Jamie Jenkins, Standard Life, shines a light on identifying the right investment funds
Imagine for a moment that we were told we had to rewire our homes. Where would we start? We all know what we want the end result to be – light and power safely and efficiently installed in all the right places. But let us be honest, it is probably not something the majority of us would ever have expected to make decisions about. More importantly, we would not feel very equipped to do so. We certainly would not feel sure about making active judgments about what kind of wiring to use or which wires to connect and how. We might be comfortable wiring a plug, but we only do so in the knowledge that it is straightforward, making sure we follow tried and tested instructions. That is a far cry from rewiring our home.
Yet the pensions industry presents people who are joining a pension scheme with thousands of choices of funds and expects them to be perfectly prepared to choose one or more. People know they want to have a safe and secure retirement, but that does not suddenly make them investment experts. Just like our inability to become an instant electrician, becoming an investment expert overnight simply is not do-able. If we need wiring done, we call an electrician. Yet how many people seek advice or have access to an expert when it comes to choosing an investment fund on joining their company pension scheme? Not very many, I suspect. So instead, many people in defined contribution schemes automatically find themselves in default funds.
Default funds have had an interesting life. It is probably fair to say that they started as a basic combination of managed funds with a bit of “with profits”. Then, back in 2001, lifestyle strategies emerged as the leading innovation in default funds. This concept had been around for some time, but now made more sense for default funds alongside the introduction of stakeholder pensions.
Over the last decade, lifestyle strategies have remained the norm in the UK, but have become much more sophisticated, with the ability to insert and blend different fund combinations, change or extend the de-risking cycle and automatically rebalance to maintain the intended mix. In the US, target date funds are the closest equivalent and these have an active rather than mechanistic management of the de-risking phase.
So today we have got a myriad of choice available and a number of different views on what the right component default fund is and whether it should be a lifestyle or a combination of target date funds. It is worth considering the merits of each of them
Lifestyles are advanced in how they work and, generally, there is less expense associated with automated switching of assets in the decumulation phase, so they can be run in different ways with different fund components, but in a scalable way. They are flexible and can easily be recalibrated if people change the date they want to take benefits (the key to this is communication in advance, not the investment itself).
Target date funds benefit from the simplicity of their communication, eg select one based upon your age and the age you want to retire. And many will argue that the inherent economies of scale of running an entire fund to a particular date will reap benefits from the active management that is overlaid. However, one downside is that there needs to be many different funds as each one represents a month or (more commonly) year which people work towards.
It is worth noting that Nest has adopted a series of target date funds to suit the needs of their target population. It has also included a less volatile entry path to ensure people do not experience significant losses in the event that markets fluctuate in the early years.
As for the component funds (no matter what structure), many default funds put in place passive options to give equity exposure at relatively low cost. There are clearly merits in this – passive funds are helpful in reducing costs as part of a wider blend of funds – but members also need to be aware of how exposed they are to market volatility, if passive funds are the bulk or totality of the investment exposure in the early years.
Active fund management opens up an almost infinite number of options and these days most pension providers will offer not just their own funds, but also those of other investment houses – albeit usually at the more expensive end of the spectrum.
The key thing about actively managed funds is that it is not purely outperformance (or alpha) that they offer. While increased outperformance targets will usually be accompanied by higher volatility, active management can offer a range of different objectives, from outperformance to reduced volatility, from diversification to sector or region specific expertise.
A common question is whether active or passive management is more appropriate in default funds. This is fundamentally the wrong question. Both have a place and often a combination will provide the right balance for a particular group scheme, for all the reasons listed above.
And “what is the right default?” is the wrong question, too. It depends upon the demographic of any particular employer’s workforce and actually the particular objective of an individual. Of course, the problem with this is we do not know enough about every workforce and individual to apply such sophisticated defaults – not yet anyway.
So the key to all of this, just like successfully rewiring a home, lies in getting the connections right. In this instance, it is about connecting the right options with the right people. This could mean in future that we see a small number of default funds carefully packaged to meet the needs of different groups of individuals. It will not be an exact science, but it will be a step forward. What we need is some understanding that this would be a well intentioned move, that these new default funds are well communicated and regularly governed and reviewed. Otherwise, the choice of default funds for many employers will continue to be dominated by fear of recrimination.
The investment innovation which we continue to see in the industry is really positive, but needs to be combined with simplicity of messaging and a commonly understood pensions language. Nest’s attempts at this are admirable and I hope this continues with a reduction in the volume of communications we need to provide people.
Not to forget for a moment that we are on the brink of auto-enrolment. People will be automatically enrolled, at a pre-determined rate of contributions, into a default fund, at a default “retirement age”. In the future, it is to be hoped that contribution rates will be automatically increased over time, just as they are in the US. The important thing is how do we better engage people in their retirement planning when many of them do not feel equipped and become passive onlookers when it comes to making decisions?
Encouraging people to engage in their retirement planning is not easy. Some would argue baby steps is the way forward and getting people contributing to their retirement in the first place is positive, which is what auto-enrolment sets out to do. But engagement remains important in helping employees understand their retirement goals and the contribution their employer and the government (through tax relief) are making.
That is where our industry comes in. Clear communications that can be targeted to specific audiences (where relevant) can really help engage individuals, along with additional support like interactive tools and even advice in the workplace. Without this, people will not engage or take an active interest in their long term retirement planning.
If we were to buy a home with round-pin sockets, it is more than likely we would plan to sort it right away. We would find a qualified electrician, get a quote and work would begin. As already outlined, it is not so clear cut for employees who need to choose their pension scheme investments. Even though they do not feel equipped to make the investment decisions, the majority are unlikely to pick up Yellow Pages or go online to find someone to advise them. To solve the problem they need support. Clear communication and pension default funds remain a vital part of the solution. It is also why, as an industry, we will always need to innovate and develop solutions that will help deliver better outcomes for employees who remain within their default fund. After all, we do not want employees to be stuck with round-pin sockets, when the world has rewired and moved on – or has the potential to move on.
Author: Jamie JenkinsJamie Jenkins is head of workplace strategy at Standard Life.