Providers are being forced to rethink how they invest savers’ funds in the wake of radical pension reforms announced by Chancellor George Osborne last month.
Under plans outlined during the Budget, people will be handed greater flexibility over how they spend their pension pot from age 55.
The reforms, which take effect from April 2015, will allow savers to take all their fund as cash. The 25 per cent tax-free lump will still be available, with the remaining 75 per cent taxed at the saver’s marginal rate.
Although welcomed by advisers, the changes have blown a hole in providers’ automatic enrolment
default investment strategies.
Hargreaves Lansdown head of corporate research Laith Khalaf says three-quarters of default strategies have been “rendered obsolete” by Osborne’s announcement.
This is because most providers invest members’ money assuming they will use most of their pot to buy a retirement income product, usually an annuity, at their selected retirement age.
So how will providers ensure the investment choices made on behalf of savers remain fit for purpose?
A huge amount of attention will focus on how Nest, the UK’s default auto-enrolment provider, redesigns its investment strategy.
Nest currently operates a “target date fund” default investment approach, with each member’s assets allocated based on their selected retirement date.
The Government-backed scheme invests members’ money over three phases – “foundation”, “growth” and “consolidation”. Exposure to risk is gradually scaled up from the foundation phase to the growth phase before being dialled down as the member approaches their selec-ted retirement date.
Nest chief executive Tim Jones says: “We now have to recognise our members have a new set of freedoms. On the one hand we could glide them towards 100 per cent cash at age 55 and assume they will want to take their money and run. But on the other hand that might well not be in their best interests.”
He says one option is to keep members in the growth phase up until state pension age and from there assume they will continue working and go into some form of drawdown.
He adds: “Then as they approach 80, they can go into annuitisation. If you took people towards a default when they annuitised at around age 80, then that might be a pretty good thing for them to do.”
This is one of a number of ideas Jones is exploring ahead of a consultation in the autumn. Nest will then produce final proposals next year although these may not be in place before April 2015.
Jones says: “Everyone has different circumstances and that is the big challenge in designing a later life investment strategy. The whole landscape is inherently more complicated because there will be different paths for everyone.
“What Nest will do is learn from other people in the market, commission some research and launch a consultation. We will then go into a huddle towards the end of the year and come out in early 2015 with our response.”
Legal & General pensions strategy director Adrian Boulding says default investment strategies will continue to play a critical role because most people will remain disengaged from the saving process.
He says: “The secret is to recognise most people still do not want to engage with pensions, hence auto-enrolment.
“We put people into a pension scheme without asking them, we choose the level of contributions and we choose the fund they are going to be invested in.
“The same will apply for at-retirement. Most people will not want to engage with all these new choices and will want the scheme to do it for them.
“So the scheme needs to have a default decumulation process it believes will be suitable for most members, with members free to choose something different.
“A default accumulation strategy can then be designed that builds towards the default decumulation process.”
Boulding says schemes will need to speak to members about their investment strategy “at least 10 or 15 years” before they plan to retire.
He says: “The scheme will need to say what the default decumulation process is and what other strategies they might pursue depending on how they plan to take their income.
“That should lead to a far better investment conversation than we have today with members.”
Intelligent Pensions technical director David Trenner says the debate around defaults emphasises the importance of advice.
He says: “People will need to be looking at getting advice at least five years before retirement.
“Lifestyle funds will automatically switch people into cash and gilts. If they are going to do drawdown, then that is likely to be inappropriate.
“But it all depends on individual circumstances and it will be very difficult to reflect that in a default investment strategy.”
Collectivism versus individualism
Scottish Widows head of corporate pensions proposition Pete Glancy says the provider will be seeking clarity on the Government’s definition of a default investment strategy in light of the Budget.
He says: “Currently, the default behaviour is for people to reach a fixed point of time and annuitise.
“We as an industry need to agree with Government whether that is going to change. If someone is entirely apathetic, what are they going to end up doing? If it is still annuitisation then that is fine but if not we will need to change the definition of a default fund. That will require legislation and regulation.”
Glancy says the next challenge the industry faces is the debate over collectivism versus individualism.
“The DWP thrust has been for collectivism and what the Treasury has done is individualise everything at retirement. There is a conflict there that needs to be addressed.”
He says there will be a “tipping point” age beyond which people will behave more like individuals.
“A lot of this will centre on emp-loyee engagement. If people are defaulted into a fund and have been happy for 20 years, when they approach retirement they need to take an active interest and behave much more like an individual.
“That is the point where we could do something quite exciting on investment solutions because people will be making an active inv-estment decision, without being subject to charge caps.”
ADVISER VIEW: SCOTT GALLACHER
Providers will still need to have a default and to an extent it will need to be lifestyled because you cannot have the vast majority of people in an equity fund when they are approaching retirement.
But people arguably need advice more than ever because we are moving from a system where essentially there were two options – to remain invested or buy an annuity – to a world people have a huge number of choices.
Scott Gallacher is director at Rowley Turton
How Nest invests members’ money:
EXPERT VIEW: LAITH KHALAF
You cannot take account of all the things people are going to do at a default level. Providers will still need to have a default fund but it is going to be extremely limited in terms of how it can address people’s retirement needs.
Prior to the Budget, you could pretty much guarantee that 90 per cent of people would buy an annuity and base your default strategy around that but that is no longer the case. There are lots of different profiles, from people who will take their entire pot at 55 to those who want to by an annuity in their 70s or later. Each one of those will need a different sort of investment.
Communication is now more important than ever before. The industry has relied too much on defaults in the past and that will need to change.
Laith Khalaf is head of corporate research at Hargreaves Lansdown