All eyes on the nest
Nest’s investment strategy cannot fail to create a benchmark for the rest of the industry. Paul Farrow checks out the competition
All eyes are on the investment strategy of National Employment Savings Trust (Nest), the nationwide pension scheme that will be up and running next year. The retirement pots of millions of workers will depend on its success and if it does work, it could provide a blueprint for the defined contribution sector.
Mark Fawcett, chief investment officer, has been charged with developing the strategy that will underpin the scheme and last month it revealed its investment principles. Fawcett, 48, who managed funds at Gartmore and was latterly a partner at investment boutique Thames River Capital, admits he was surprised that the scheme has such a high profile when he arrived: it is a profile that is only going to get higher.
There will be over 45 Nest Retirement Date Funds, a series of yearly target date fund members will be enrolled into, that targets the year they expect to retire.
To be honest, when I joined Nest I had no idea quite how high profile the job was going to be
Controversially, younger employees will invest their initial contributions in assets of a low risk profile such as gilts, which goes against the general wisdom of financial planning. It is a decision that has, not surprisingly, stirred opinion.
At Nest’s rather humble offices in Borough High Street, just a stone’s throw from the gleaming mid-construction Shard skyscraper at London Bridge, Fawcett explained how he and his colleagues came up with the scheme’s investment strategy and why he thinks it will work.
Q.Why have you decided to adopt a low risk strategy for workers under 30 in a so-called foundation stage?
A.We have undertaken a lot of research on potential members - and we know that the majority of the target audience is more risk averse than those (older) people currently able to save for a pension.
Although older people say they don’t like to suffer loss, they seem to be able to live with it better and so don’t tend to act on falling fund values. On the other hand, younger people are more likely to act. They may say, “I’m not going to contribute anymore.”
Q.Is there an investment case for a cautious approach?
A.Yes. People are making a lot of noise about the foundation stage but it doesn’t matter how much risk you take in the first years in terms of the final outcome. The pot is so small in the early years and whether you invest 100 per cent in equities or 100 per cent in bonds it won’t make too much difference to the total return over 45 years (see graph).
The middle years of investing our growth stage will be the most important. All we are trying to do is introduce risk gradually to members, so the initial portfolio will be half in gilts and cash and half in equities. It is not ’no risk’, just lower risk. The strategy feels like the right judgment.
We had thought about having a foundation stage for all those of all ages but had we done that people would have said that we are being ultra-cautious to protect your reputation.
Q.Do you believe that Nest offers members’ value for money?
A.Contribution charges at some point will disappear after around 10 years and it works out that charges in total over the lifetime will be equivalent to around 0.5 per cent a year. We are not against active management, absolutely not. It is about getting value for money. We will introduce active portfolios at a later stage as the funds grow and when we diversify into assets such as property.
Q.Do you feel under pressure to deliver?
A.To be honest, when I joined I had no idea quite how high profile it was going to be.
The scheme’s trustees must feel the weight of that scrutiny and the amount of work we have done and evidence we provided them with is commensurate with that scrutiny. We have worked hard to get all the angles covered.
The financial media has quite a short memory, even when talking about someone like Warren Buffett, the world’s greatest investor. He bought Goldman Sachs shares during the credit crunch and was getting bad press because he hadn’t made any money in the first six months.
I am convinced we have the skills to manage the risk in way that is appropriate for our members. Sometimes that will involve making decisions that will involve a lot of scrutiny in the short-term.
We are not against active management, absolutely not. It is about getting value for money
Q.How hands on will you and your team be?
A.I have a team of experienced fund managers and we will have quarterly meetings with the investment committee. We will control risk of portfolio but our job is not to make big market calls.
There will be times when shares become volatile and become expensive and if this is the case we may trim back the equity exposure for those in target date fund about to enter the consolidation phase, or at least stop making contributions for a few months. But we will not be making a ’sell all our equities call’ across the board that wouldn’t make sense for someone who is 30 years old.
Q.Do you think that Nest will become the benchmark for DC arrangements?
A.No. Benchmark is far too strong a word, but I think we are contributing to the target-date debate. I’m proud of the focus we have put on understanding the characteristics of our audience. The target date funds are a good innovation for DC because it gives you flexibility to manage individual risk profiles right through their savings career. Good academic research supports the idea that you don’t just fix your asset allocation or even fix the whole glide path we don’t know what the world is going to be like in 30 years’ time, so why would we be arrogant enough to act like that.
Q.Do you think criticism of Nest is unfair?
The people who take the time to do the research and have an informed discussion give us a fair hearing. But there is a lot of chat around the edges. The only time I will be concerned is when the criticism is well-informed.
The industry perspective
The National Employment Savings Trust has been picked apart before it gets up and running.
The scheme is aimed at those at the lower end of the income scale. The idea is that employees will automatically join Nest (although they will be able to opt out) and they will contribute 4 per cent of their own money, with the employer chipping in 3 per cent and the Government an extra 1per cent.
For starters, some question whether 8 per cent contributions are sufficient to build a meaningful pot.
A recent survey by the Association of Consulting Actuaries showed that most defined contribution pension schemes run by smaller firms are attracting combined employer and employee contributions of less than 8 per cent of earnings, with little evidence that these are keeping pace with the increasing cost of building a sufficient pension as life-spans extend.
The ACA reiterates that final salary schemes provided are based on average receiving combined employer and employee contributions of 24 per cent of earnings.
Perhaps, more worryingly, is that the survey found that smaller firms expect 35 per cent of employees to opt out of schemes one of the main reasons being ’disillusionment’.
It is not the first survey to pour doubt on Nest. Other surveys suggest that the contribution levels set by Nest will be mirrored by other DC schemes that currently contribute far higher amounts to their employees’ plans.
