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OPDU Report 27 June 2010 - Annual Risk Conference Special Edition Defined Contribution Investment Options – what could possibly go wrong? Defined Contribution (DC) schemes are an important and growing part of the UK pensions market, but we need to face the facts that members of DC schemes tend to spend very little time planning their retirements. It is also extremely difficult to get them to engage or take any actions relating to their pension. BlackRock conducted focus group research amongst members and non-members of pension schemes in 2008 and research with HR Directors and employees in conjunction with the Chartered Institute of Personnel and Development (CIPD) last year. The CIPD is the UK professional body for those involved in the management and development of people. One of the main findings was, unsurprisingly enough, that the pressures of day-to-day living mean that planning for retirement, in terms of actually putting money into a pension plan, always takes second place to other priorities, even though the intention is to do something about it. Up to the age of 30, living for today is understandably the priority, and then other commitments take over in the 30s and 40s. Once in their 50s, people feel it is too late to make a difference. Overall, we see a pattern of excuses and then regrets. Lack of financial education It would be wrong to blame employees for the current state of DC. Very few people are given any form of financial education at school and the industry has attempted to fill this knowledge gap with fact-heavy impersonal information, explaining investment characteristics of equities, bonds, cash, property and alternatives, with little explanation of the benefits or the ‘what’s in it for me?’ factor. In fact in the US, academics are increasingly of the opinion that the goal of educating the public to better choose their financial products is neither sensible nor achievable. (Source: ‘Against Financial Literacy Education’, Lauren Willis, University of Pennsylvania Law School). They find that through no fault of their own, the public do not have the knowledge, time or maths skills to make good financial decisions, and that if the education is not personal or specific it will not do any good. This is reflected in some depressing facts: In the US, less than 10% of consumers understand APR, and when measured by tests before and after financial education programmes, there was only a 2% increase in financial literacy. So the end result of this type of education could be that employees will end up being much more confident but will still make bad decisions. Decision avoidance Of course the main problem is not employees making bad decisions, it is employees who will not make any decisions. Behavioural finance experts have identified five main biases that cause people to avoid making financial decisions. (Source: University of Cambridge research sponsored by Towers Watson and BlackRock).
Why have a default option? Bringing this back to the DC investment context, there are many reasons to offer a default investment option - a key reason being that employees will not and do not want to choose. The following is a direct quote from our focus group research and is typical of many similar statements we heard: “I don’t want to be an investment expert but I want an expert to make the investment decisions for me.” There are many other reasons to have a default investment option:
My contention is that is not really a problem. In reality it is what we should expect and it is not a good use of our time to badger people into making decisions that they are extremely uncomfortable with. Instead, we need to ensure that the default option is the best it can be. What are the hidden risks within a lifestyle default strategy? Historically, lifestyle has been the most popular default option. A typical lifestyle strategy would use equities in the build phase (the years during which contributions are made into the pension scheme) with a five-year switching period into bonds and cash (the final five years before retirement). Are there hidden risks in this structure? Does lifestyle do a good job for the member? My view is that the standard 100% equity investment in the build phase does not cater well to members’ investment needs. Members hate seeing their fund values going down, no matter what they are told about the benefits of pound cost averaging or the fact that a pension is a long-term investment, but with 100% investment in equity they will inevitably see fluctuations in value. Also, based on our research, members do not necessarily understand benchmarks, in particular why the manager of a global equity fund stays invested in global equities when the market is falling. One of my own particular bugbears is that members, quite understandably, think that lifestyle means that their managers are making asset allocation decisions on their behalf when they are not - the money just stays in global equities until a few years before retirement. Lifestyle has also been described as a blunt instrument when it comes to adjusting asset allocation towards a retirement date. Right now many members retire early, as most of their benefits come from DB schemes, but going forward more members are likely to have to work for longer. Responses from our focus groups showed that members tend to think about savings and investment in very different ways. Savings are seen as safe, accessible, visible and something that employees are in control of, whereas investments are risky, with a lack of control and you need to be clued up to use them. So the basic psychology is that members want to save for retirement - they do not want to invest. The following quote is typical of the kind of responses we heard in the focus groups: “I want to get back what I put in plus a bit more on top.” Alternatives to lifestyle Can we deliver a default option that meets more of these needs and reduces some of the risks? Something we have seen in the past 18 months is the use of diversified growth strategies in the DC space. The main characteristics of these products are listed overleaf:
What does this look like from a member’s perspective? These funds aim to achieve long-term growth in excess of inflation, which is essential. Critically, they should be less volatile than the 100% equity alternative, while looking to capture most of the gains in rising markets but, vitally for DC members, reducing the downside when markets fall. For DC members, seeing a loss is considerably more painful than missing out on the equivalent gain. Of course, in this type of fund, a member’s money is in the hands of experts who make the asset allocation decisions on their behalf, which is what members expect their managers to do. Is this your final answer? So, does this alternative remove all the risks? Sadly no, as there are still risks that members, trustees and providers need to be aware of: 1. Diversified growth strategies are relatively recent arrivals – is there any evidence that they can deliver what they say they can?
There is evidence but no manager has a very long track record in this area. We run both active and passive diversified growth strategies at BlackRock, but the active strategy has the longest track record. Over the six years since the inception of a sterling version of the product, it has delivered equity-like returns with greatly reduced volatility, as shown by the table above. Source: 2. As this is DC, there is always the member point of view to consider – can we communicate this product to members? We say the product has a target of cash +3% but it is very easy for a member to hear that as a guarantee of cash +3%. There is a lot of detail behind the strategies that members will not want to hear, but we need to make sure we deliver the right information to stress the benefits and outcomes, and to set the right expectations. We have found that effective visual illustration, such as pie charts showing changes in asset allocation over time, can be very useful in explaining the key facts to members. 3. Finally, is a cash + 3% target enough, especially in the early years, when members perhaps should be taking more risks, given the fact that DC contribution rates are not generally that high? In order to address this risk we can adapt the basic strategy to take into account how long members have before they reach retirement. We have already created a ‘Plus’ version of our DC Diversified Growth Fund that targets cash + 4.5% by blending the original fund with higher-risk equities. At the other end of the scale, you could blend the fund with cash to create an even more certain outcome as retirement approaches. I think the new breed of default options help to deal with the risks faced by DC members. One of the reasons that they are here to stay is that they meet members’ require-ments much more closely than traditional equity fund. A well chosen default option can really make a difference to a DC member’s income in retirement, which, ultimately, is what the DC industry is here to do.
Emma Douglas
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