Pensions World

Allison Plager, financial journalist, looks at how consultants are getting on with investment issues for DC schemes as they gradually take over from DB

As the decline of the much loved defined benefit (DB) pension scheme continues apace, companies are offering money purchase schemes to replace them. The National Association of Pension Funds’ Annual Survey 2011 showed that 23% of final salary pension schemes are now shut to new members and accruals.

Providing a defined contribution (DC) scheme is much cheaper and less of a financial burden for the employer, because the risk is shifted on to the member. One key to the success of a DC scheme will be effective investment of the member’s contributions and this is where the investment consultant can have a role to play, particularly as investment products develop and become inevitably more complex.

Specialist team

Pension consultants offer a range of services, investment consulting being one of them. The Table shows a selection of consultants that currently offer DC investment consulting. Some have a dedicated DC specialist team, eg Aon Hewitt and JLT, while others have specialists within their investment consultancy department. These include Deloitte and Mercer.

With the growth of DC schemes, many of the firms have been taking on more DC experts. “Many consultants have put together dedicated DC teams”, said Hugh Cutler of LGIM, “and are helping develop strong solutions. This theme reflects the fact that they realise that DB alone cannot support growth.” Deloitte’s Andrew Green said “as we expand our investment and pensions team, there is an increasing focus on hiring individuals with experience of providing advice on DC arrangements”. Bluefin’s Peter Dean said the business has “spent considerable time over the last three years expanding and developing our DB proposition”. Having met that demand, the firm is “able to divert increasing resources from DB to DC to meet the growing demand”.

In the ascendant

Given that DC schemes have gone forth and multiplied many times over in the past ten years, as well as developing as a product, the investment management of such schemes has had to progress with them. In addition, scheme members have also become more aware of investment volatility as pensions feature in the headlines and the unsure economic situation continues.

It is probably not surprising that, with DC in the ascendant and having put considerable effort in to their development, consultants are working on how to bring DB style investment products into DC schemes. Aon Hewitt’s Jesal Mistry said: “There is significant bias at the group DC level towards passive management to keep costs low and investment options easier to understand. However, over the past five years, employers and trustees have been starting to revisit this stance as markets continually disappoint.” He mentioned that new products, such as diversified growth funds, from the DB market have moved into the DC market, and “some clients who may be familiar with these concepts also see value in them being included in the DC environment”. However, these products are often actively managed which has meant a change in direction for some clients, who have to be “comfortable with them” before offering them to members.

As well as existing products moving across schemes, investment managers are beginning to develop products specifically for DC schemes as they can see that market is growing.

Mr Green said that there has been a rise in “the range of funds offered to members, providing greater choice and flexibility, and the use of investment platforms providing access to funds from a range of investment management organisations”. He too has seen a move towards “broader multi asset diversified growth and specialist funds”.

Different default strategies

Most DC schemes offer members a choice of investment funds so that they can control the investment of their contributions. Many schemes also have a default fund for members who prefer to take a more passive approach to their investment and, with the imminent arrival of auto-enrolment on the pensions scene, the default is likely to be, initially at least, where auto-enrolled members end up.

What make a suitable default fund? According to JLT Investment Solutions’ Peter Ball, “the typical DC member has an asymmetric view of risk and return. They require ‘growth-like’ returns, yet they dislike a -20% far more than they value a +20% return. So an investment solution that attempts to manage downside risk is far more in tune with members’ needs than the classic default that is 100% (or nearly 100%) equity.” He said that some diversified funds can do this, adding that “an overall default fund comprising more tactical diversified funds combined with other more long term strategic holdings in diversifying asset classes provides an investment solution that will result in better member outcomes”. Overall, he concluded that there is likely to be “a very significant move away from the classic default funds into new more diversified solutions”.

KPMG’s Stephen Budge said the firm did not promote a model approach to the default, believing that “regulatory guidance indicates scheme specific default design”. He went on: “the more common default design has been a lifestyle strategy incorporating two distinct phases of growth and pre-retirement. The growth portfolio has typically been made up of a mix of passive global equity and diversified investments. The pre-retirement phase, between five and seven years before the member’s target retirement age, is a combination of long dated corporates and gilts, as well as low-risk money market.”

It is sensible to carry out some analysis of the members of the DC scheme before deciding on the best default fund. Mark Jaffray of Hymans Robertson said: “The most appropriate default strategy for any pension scheme will depend on a number of factors including the level of contributions being paid, the level of understanding and risk appetite of members and the likely retirement pattern of members.” He suggested that the trustees will need to understand “what level of replacement income might be achieved from the existing default strategy and contribution rates as well as assessing members’ understanding of the pension scheme and what income they expect to achieve in retirement”.

In some cases, Mr Jaffray has found that, as a result of the research, companies consider “implementing different default strategies for members with different characteristics”, such as salary levels or contribution rates.

Value for money

The old bugbear of fund management charges is difficult to ignore when there is so much sensitivity over the size of the fund the member will have in retirement. Everyone wants value for money, but the old adage “you get what you pay for” has some relevance.

As Mercer’s Brian Henderson said, while fund management charges can be high, “it depends on the objectives of the scheme and a number of factors, such as the size of the scheme, the cash flows, and the value of the assets”. He added that it is his job “to make sure clients benefit from Mercer’s scale in such negotiations”.

Confirming that it is not all about cutting costs, he said that while members get a good service at low cost, the goal should be to add value: “at times it can be worth paying more to get a better overall net of fees result. It is this result which should be focused on as this is what the member experiences.”

He went on to warn that “better member outcomes do not necessarily mean taking up the cheapest solution on offer – the challenge is to demonstrate that jam tomorrow is sometimes worth the wait as well as paying a little more for”.

Accepting that high or unclear charges should be addressed, Mr Henderson was concerned that “the introduction of very low cost DC solutions could result in a significant drop in quality of service to members, especially when the challenges around auto-enrolment take grip”.

DC assets to outstrip DB

It is not going to be that long until the amount of assets in DC schemes outstrips those in DB. But as Mr Henderson pointed out “some manager products are not aligned with the needs of DC members – others have been quicker to adapt”.

With the advent of auto-enrolment and Nest, companies will have to ensure that their DC schemes are fit for purpose. To this end, Xafinity Consulting’s Richard Lunt said: “Clients should consider whether or not their arrangement stands up to scrutiny against the Investment Governance Group ‘best practice’ principles.” These principles relate to the investment governance of DC work-based pension schemes (full details can be found on the Pensions Regulator’s website, see Box) and have been drawn up with the aim of encouraging better investment governance and decision making by those involved in such schemes.

Mr Lunt added: “The DC investment industry is more complicated than many realise”, which means that advisers with specific expertise will be in demand. Consultants are clearly developing their skills in this area as employers increasingly turn to them for advice on the growing number of investment products that are coming on to the DC market.

Mr Cutler summed up: “The focus should be on simplicity, transparency, value and delivering risk aware investment solutions. Getting the right balance is always a challenge, although understanding what matters most to investors should always be at the core of any successful DC proposition.”