There has also been criticism of its charges, which many believe are too high. The scheme will charge employees an annual management fee of 0.3 per cent fairly cheap, but contributions will attract an additional charge of 1.8 per cent. Put the two together and the scheme looks extremely expensive.
Not so, says Nest. It argues that over the long term the combined fees average out at just 0.5 per cent a year, which stacks up well against other large occupational pension schemes and stakeholders, it says.
But the major talking point today is the decision to adopt a low risk strategy at the outset for young joiners. Many in the pensions industry fear that it is a strategy that might back-fire.
I am convinced we have the skills to manage the risk in way that is appropriate for our members. Sometimes that will involve making decisions that will involve a lot of scrutiny In the shortterm
Brian Henderson at Mercer Investment Consulting says: “Without sufficient growth to overcome the initial entry fees there is a potential risk that the early year low-risk foundation stage could linger. Nest will have to strike a balance between the risk of not building up enough funds for the members and of losing money through risky investments in the early years. A solution to this problem would be to ensure the scheme offers a range of truly diverse growth-based assets that will help manage the volatility of the returns.”
Stuart Fowler at No Monkey Business, the wealth manager, reckons that the scheme’s aim to beat inflation by 3 per cent is too low because historically equity-type risks have provided on average a margin of 6-7 per cent over inflation.
“In the early, ’foundation’ phase, equity backing will be even lower, in case volatility in the portfolio value scares off younger and less informed members. This is not so much paternalistic, which has some justification, as patronising,” says Fowler.
Mark Dampier, head of investment research at Hargreaves Lansdown says that he is not surprised that respondents answered that they didn’t want to take a risk with their pensions but suggests that embracing this concept could deliver “extremely” mediocre returns. He admits that he is an “investment purist” but questions why at the age of 22 you would want to be in low risk assets.
“At that age you should be embracing volatility. You need to explain to people that even if they pay in £1,000 over five years and that is only worth £800 it is not the disaster that they may think,” he says.
“The ideal profile for a monthly saver is for the markets in the early years to fall because you won’t have very much money in them. The strategy to protect investors from the distress of seeing short-term losses actually costs them a fortune in the long term.”
Fidelity a supporter of target date funds believes it is unclear whether the design will mitigate member concern sufficiently in the event of a significant market downturn. “We would hope that, over time, the Trustee moves to a position of explaining the true nature of long-term investment rather than skewing the design away from what is in members’ best interests to avoid disappointment,” says Richard Parkin at Fidelity.
Without doubt communication is going to be key.
But some question whether it will be able to communicate the aim of the funds to beat CPI by 3per cent and wonder whether the target will be seen as a guaranteed absolute return, which of course it isn’t.
“The choice of CPI-plus benchmarks is understandable but may be misinterpreted by the public who may see these benchmarks as providing some guarantee of inflation protection (and so absolute positive return) each year,” says Parkin. “As well as making sure members understand the long-term nature of these benchmarks, thought will need to be given around expectations of short-term returns by members.”
Yet engaging with members is a DC-wide problem why else do 90 per cent of members simply opt for the default fund many of which have been dismal performers over many years.
John Foster at Aon Hewitt says: “It is always a challenge to engage with DC members but those that have the option in the private sector are already engaging to some degree I wonder whether those that are auto-enrolled will engage as much.”
So will workers build up any meaningful pot with a fund aiming to beat inflation by around 3 per cent a year?
According to Nest, an employee earning £18,200 (eligible earnings £13,165) would have a pension pot of around £88,445 after 45 years (net of charges). At today’s annuity rates that would buy them an income of around £4,864 an income replacement ratio of 27 per cent and all for net contributions of £23,270.
People who take the time to do the research and have an informed discussion give us a fair hearing. But there is a lot of chat around the edges
However, not everyone will be a sprightly 20-year old when they auto-enrol.
A 30-year old will get an annuity of £3,506 based on net contributions of £20,011 and a replacement income of 19 per cent. Meanwhile, 45 year-olds may question whether they should opt out. They will get an annuity of just £1,509 a replacement income of 8 per cent of their salary.
Fawcett says: “A replacement rate of 27 per cent out of net salary is £23,000 pay is back pretty good for a low risk fund.”
An income of £5,000 based in an outlay of £23,000 sounds a fair deal, but late joiners who could end up with an annuity worth less than £2,000 a year may take some convincing that they are getting such a great deal.
Nest has an enormous task ahead, yet given its brief and its target market it has constraints to deal with. If the investment strategy it has in place is successful and if the majority of members walk out with an income replacement ratio of around 27 per cent then it would have done its work. The DC industry, which has yet to come up with a blueprint for the ideal scheme to outdo Nest, will be watching.
How does an upfront 1.8 per cent charge on all contributions work out cheaper than an annual fee of 0.5 per cent? The following illustration, assuming a person contributes £100 a month (leaving investment growth aside), brings clarity to the issue.
In the first year those paying just a 1.8 per cent contribution fee would pay £21.60 in charges (in other words they are losing £1.80 a month), whereas with a 0.5 per cent annual management fee, charges in the first year would be just £6. In year two those paying a contribution fee would pay another £21.60 (so they’ve paid £43.20 in total) while those on an annual management charge will pay £12 (so total charges are £18 to date). Moving on to the seventh year and the situation is reversed. At this point those paying a contribution fee have paid £151.20 in total, compared with £168 from an annual management charge. And after 30 years, the difference is huge: £648 in fees from a 1.8 per cent contribution fee compared with £2,790 paid through an annual 0.5 per cent charge.
With the Nest scheme savers will pay a bit of both, the upfront charge in early years, with a small (0.3 per cent) annual fee, so charges will escalate, but this example shows how over the long term the 1.8 per cent upfront charge becomes proportionately less significant.