Pensions World

With the arrival of auto-enrolment, it is vital that members understand how the default option works warns Malcolm McLean, Barnett Waddingham

As we get ever closer to the start of auto-enrolment, there is growing interest and concern about the use of the default option, given the large numbers of new scheme members who are likely to be enrolled into it in the future.

Following a consultation exercise, the Department for Work and Pensions (DWP) has recently published guidance setting out its expectations as to the parameters to be used in designing and communicating a scheme’s default option and how it might work in the best interest of members.

But there is not, nor in my view should there be, one standard model as a catch all. Schemes vary and the needs of individual members vary and the DWP has clearly recognised this in framing its guidance. That said, I think we can all agree that designing and implementing a default option is vitally important and is something the trustees and their advisers must take care to get right.

Scope for misunderstanding

My own experience, usually from the outside looking in, is that members often do not appreciate what the default option is or how it is supposed to work. Many think that by not themselves exercising a choice of the various investment vehicles on offer, someone within the scheme will take it upon themselves to select something bespoke for them and put them into it. Whether this misplaced optimism and belief works out for them in the end is as much a matter of luck as good judgment, but good communication and regular reviews along the way can often steady the ship and ensure a safe landing.

But you should never underestimate the scope for misunderstandings in pensions. Although perhaps symptomatic of a wider malaise, one recent complaint I was told about from a member did surprise me a bit. It came from a man I shall call Jack Jones (not his real name) who wanted to complain about having been put in an “active lifestyle” fund. Apparently he had joined a defined contribution (DC) pension scheme and had not indicated a preference for any of the investment funds on offer. In consequence, he had been put in the default option which had been set up as a lifestyling arrangement.

So, what was Jack complaining about? He said it was because, in his view, he did not have a very active lifestyle and he objected, therefore, to being put in a fund carrying that name. Jack said that on a typical day he got up in the morning, had his breakfast, drove to his office, sat at his desk, had his lunch, sat at his desk, drove home, had his tea, watched television and went to bed.

“Does that sound to you like an active lifestyle?” Jack asked.

“Of course not”, was the reply “but it doesn’t actually mean you yourself have to follow an active lifestyle. It is more about the type of investments that you are in at different stages of your life and minimising risk as you approach retirement.”

“Well, why didn’t you say that in the first place”, came back the perhaps predictable response.

Wrong end of the stick

There are two points I would make on the basis of this story.

The first is, as I have observed on many occasions in the past, that we really must stop using jargon when dealing with the general public. Words and phrases like accrual, franking, protected rights and so on will not have any meaning for the average person. Even worse is the form of jargon which uses everyday language and sounds like it should mean something but in fact means something else. Lifestyling comes into that category as does a trivial pension (which could be in value as much as £18,000 – hardly trivial). Other examples would include crystallisation (is that the art of glassmaking?), an annuity (is that a payment that can only be made annually?) and the Barber window (is that the outside of a hairdresser’s shop?).

I have seen all these expressions used without explanation in correspondence with scheme members and frankly you cannot be surprised if people are bemused or, like Jack, get the wrong end of the stick. It was no surprise to me when, accompanied by a BBC film crew, I went to Ealing in July to ask members of the public, selected at random, for their understanding of the sorts of words and phrases in common use in pension communications. The resulting video which was placed on the BBC News website speaks for itself – there was little or no understanding of the meanings. It is so easy to slip into jargon without realising you are doing it. We are all guilty of it to various degrees and it really is something you need to steel yourself against. There is a Nest phrase book which I would strongly commend as a plain English guide to many of the less understandable pension expressions as well as something similar from the Department itself which is well worth a read through.

My second point relates more directly to the use of the default option and the hidden dangers in it. I am told that perhaps as many as 90% of DC members are currently enrolled in default options and the majority of those will have some form of lifestyling. That very high figure might even increase further when Nest comes fully into force. So there is nothing unusual or wrong in Jack ending up in that type of arrangement. But my fear is that Jack and others like him might not fully understand the mechanics of how it is going to work – that he will probably start off 100% invested in equities (shares) and then at some point perhaps ten or five years away from retirement his funds will be automatically moved gradually into less volatile investments such as bonds or cash. But what about if, somewhere down the line, he changes his retirement plans – brings them forward or puts them back? How would that work? What about if, at the very point where his money is being moved out of equities, the stock market has just dropped to an historic low? Would that really be the right time to move, but then if the process is an automatic one would anyone take that into account and/or be asking Jack how he feels about it?

Pitfalls and problems

These are all potential pitfalls and problems that can so easily arise. But the increased number of DC members likely to be in lifestyle default strategies highlights the importance of getting both the design and the profiling right. Lifestyling is often the answer in dealing with market turbulence but, as many people have found to their cost, it can backfire.

I believe it behoves all schemes and their advisers to review the arrangements on a regular basis to make sure they are working for the majority of their members. Of particular importance will be the communication strategy – what members are told and when, how they are consulted before a switch is made and what attempts are made to check the continuing validity of the member’s retirement intentions. 

I do not think that schemes can distance themselves completely from the consequences of the process going wrong, particularly if they have done nothing to satisfy themselves as to how it is working. Not to do so is effectively them defaulting on the default option they have elected to use.
The recent market turbulence has in some respects been a dramatic wake up call to everyone involved. For those on the cusp of retirement, being 100% invested in equities (shares) at that stage of their lives would have been a complete disaster if they had proceeded as planned and suffered a large reduction in their fund value with a resulting knock on effect on their annuity. We all know that getting the timing right in these matters is notoriously difficult and there are risks and potential downsides in most plans.

All members must accept some degree of responsibility for their own retirement planning, but pensions are, I am afraid, still an alien concept to many. People like Jack depend on their chosen scheme to do their best for them. That is not asking too much, surely, or be a task beyond the collective wisdom of the trustees and investment managers involved?

Jack’s non-active lifestyle may be a problem for him in other respects. Hopefully, his pension scheme will not be.