Defined Contribution (DC) provision in the UK is evolving, with sophisticated investment strategies, communication tools to help drive engagement, and stronger processes to improve member experiences. The current narrative serves to develop strategies to ‘get returns’ and ensure members’ pots ‘grow over time’, and it aims to do this at a low cost. It’s time for a change: the focus should be on understanding the level of income members need at retirement and setting strategies that aim to help members achieve that level.
Rise of DC provision
The first company pension schemes were established in the 17th century for (then) quasi-government agencies, such as the Bank of England or the East India Company. One of the earliest private schemes was the Chartered Gas Light and Coke Company, which paid between 3/12 and 8/12 of annual salary on retirement. The motivations for pension schemes at that time are similar to the motivations today; to provide a retention tool for employees, and help people make ends meet at retirement1. As an industry, we have since worked out that trying to provide defined benefits (DB) at retirement is challenging due to the ongoing longevity costs and reliance on the sponsoring employer. Key to the shift in DC provision is reducing reliance on the sponsoring employer – instead of a system that looks to provide a guaranteed income, members can build up a pot of money which they can then use to buy an income, in some form, in retirement.
In simpler times, the default options targeted a final position of 75% annuity matching assets and 25% cash. Following the introduction of pension freedoms, we now need to consider all of the choices members might take at and during retirement; cash, drawdown, an annuity, or a combination thereof.
This choice has typically resulted in a shift in the ‘default’ final position across the DC landscape. Schemes have adopted a more flexible asset allocation at retirement – a onesize fits all (none) approach. The industry is focusing on driving better member outcomes by ensuring members have both choice of how to receive their benefits, as well as having the tools to help them understand their options.
Following the narrative
Whilst the current narrative has prevailed in terms of the flexibility and choice it provides, does this really drive better member outcomes? Many schemes have followed this investment narrative – create a default that allows members to take more risk earlier on and de-risk as they get closer to retirement, into an allocation at retirement that aims to allow them to pursue the wider retirement choices available.
The aim of this investment strategy is, therefore, to try and ensure members ’get returns’ at the lowest cost. We still see many schemes invested heavily in passive global equity – if markets were to fall 20% and fund values fell 20%, this would be considered a success for the investment strategy.
While excessive risk management is not the answer either, it is important to be cognisant of what members need. For example, let’s assume members are invested in a passive equity lifestyle that de-risked from 10 years away from retirement. Suppose a 55-year-old was planning to retire at the end of 2018 and was therefore invested 100% in passive equity.
In that case, because of investment returns in the 4th quarter of 2018, that member’s pot would have fallen by around 10%2. If that person was planning to buy an annuity, then the income they would have received for the rest of their life would have also fallen by around 10%. The Dutch have a saying; “Friday is the day you work for your pension” (contribution rates are 20% in the Netherlands). In this case, every Friday morning our member has ever worked in their life has been wiped off by a poorly thought out investment strategy.
While there are a number of assumptions made for this 55-year-old, not all of which will apply to everyone, the fact that this situation has the potential to occur leads us to question whether members are getting good outcomes.
Helping trustees/employers identify members’ needs. How is this done in practice?
Firstly, by understanding how the key levers that determine retirement savings interact, which means analysing contributions, time horizons and investment strategy. It is then important to define the key input – what income members need at retirement.
Australia adopts a ‘basket of goods’ approach, helpfully categorising expected retirement spending habits across a low, medium and high scale which in turn provides an income requirement at retirement. In the UK the Pensions and Lifetime Savings Association (PLSA) are working on something similar, putting outcomes in terms members can easily interpret, such as the quality of wine or frequency of holidays they would like in retirement.
The level of income needed at retirement to provide these outcomes should then be the first step when setting the investment strategy.
Schemes can build an investment strategy based on their own contribution rate. For example, a scheme contributing 20% of salary can probably afford to take less risk than one where contribution rates are 10%. Success of the pension scheme is then easier to measure. It can be based on the investment strategies’ ability to keep pace with the return members need in order to achieve the level of income they are targeting at retirement.
It is important not to overlook the impact of consolidation, another key topic in the DC industry on all this. In reality, schemes with multiple employers, with a number of different contribution rates, all under the same investment approach, need to give careful consideration to meeting the needs of their members.
As a simple example, at current autoenrolment rates, investment returns of between 5.5% and 8%3 above inflation every year for the members’ whole working lives would be needed to maintain the same standard of living at retirement. This level of return is unrealistic and highlights the importance of educating members of the need to make appropriate and sufficient contributions.
It’s time to go back to basics, starting with the level of income needed by members at retirement. Setting clear, objective-based investment strategies around something as definable as that can help members achieve both that level of income and better outcomes.
1. Source: Pensions Archive Trust.
2. Source: MSCI (data for Q4 2018, run in July 2019), R&M Solutions, a division of River and Mercantile Investments Limited (calculations in July 2019).
These figures refer to the past and past performance is not a reliable indicator to future performance
3. Source: R&M Solutions, a division of River and Mercantile Investments Limited (calculations in July 2019).
These figures refer to the past and past performance is not a reliable indicator of future results
Head of DC – River and Mercantile Solutions