Gail Moss finds that UK product providers, like many of their international peers, are grappling with how best to pay out income in retirement
At a glance
• Providers are reluctant to innovate for the low-income end of the pensions market as it is considered uneconomic.
• Regulation may be needed to reduce the number of providers.
• Diversified growth funds often provide a one-size-fits-all solution for this market.
• The market is seeing a rapid shift from annuities to drawdown options.
When the National Employment Savings Trust (NEST) – the UK’s largest auto-enrolment scheme – asked its members what their priorities were for retirement, the answer was inflation-protected income, lifetime guarantees, protection against market falls and access to cash lump sums.
In response, NEST unveiled its blueprint for a post-retirement defined contribution (DC) model, which is intended to accommodate all these features. The new default system will blend income drawdown, a cash fund and saving towards an annuity, in the same plan.
At retirement, 90% of a member’s pension pot will be transferred to the income drawdown fund and invested in an income-generating portfolio. The monthly returns will provide a retirement income, while each year 2% of the fund will move into another fund to purchase a deferred annuity. The remaining 10% will be moved into a cash fund for members to access when required.
However, this model will need input from various providers to be viable – and past experience shows that they are reluctant to innovate for low-income sections of the market because it is uneconomic.
Mats Langensjo, head of Nordics at Lombard Investment Management, says: “The UK DC market is too fragmented, with several thousand pension funds, and this holds it back, stalling innovation. For instance, it leads to high fund fees caused by a lack of scale.”
Langensjo says in Sweden and Denmark the move to DC has dramatically reduced the number of schemes, which has increased assets under management and driven down costs. He says: “There is a 75bps cap on fees in the UK, but in the Nordics fee levels are much lower. Scheme consolidation will happen in the UK because otherwise costs are too high and scale is required.”
He also says a lack of innovation in the default market has led to adoption of diversified growth funds (DGFs) as a one-size-fits-all solution. “The return dispersion between DGFs with different risk profiles is huge, so individuals really need advice,” he says. “It is better for providers to ‘nudge’ (compulsory enrolment) the broad groups into efficient products, and allow an opt-out for those groups or individuals with a reason to change risk profile, savings rate, and so on. They need to build in complexity while keeping it simple.”
But the slow pace of change in the UK is not just because of lack of a interest from providers, says Rob Booth, director of investment and product development at Now Pensions. He says: “Most products are being developed in the retail space, which leads to a mismatch between contract-based individual products, and trust-based workplace schemes.”
He says because retail clients already have responsibility for their own decisions, it is often a natural step to select a product to provide them with a retirement income.
“But within a trust-based scenario, responsibility falls much more on the trustees,” he says. “For individuals who have been saving within a trust-based scheme to suddenly find themselves having to find their way through the maze of selecting the right retirement income product is not always easy. And a large number of scheme members also perceive a cost barrier to accessing independent advice.”
Booth says unclear regulation is the reason product development has been slow, even though many trustees would like to be able to offer their members a ‘safe harbour’ retirement income product.
Emma Douglas, head of DC distribution, Legal & General Investment Management (LGIM), says: “A lot depends on what people are asked. Ask if they would like flexibility and added features incorporated into their plan, most will say yes. Ask if they want to pay for increased flexibility, most will say no.” LGIM’s answer is for providers to consider more carefully the personal financial positions and future needs of members.
However, others are more optimistic about marketplace innovation. Data from the Association of British Insurers shows that during the six months after the pension reforms, £2.85bn (€3.8bn) was invested in drawdown products, while £2.17bn was invested in annuities.
Steve Budge, principal at Mercer, says: “The speed and ease of take-up of drawdown options, rather than members opting for an annuity, has happened incredibly quickly. Workplace pension providers have scrambled to get their drawdown solutions ready, and we expect to see greater take-up of internal drawdown solutions over the coming years, in a similar way that internal annuities remained popular choices because of the ease of take-up.”
The latest figures from the UK regulatory body, the Financial Conduct Authority, underline this trend – from July to September 2015, 58% of drawdown customers stayed with their existing provider, while 64% of annuity customers stayed with their existing provider.
