers are more cautious with capital expenditure.”
In the end, demand will come from those with freedom and space to innovate. In its Future of Retirement paper, NEST challenges the insurance and asset management industries to help in post-retirement product design. While the thinking behind NEST’s proposed solution is sound, the lack of a deferred annuities market makes it difficult.
The larger insurers like Legal & General, Standard Life and Aviva, have already started to work with clients and with their asset management subsidiaries. Douglas is confident that LGIM can produce something within three years.
Innovation will depend entirely on how schemes approach member needs. Niche retirement investment products already exist. Schemes and providers together ought to able to exercise scale and distribution power to ensure they become staple retirement products.