N ext year’s hot group pensions topic is set to be investment. The two main regulators are converging on the issue of investment choices made by members of defined contribution, group personal pension and group stakeholder schemes.
The FSA, working under its treating customers fairly banner, requires that firms ensure members of contract-based schemes are being treated fairly. The FSA sets outcomes that it expects to see as evidence that TCF is operating properly.
These outcomes cover issues such as product design and meeting the needs of the target aud-ience. In the context of group pension scheme investments, this is important because a significant majority of new members – over 90 per cent in some schemes – do not make an active fund choice. Therefore, the design of the default fund option is very important.
It is also incumbent upon the firm to keep customers informed after the point of sale. This might raise issues for some with-profits funds, particularly those funds where the investment strategy has changed significantly, for example, so that the fund can pay the bonuses it has promised.
The Pensions Regulator has consulted on DC risks and governance over the course of the last year. TPR is responsible for regulating all work-based pensions, including contract-based schemes.
In its papers, the TPR highlighted “poor investment choices” as a key concern. In trust-based schemes, it specifically highlighted the need to analyse the pros and cons of investment reviews leading to mem-bers switching unnecessarily. TPR also highlighted the importance of comm-unicating with scheme members.
In particular, this should cover choices and risk appetite, with the aim of avoiding confusion and inertia through providing too much information.
Now that the FSA and TPR have set their agendas, how should providers, advisers, consultants, employers and trustees work together to deliver this vision?
The way a member accesses a default fund (if there is one) and how that fund operates would appear to be issues of fundamental importance.
As noted earlier, in many schemes, both trust-based and contract-based, a large proportion of members fail to make a choice and end up in the default fund.
Today, the most common default fund is a lifestyle fund. Lifestyle funds are usually based upon a speculative managed approach, containing initially a high proportion, usually 50-70 per cent, of equities.
As the member reaches their selected retirement date, the fund is gradually switched into bonds and cash in order to mimic the most popular method of drawing a retirement fund; an annuity plus tax-free cash. This process takes place normally between five and 10 years before the selected retirement age.
But is such an investment approach suitable for all? For example, what happens if your selected retirement age changes, for example, you now need to retire at 67 rather than 63?
Unless the member recognises early that they are likely to work on, the fund may have already become largely bond and cash based by the time they realise. In this case, switching would begin from age 53. Would the member know at that age that they now intend to retire at age 67?
So, this is one drawback of the lifestyle approach – it is built around a selected retirement date chosen 20 or 30 years in advance and has no automatic correcting mechanism.
Another problem with lifestyle funds is for scheme members that ultimately choose income drawdown.
Apart from superior death benefits, another reason why pensioners choose drawdown is that it allows the potential for superior investment returns, usually by investing in equities or property. If you were planning to move into drawdown, why would you want your fund to switch into cash and bonds beforehand?
If variable annuity products take off as they have in the US and Japan, then lifestyle funds are probably not the most appropriate pre-retirement fund. This is because variable annuities are an adaptation of income drawdown rather than a conventional annuity approach.
New pre-retirement approaches are also likely to develop for equity and managed funds. Rather than switch into bonds and cash in advance of retirement, the member will add downside protection to their fund, say, five years in advance of retirement. This sort of approach has some great advantages over lifestyle.
The first advantage is that by the time you add the guarantee, you are reasonably certain of your retirement date, unlike lifestyle where your selected retirement age is chosen years in advance.
The second advantage is that if you do select income drawdown or buy a variable annuity, then you have remained invested in the funds that you are likely to maintain under your post-retirement phase.
Some schemes have sought to encourage greater fund choice by specifying a default fund that forces members to switch such as a cash fund. Although some of these schemes have been successful in encouraging active member choice of investment fund, a hard core of members, perhaps as many as 25 per cent fail to move out of cash.
Therefore, the trustees, employers and advisers need to consider what is the best approach – choose a default fund that is likely to be suitable to the majority of members but accept that few members will make an active decision. Or try and force members to make active investment decisions but with the risk that a significant number of members remain invested in a fund which is an inappropriate choice for many of them?
Good decision-making on the part of trustees and employers is important and their advisers should ensure that their clients are aware of market developments so that some future proofing can be built into these choices.
After that, it should be down to good communication. For example, it might not have been foreseen just 10 years ago that with-profits would meet such a sudden demise. What might have been a suitable default fund then, may not be now, particularly if its investment mix contains a very high proportion of bonds. It is incumbent upon providers, employers, trustees and advisers to make members aware of these changes so that they can now review their choices.