Nyree Stewart investigates how the Personal Accounts Delivery Authority is faring in its task of delivering a national low cost DC scheme within three years

With the latest round of pension reforms just three years away, including the introduction of auto-enrolment, the Personal Accounts Delivery Authority (PADA) is picking up pace in its aim of delivering a national, low cost, trust-based defined contribution (DC) scheme by 2012.

The requirement for all employers to auto-enrol eligible employees into a ‘qualifying’ workplace pension scheme is expected to lead to an additional 10 million pension savers.

Although not all of these will enter personal accounts, PADA estimates it needs to be prepared to service between two to eight million members.

Employer duties are expected to commence in October 2012 but PADA has already begun the procurement process for scheme administration, and while an appointment is expected in June 2010 it has shortlisted four suppliers for the role, including Danish pension fund ATP Group.

Meanwhile PADA has been consulting on operational issues for the scheme, with the latest exercise - which closed in August - focusing on investment strategy.

The document produced more questions than answers, but Mark Fawcett, investment director at PADA, highlights that “one of our firmer proposals” is the use of target date funds instead of a lifestyling approach.

He says: “The advantage of target date funds is you can actually be quite flexible about your retirement date. So, say you think you’re going to retire in 30 years’ time, you enter a target date fund for 2039 and then as you get closer to retirement if there’s reason to think you’re going to retire sooner, or if you want to extend your working life, you can switch funds very easily.”

In comparison, he suggests that while it is not impossible to change your retirement date with mechanistic lifestyling “there’s a lot more administration involved with that”.

Fawcett adds: “Target date funds have received a very good response. Its about simpler administration, which reduces costs; easier communications, along the lines that focuses people about when they’re going to retire. Then if they change their mind they can, and it gives more flexibility in asset allocation.”

In a mechanistic lifestyling approach used in many UK default funds, members get automatically switched every year, or every quarter, from equities to bonds, irrespective of market value and timing.

Target date funds, which are predominantly used in the US, use a ‘glide path’ which can be quite a long period of time where the asset manager manages the de-risking process from equities to bonds.

If equity markets performed very strongly for two or three years the process can be accelerated, or if they have performed less well it can be decelerated to a certain extent, which means “you can manage the asset allocation much more intelligently”, explains Fawcett.

However in response to a less than positive performance by some US target date funds recently, Fawcett claims that the asset allocation in the US is different to the UK because people don’t buy annuities so there is still an allocation to equities at the retirement date.

“It is not the target date funds,” Fawcett explains. “It is just a way of implementing a strategy. It is the asset allocation strategy and glide path you choose that will influence performance.”

PADA has placed most of the focus in the investment consultation on the design of the default, as it estimates that 80-90% of members will fall into this fund.

But Fawcett claims: “We want to design a fund that people don’t just default into but would actively choose. They will look at the choices and a lot of them would want to choose the default if we design it right. But clearly there will be other choices beyond that.”

PADA has looked at a number of schemes in other countries, including the Swedish Premium Pension System, but the US Thrift Savings Plan (TSP) has been particularly helpful in the research by sending a secondee to visit the UK, while PADA has had “a lot of conversations with them around asset management fees, strategies and glide paths, all the work we’ve been doing”.

Fawcett admits PADA has “learnt a lot from them”, but adds that the aim of the consultation is to “try and get best practice from across the UK and around the world to try and avoid some of the pitfalls”.

The authority is already shying away from a default invested 100% in equities, says Fawcett, as in a market downturn “people may simply just opt out. It doesn’t matter how great the investment returns are if the amount of money invested is very small because they opted out. So we think a more balanced approach is appropriate.”

PADA is considering a well diversified approach with “a whole range of asset classes but probably centred on equities and government bonds,” says Fawcett, who suggests that a key issue for the trustee corporation will be to “adjust the allocation between equities and bonds over time to try and capture the periods of good performance”.

The use of a tactical asset allocation (TAA) as an overlay to the default fund has also been raised, but for the long term, Fawcett says, “the key is to get the strategic asset allocation right. How much in equities, how much in bonds, how much in other types of asset such as corporate bonds, property, et cetera.”

He adds that the size of the default fund could favour the scheme in negotiating a “fair level” of management fees so it “can invest in some active strategies and some passive strategies but at an appropriate price so that we keep our overall costs down”.

But he warns that challenges relating to the use of active management include identifying the asset classes where added value is likely, and having the skill to pick the right manager, as a “real risk of going down the active management route is significant underperformance. The average active manager will underperform because of costs”. Choice outside the default fund is expected to be limited to around 10-15 funds underpinned by “excellent governance”.

Despite growing calls for institutional investors to become more engaged in corporate governance and responsible investment, issues Fawcett says that at the beginning the scheme will be quite small and will have less influence.

Therefore, it expects to use fund managers for this in the early days of the scheme, but as the fund grows and gains more influence “at some point we will take an approach something like CaLPERS and take it in-house”.

Fawcett adds: “The challenge is to find a solution allowing us to be engaged investors, while keeping costs proportionate. Overlay services have 20-25 people doing global corporate engagement, so in order to do that as well or better we will need that many people, and there is the cost associated with that.”

However, he notes that it “may not be a direction the trustees want to go in the early years”, because although PADA will make recommendations, the trustees will be responsible for the ultimate decisions and for agreeing the statement of investment principles (SIP).

The results are expected to be published later in the year and although PADA has outlined some ideas Fawcett says: “We are very open-minded and are challenging the industry to give us their best ideas”.