In recent years, two major developments in UK Defined Contribution (DC) pensions have taken place – introduction of a charge cap at 0.75% p.a. for default strategies, and implementation of what was dubbed as a ‘pensions revolution’ when the then Chancellor of the Exchequer, George Osborne, effectively abolished the de facto requirement to buy annuities at retirement.
Effectively, any DC member is currently able to withdraw funds from their pension at any time from the age of 55 (subject to applicable taxes) and instead of being channelled into annuity purchase by default, DC scheme members now have 3 main options:
- Cash Withdrawal
- Annuity Purchase
- Income Drawdown
THE STATUS QUO
At present, most DC default strategies take form of a lifestyle arrangement that works as follows: the growth stage spans the younger years of an investor when the investment horizon is longer term and the investor has a higher market risk tolerance. During this stage, investment contributions are usually invested in higher risk assets, such as equities, to maximise fund growth. As he or she approaches retirement, the focus is to protect the pension pot from sudden large falls in value, through investments in lower risk assets such as bonds, and to structure investments in such a way that they target a specific outcome, which is still annuity purchase for the majority of DC schemes.
Such lifestyle strategies are set up on an individual member basis and the movement from one stage to another is done based on a person’s age by a pension administrator on a regular basis, such as monthly or quarterly. These switches follow a mechanistic approach whereby a certain percentage of higher risk growth funds is sold and units in lower risk pre-retirement funds are purchased.
Traditionally, this has been an approach of choice for the overwhelming majority of UK DC schemes. As this approach is so well established, trustees are reluctant to make drastic changes and to be early adopters of any other approaches. That is not to say that changes are necessarily required, however, pension freedoms have highlighted the relative inflexibility of such strategies and we believe that the time is right to look at other approaches available, particularly, Target Date Funds.
ZOOMING IN ON TARGET DATE FUNDS
Target Date Funds (TDFs) have traditionally been a default of choice on the other side of the Atlantic due to the protection that exists for pension scheme sponsors and a stronger role that fund managers play in DC. Here we discuss how a UK DC scheme can benefit from this approach.
These funds work on a similar principle to a conventional lifestyle, but instead of being a combination of several stand alone funds, as a lifestyle is, a TDF is a single fund with various asset classes underneath, where the fund’s investment managers make decisions on the asset allocation between them. Also, as a fund matures, de-risking switches would occur within the fund itself, and not on an individual member level.
Members’ investments are thus aggregated into various TDFs based on their anticipated retirement year. A member expecting to retire in 2040 would usually invest in the ‘2040 Fund’. This would have an internal switching mechanism and would start to switch into less risky assets in say, 2030, so that by 2040 the fund is positioned for retirement. This differs from a lifestyle method where scheme administrators are responsible for implementing the switches for each member. Elevating the switching procedures from the member to the fund level significantly reduces any potential errors and omissions. In addition, larger trades at fund level are far more cost efficient than small trades on individual accounts.
While lifestyle switching is always done on a mechanistic basis, most TDFs allow investment managers a degree of discretion to consider the timing of the switches and thus allowing them to respond to market conditions.
From a member communications point of view the attraction is that these funds are potentially easier to understand - they help members focus on the final outcome, hence making their choice easier.
TDFs are also more versatile, allowing members to phase retirement by investing in more than one fund, or to change the retirement date by switching to a different fund.
THE KEY POINT
The most important benefit of TDFs, however, came to the fore with the introduction of pension freedoms. As soon as it became evident that annuity targeting would no longer be the most appropriate strategy for the majority of members, TDF managers implemented strategic changes within their funds’ pre-retirement allocations in order to move away from annuity targeting, to approaches that allow for the ultimate flexibilities as members come up to retirement. They were able to do it “under the bonnet” almost instantaneously after the change in the pensions regulations for the benefit of the members. Meanwhile traditional lifestyles are still to be updated for a large number of DC schemes due to the time it takes to make decisions under a normal trustee meeting cycle and the complexity and costs of changing administration arrangements for lifestyle based defaults, not to mention member communication requirements.
With the Department for Work and Pensions placing greater emphasis on the governance of DC schemes, specifically with a focus on good quality investment arrangements and stricter requirements regarding these, particular attention needs to be paid to the design of default strategies and the on-going monitoring of their continuing suitability for membership.
Once an appropriate TDF is selected, the onus of ensuring that the strategy remains in line with the latest regulations and member options is outsourced to the fund manager. Also, one TDF manager is a lot easier to monitor compared to a collection of managers running different funds within a lifestyle arrangements. This reduces governance costs and allows trustees more time to concentrate on other important scheme issues, which ultimately leads to better governed DC schemes to the benefit of the members.
There is no clear winner when it comes to the comparison of lifestyle vs TDF approaches as there are clear benefits to both.
A lifestyle approach enables trustees to keep the highest degree of control over investments and create bespoke solutions that are suitable for their specific schemes. However, the speed and cost efficiency of implementing changes within a TDF structure may ultimately serve members’ best interests by keeping their investment strategies up-to-date.
The crux of the matter is though that the DC environment has changed dramatically in the UK and there is room for alternative approaches like TDFs that could be an ideal solution for many schemes – is yours one of them?
If you would like to discuss the suitability of your current DC default strategy, contact your usual JLT consultant or
Maria Nazarova-Doyle, Investment Consultant| T: +44 20 7309 8108 | E: firstname.lastname@example.org.