Rebuilding trust in DC
DC plan members carry all the downside risk in the UK and Ireland, and took a particularly bad beating in 2008. Gail Moss assesses what can be done to improve the situation
The pension schemes worst mauled by the stock market turmoil of the past year were, of course, those whose portfolios were heavily biased towards equities.
It is the sponsoring companies and pension funds themselves that are shouldering the burden in defined benefit (DB) plans, but the members who bear the brunt in defined contribution (DC) funds in the UK and Ireland.
DC scheme members in the UK and Ireland have been particularly badly hit, as performance figures testify. The median performance for balanced UK pension funds was a loss of 20.5% net of fees for the year to 31 March 2009, according to BNY Mellon Asset Servicing. Irish managed funds suffered an even worse performance, losing an average 30.4% net of fees for the same period, according to Hewitt inVision.
The situation was summed up recently by Ros Altmann, an independent expert on pensions policy and former UK government adviser, in her report Planning for Retirement: You're On Your Own, in which she wrote that the credit crisis had hugely damaged the UK's pensions system, leaving retirement savers disillusioned.
Altmann noted: "Policymakers never seriously entertained the idea that stock markets might not deliver strong returns and good levels of retirement income over the long term." She argued that this "bet on equities" allowed governments to cut the state pension to low levels and to shift responsibility to employers, only for employers in turn to cut pension provision, as government regulation and policy changes increased their costs.
Research by MetLife, which sponsored the report, showed that 54% of UK adults say their pensions will fall short of expectations and are worried about their retirement income, while only 9% still believe the stock market is a sound long-term investment.
"In Ireland, members and trustees have been let down by the old investment strategies," says Deborah Reidy, director, Hewitt Associates in Dublin. "Equities were in large-cap stocks with a bias towards Irish equities. Over the past six or seven years the consultant community in Ireland has been campaigning for investment managers to adopt a more global strategy, as the Irish market was too small. But we were ignored, because Irish equities were surging ahead."
By the time the crisis hit, says Reidy, the 20-plus managed funds commonly used for DC schemes were invested up to 80% in equities, with a bond element as low as 12-13%, and the rest of their portfolios in property and cash.
Plummeting share values are, of course, an occupational hazard for any market-based investment. But with the UK and Irish governments both paying some of the lowest state pensions in Europe, income from private pension plans, including DC schemes, is going to be absolutely crucial to the future well-being of members.
So how can trust in DC schemes be revived? Many experts feel that the key to this are the employers, and a realisation of their own vested interest in running a successful scheme.
"For many employers, DC is part of the benefits package to recruit and retain staff," says Andy Tully, senior pensions policy manager at Standard Life. "Share option schemes can also be used as part of the benefits package and can be rolled up with pensions in a tax-efficient way. Even when markets are as volatile as at present, companies still find they help recruitment."
Recruiting and retaining good staff will become more important as the UK and Irish economies recover.
But it is one thing for the employer to be convinced of a DC scheme's merits, and another thing entirely to convince the workforce. To do this, it is vital to start at the recruitment stage, says Gerry Moriarty, director of policy at the Irish Association of Pension Funds. "The pension scheme should be explained at interview and induction - joiners could be given a DVD about it," he says. "And employees could be told that they are turning down free money if they don't join the scheme, because of the employer's contribution."
The message that pensions are a company benefit can be reinforced by, for example, printing the scheme documentation in corporate colours. Schemes can also be made more accessible for foreign nationals by translating documents into their languages. But the underlying principle should be to explain the mechanics of pensions as simply as possible, says Moriarty. "Companies are often complacent about language and talk jargon, but people find it terribly complex."
Once employees have joined a scheme, the content of the benefits statements they receive needs equal attention.
"Confidence in DC schemes has collapsed, but because of poor communication, not poor fund performance," says Ashish Kapur, European head of solutions at SEI International. "Employers do not write appropriately about what's really happening in the pension fund to scheme members. The focus should be on contributions rather than performance."
Kapur says that most scheme members are unaware of either any matching contributions by the employer or the tax relief they enjoy on their own contributions. Fund performance figures sent to members should, therefore, make clear the value of these contributions.
He adds that the benefits of pound-cost averaging should also be underlined. "Markets have come down, but if you bought all the way down, the return on investment wouldn't be the same as for the whole year," he says. "And if a member's fund has been built up over decades, they are still benefiting because they bought when units were cheaper."
He also says that employees are often ignorant of the extra benefits attached to the scheme. For example, an employer might be paying an insurance premium on the employee's behalf, but the employee is unaware of it because he or she never falls ill.