Budge continues: “The proposal from NEST does seem a sound blueprint for one option for how a member could opt for retirement provision. In particular, in a similar way to our own global research, they have picked up on the distinction of key phases of retirement and how member needs change through these periods.”
But he warns: “The difficulty with developing any mass-market, post-retirement proposition is that in the current market one cannot predict how many members will use the provision either through internal conversion or external transfer – and further, what the average pot size is likely to be. I also question whether product sophistication is likely to be a significant factor in a member’s decision to use a particular post-retirement solution, as the driver for choice is around getting access, hence constraining the need to innovate in this area – at least for the time being.”
Sweden and Denmark, as pioneers of the wholesale DC route, can be considered leaders in this market. Langensjo says: “In the late 1990s, default solutions were considered the last resort for those people who couldn’t do anything else or were not engaged. But many schemes were then hit by the dot com crash and, as they had a high allocation to equities, people were disappointed by poor returns.”
But about two thirds of Swedish employees are in default schemes as a conscious choice as a result of improvements made by providers. “Defaults need to be the best scheme, rather than a no-frills arrangement that is barely adequate,” Langensjo says. He says, the most successful Nordic DC schemes are those with brands people trust, rather than those that offer the best products, as long as they are not the worst performers.
He adds: “The most successful member communications are from those providers who communicate as little and as clearly as possible, but still give members the feeling they are in a system they trust. The new online providers are really good at this, and also avoiding industry jargon.”
Booth highlights the online dashboard used in Denmark, which provides a one-stop site listing all an individual’s pensions and future benefits. “This is being looked at in the UK, and would certainly be very helpful for members,” Booth says.
At a European level, the situation is blurred by the agendas of the different vested interests, says René van Leggelo, product manager, international retirement at Amundi.
Last June, Amundi launched its pan-European pension fund, Amundi Pension Fund (APF), which offers members a choice of payout modes while being tax-compliant within individual countries.
“Given the choice, the vast majority of people choose to take a lump sum,” says van Leggelo. “In the short term, politicians prefer them to do this because it means they will spend it and invest in the economy. But academics warn of the need to protect individuals [from] spending their money too early, which may result in poverty in the long term.” However, inflation-protected annuities are costly for insurers, providers and employees.
Within APF, Amundi systematically profiles the risk appetite of members when they join, so that not only the investment strategy, but also payout options, can be suggested that match their attitude towards risk.
Looking further afield, Douglas says: “The US and Australia are often identified as examples of more mature DC markets but both generally have fairly expensive retirement options. In the US, annuities (known as ‘immediate annuities’) make up a pretty small proportion of the total market. Many go for ‘variable annuities’ which typically have some form of minimum payment or linkage to investment performance.”
But with some US providers under review for possible conflicts of interest in the sale of those products, he says the US may be heading for a revamp in the style of the UK’s Retail Distribution Review.
Could robo-advice be the way forward?
Robo-advice – the provision of automated (particularly online) recommendations on pension products, which are tailored to individuals – is seen as a panacea for providers to the low-income end of the pensions market.
Emma Douglas, head of DC distribution, Legal & General Investment Management says: “Complexity requires independent financial advice, but in our view, members with small pots are simply not going to pay £1,000 (€1,340) or more for advice. So there is definitely potential for robo-advice to help bridge that gap.”
But she warns: “Although decision trees sound great in practice, a lot will depend on how the regulators approach this, particularly in the UK’s Financial Advice Market Review later on this year.”
Steve Budge, principal at Mercer, says: “Mercer is working with schemes and sponsors wanting to do more in this space to reduce the likelihood of poor retirement choices with a specific budget in mind, through seminars and targeted communication. However, more interactive solutions such as robo-advice do seem a logical step in the value battle of improving member retirement decisions.”
Rob Booth, director of investment and product development, NOW: Pensions also sees potential in online advice, but he says: “It will have to be developed better, and will be a focus during the next 12 months. No-one’s cracked the robo-advice concept yet.”
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