Pensions automatic enrolment in the UK passed its first anniversary this autumn. Initial reports indicate that it has been a success, with low levels of members opting out. But what impact has it had on the broader defined contribution (DC) environment?
Looking at the big picture, there has undoubtedly been an impact on DC regulation and policy with a new code of practice on governance of trust-based schemes imminent. According to Richard Butcher, managing director at independent trustees PTL: “The Pensions Regulator did not previously engage sufficiently with DC so it’s now a case of shutting the stable door after the horse has bolted.”
The regulator is also working in conjunction with the Institute of Chartered Accountants in England and Wales (ICAEW) on an audit assurance framework for master trusts. This, Butcher says, will create a huge amount of work for master trust providers.
There has also been a lot of change from a product point of view. Those pension providers that wanted a slice of the auto enrolment action have been busy modifying their DC offerings to make sure they qualify under the Pensions Regulator’s guidelines. Some of the resulting solutions, such as master trusts, have been developed in direct response to what employers said they needed, rather than what the providers wanted to offer.
There has also been a huge amount of attention directed at costs, which have been driven down to less than 0.5%.
Another outcome has been the apparent rehabilitation of the default investment fund. There has always been a sense of unease about the fact that over 80% of DC scheme members invest in their scheme’s default fund and rarely review this ‘choice’.
Part of this discomfort has been due to a concern that members see the default as the ‘recommended’ option – a perception that might come back to haunt the trustees many years in the future. Accordingly, there has traditionally been a strong focus on educating members about investment and the associated risks so as to empower them to make their own choices.
This, however, looks set to change. Automatic enrolment makes the provision of a default investment option compulsory and some people now believe that choice is not necessarily a good thing. Efforts are increasingly focused on making sure that default options are appropriate.
“We are seeing greater diversification through the use of diversified growth funds and other asset classes as lifestyle strategies,” observes Robin Hames, head of marketing at Capita Employee Benefits. “Target date funds seek to deliver smoother returns through a broader set of asset classes and more sophisticated glide paths.”
While potentially benefiting the whole of the DC market, recent developments in default funds are a direct, commercial, response to auto enrolment. “There was previously no innovation in DC because the money was in defined benefit (DB),” says Butcher. “The providers have woken up to the fact that by the end of auto enrolment there will be about 20 million people paying up to £20bn a year into DC pensions. Now there are more prospects for the providers and more guidance on what a good default fund should look like.” Today, as well as the more traditional lifestyling approach of investing mainly in equities until 5-10 years before retirement then gradually switching into bonds and cash, DC schemes have access to default funds offering investment strategies previously only available to DB schemes (see table).
Among the providers to appreciate where the opportunities lie is JP Morgan Asset Management (JPMAM) which launched its dedicated UK DC business, UK SmartRetirement, to coincide with auto enrolment’s first anniversary. This offers a series of actively-managed target date funds aimed at getting as many members as possible to the ‘retirement finish line’.
JPMAM says its approach aims to get members to a pot size which provides an income in retirement replacing 55% of their pre-retirement earnings. “In effect we are trying to make sure we have the appropriate levels of risk and diversification within the glide path to maximise the number of people getting there, without just focusing on the average outcome,” says Katy Thorneycroft, portfolio manager for the SmartRetirement funds.
On the face of it, the greater availability of default funds designed to be ‘bought and forgotten about’ should provide comfort for trustees, but they bring their own set of challenges. “It is generally accepted that default options will receive the vast majority of funds and there is recognition that this will require trustees to apply greater scrutiny to their design and governance,” says Hames.
As now, trustees will need to assess whether their default funds are achieving their objectives, but this could be tricky, given the very long timescales over which the new strategies are designed to operate. Thorneycroft says that JP Morgan will report performance against its own custom benchmark, but suggests that trustees also compare this with how other providers and strategies are doing.
Hames believes trustees are beginning to draw up clearer expectations in terms of volatility and relative returns, which will help them to benchmark default strategies and put in place effective governance. He remarks: “This is still in an embryonic stage and DC investment governance has not yet reached the maturity of its DB counterpart.”
Once trustees have got to grips with how to assess the performance of their default funds, they will then need to consider how to communicate this to their members.
To date, auto enrolment seems to have had a broadly positive impact on UK DC as a whole, but there is still plenty of scope for improvement. It’s clear that there is a need for trustees to become more engaged with DC, but as Hames remarks: “The combination of auto-enrolment and regulatory guidance and oversight is helping DC governance to evolve to meet the needs of the new pensions world.” With DC assets under management predicted to outstrip DB by around 2020 and people increasingly working later in life, it also seems likely that we will continue to see innovation in default fund design.