Pensions World

DC schemes are vulnerable to sudden changes in legislation and expectations, not least retirement date says Anthony Hilton, Evening Standard

If there is one lesson which the world of pensions should have no difficulty in grasping, given the experience of the past decade, it is that pensions can be dramatically affected by events over which they have no control.
 
For example, no pension manager could have foreseen the plunge in short term interest rates to well below the natural long term levels which has been engineered by the Bank of England as part of its plan to avoid the economy going into slump. If pension managers had seen this policy coming in advance and sought to influence the trustees to position the scheme to take advantage of it then either no one would have listened or at best their ideas would have been dismissed as too risky, going as they would have done against the conventional wisdom of the time.

Though the Bank of England is acting for the best of motives and what it believes to be in pursuit of the greater good, the collateral damage to savings in general and pensions in particular has been immense. It is now the accepted wisdom in the private sector that defined benefit (DB) schemes with the traditional link to final salary are unlikely to survive.
 
No one single event can affect defined contribution (DC) schemes so dramatically as they do not have built in guarantees which have to be met regardless of the cost to the plan sponsor. But they are, nevertheless, vulnerable to sudden changes in legislation and expectations. Witness the confusion in the industry which is coming in the wake of the recent decision by government to abolish the default retirement age so that it will no longer be possible for employers to force men – and in time women – to retire at age 65 if they do not agree to do so.

Catastrophic drop

The complication for DC schemes is that most are currently structured and managed on the understanding that there is a fixed and known date in the future when the cash in the pot will be used to buy an annuity. This fixed date – currently in the case of males the age at which they turn 65 – is the driver of the investment policy, with monies being switched from the pursuit of capital growth to the preservation of capital as the due date approaches during which period growth seeking assets like equities are sold and less volatile assets like government bonds are bought. The point of the switching is to reduce the risk of a sudden catastrophic drop in the value of the fund shortly before maturity and when there is no time left to build it back up again.

Certainty around the date of retirement is crucial to the effective management of DC schemes because it allows for default funds to be created. These provide a blueprint for how contributions will be invested when the member feels unable or unqualified to make such a choice as most do. The second aspect is that default funds have a life-styling overlay which drives the change in investment strategy as the funds approach the point where the money will be needed.

But under the new regime there could be 1,000 scheme members with a similar age profile who come up with 1,000 different retirement dates. Moreover it is doubtful whether they know themselves what the date will be because there are so many variables to consider. So with the best of intentions the employee could indicate one date, but be likely to chop and change it right up to the moment of retirement.

Collapse

Though it is not widely commented on, the other side of the collapse of DB schemes is the haste with which DC has come in to take their place. Inevitably that  has meant that the philosophical underpinning and framework in which DC will operate has not been fully thought through and that there are gaps. What we are now beginning to see is some of these gaps appearing.
What is needed is for the pensions industry to work out what needs to be done and put in place plans to deal with them, preferably before rather than after they become apparent to the public.
Anthony Hilton is financial editor, Evening Standard; anthony.hilton@standard.co.uk