Kapur says employers should specify the value of benefits attached to the scheme in the annual benefits statement. This can be expressed as simply as "The value of your benefit is (for example) £2,000."
Besides written reports, another way to engage with scheme members is workplace seminars. Some providers organise these and say that contributions have risen as a result. Members can be given a general idea of how much they should be contributing by, say, providing an average figure for their peer group.
UK and Irish employers might even consider an idea from the US, where some companies routinely require employees to sign a form acknowledging attendance at a pensions seminar before the company will pay them the annual bonus.
But what can be done to improve DC schemes themselves?
The major cause of the damage in the market catastrophes of the past 12 months was asset allocation. In Ireland, providers are already addressing this, having launched a number of diversified funds within the past year. As well as equities and bonds, these include other asset classes such as commodities, infrastructure, global property and hedge funds. Funds range from the Standard Life Global Absolute Return Strategies fund to Irish Life's Diversified Cautious, Balanced and Growth funds, and other diversified managed funds from a number of providers. In addition to including a wider range of assets than the traditional managed funds, the new funds are also diversified away from Ireland. The relatively small peer group of funds relieves managers from the obligation to follow the herd.
"These new funds will definitely help, although there is a fear that now might not be the right time to move into them if there is an equity bounce," says Reidy.
The UK has seen a similar clutch of funds come to the market in the past two or three years.
Paul Black, investment partner at Lane Clark and Peacock, agrees with the diversification of asset classes within pension funds. He points out that around 80% of DC scheme members go into a default fund. And while default funds are typically lifestyled, to gradually reduce investment risk as the member approaches retirement, he says that traditional lifestyling products - containing equities, bonds and cash - have failed to protect pension pots against the ravages of the recent stock market upsets.
To reduce volatility in the growth phase, Lane Clark and Peacock advocates the use of more diversified portfolios which include alternative assets - now widely used in DB schemes - as well as funds with a target return and risk. And as a protection against pension conversion risk, it says that growth investments should start to be converted to lower-risk assets much earlier than is the norm at present - specifically, at 15 rather than 10 years before retirement. A further protection would be the use of longer-dated and diversified bond funds in the low-risk portion of the portfolio.
The introduction of DB features is also taken up by Watson Wyatt, which suggests incorporating LDI and using insurance-type strategies. Furthermore, it says that DC schemes could use new technology to capture members' personal circumstances and allow more customisation of investment strategies.
The perennial bugbear of DC schemes - which has been exacerbated by the current climate - is the legislation in both countries requiring annuity purchase to take place within a certain length of time.
In Ireland, it is expected that an annuity purchase should occur at the same time as retirement. And as a once-in-a-lifetime purchase, it can be disastrous for members whose pension funds have been hit by a stock market collapse, especially at a time when annuity rates are low like now. However, earlier this year the Irish government made a concession allowing scheme members retiring between 4 December 2008 and 31 December 2010 to defer annuity purchase until the end of 2010.
Though welcome, this does not go far enough, says Moriarty. "In the long term, there needs to be much greater flexibility about retirement," he says. "The approved retirement fund [which allows retirees to transfer accumulated capital to a drawdown plan with no time limit for annuity purchase] should be available to everybody."
Meanwhile in the UK, DC scheme members are required to buy an annuity by the age of 75. This has long been unpopular with a large part of the pensions industry, and both the Conservative and Liberal Democrat parties are committed to abolishing the limit if either form the next government after the general election due by June 2010.
One way to protect DC scheme members' investments while still allowing some participation in stock market returns would be the use of guarantees, as favoured in Germany and Switzerland.
However, the main barrier to using them is cost. "Guarantees are becoming increasingly expensive," says Kapur. "DC investors pay 1% on top of other costs to buy downside protection. Over 40 years, that's an awful lot of return to take away."
But he does see a chink of light appearing over the next few years. "If there was a sufficient push to keep costs down - to say 0.1% - it could happen," he says. "The UK's Personal Account Delivery Authority (PADA) is considering this kind of structured product as its default option. By becoming a huge buyer of this arrangement, PADA might be able to bring down costs."
Stephen Ryan, senior investment consultant at Mercer in Dublin, thinks it unlikely that it is insurance industry intransigence that is blocking the way to cheaper guarantees. "There are cheap providers in the insurance industry," he says. "But if it were a gravy train, there would be more entrants to the market."
However, cost is not the only issue - there are also concerns about a lack of transparency, especially since many products use derivatives, and the credit rating of the guarantor.
Finally, Ryan warns that guarantees do not present a win-win solution. "German funds felt the pain two years ago when stock markets were roaring ahead," he recalls.