Author: Brian Henderson, Partner | Director of Consulting, Mercer UK
Pensions may be a long-term endeavour, but it still has its fair share of surprises. Trustees and the industry alike were taken by surprise when the government announced, in 2014, measures introducing greater freedom and choice for defined contribution (DC) members. Three years on, time is fast approaching for trustees to undertake their obligatory review of the investment choices they made in response to the new flexibilities.
Freedom and choice means DC members are free to withdraw their savings from age 55 via any combination of cash annuity or income drawdown. It was a historic liberalisation of the pensions system and necessitated a rethink of how pension schemes should invest.
Not knowing when DC members retire and how they will take their money posed significant challenges to schemes’ existing investment strategies, which had been geared towards the near certainty of members buying an annuity at retirement age.
At the time, trustees had little idea of the decisions members were likely to make.
Some schemes decided that people were likely to stay invested for longer, gradually withdrawing their money over the course of their retirement. Their strategies therefore maintained at least some exposure to risk assets at the scheme’s normal retirement age.
Others opted to assume members would take cash at 55 and adjusted their investment strategy accordingly.
Yet another tranche felt that annuities and the certainty they offer would remain a popular choice, particularly for members who decline to self-select their own investment profile. There was no right or wrong answer.
Three years later, a body of evidence is accumulating about the decisions members are making, giving trustees further insight and potentially helping them make better-informed decisions about investment strategy.
Freedom and choices
The implications of freedom and choice on retirees’ decision-making have been dramatic. There has been a substantial drop in demand for annuities, with people perhaps being put off by the perceptions of them offering poor value.
Twice as many pension pots are being moved into drawdown than annuities, according to data from the Financial Conduct Authority (FCA) in its Retirement Outcomes Review: Interim Report, published in July 2017.
Encouragingly, fears that savers would splash their cash on expensive cars and round-the-world cruises have proved unfounded. If anything, retirees are being overly cautious with their money, the Work and Pensions Select Committee concluded in a March 2018 paper, Pension Freedoms.
The FCA found that 32% of people who withdrew a pension pot in full saved the largest share in standard savings products, such as premium bonds or a cash bank account.
These significant changes in behaviour mean that, three years on from freedom and choice, it’s time for trustees to review the choices their members have been making and consider whether they need to adjust their investment strategy, paying particularly close attention to the default fund. Furthermore, this also gives trustees the opportunity to revisit the decision they originally took on investment design to see if member behaviour has largely played out as anticipated.
Reviewing the strategy
Investment is an inherently uncertain process, and it is very difficult to predict how longer-term legislative, market and technological changes could affect members’ pension pots. Trustees and their advisers are effectively risk managers, responsible for growing money over the long term. It’s a challenging job, and it can be tempting to focus on the short-term factors which are a known quantity, and therefore more straightforward to control.
Despite this inherent uncertainty, there are some steps pension schemes can take to make sure their default funds are better equipped to deliver good retirement outcomes for members. By looking both at existing patterns and into the future, schemes can make sure they are future-proofing their investment strategy as much as possible.
The three pillars
An effective review is constructed on three pillars:
- First, this is a great opportunity for schemes to conduct a member survey or look at existing statistics on how members are responding to freedom and choice. Is the scheme’s investment strategy still aligned to members’ behaviour and critically do member communications reflect the actions required to get the most out of the design?
- Modelling future retirement outcomes could form the second pillar of the review. By looking at cohorts of members who are all a similar age and projecting how their pots will grow in a variety of different economic climates, schemes will be able to assess whether they are on track. This review is also an opportunity to set expectations for the scheme’s investment goals for the next three years.
- The third and final pillar could be for schemes to look back at the last five or ten years of investment performance. Has the default fund performed as expected and if not, why not?
If investment strategy alone looks unlikely to help members reach a comfortable retirement, trustees could consider whether encouraging an increase in contribution rates is viable. Could individual members be nudged to increase their contribution levels? We know from own experience at Mercer that using personalised videos with a specific call to action aimed at improving member contribution can achieve the desired positive impact; typically a third of those who view their videos save more.
Once schemes have reviewed and adjusted their strategic objectives and investment strategy, they can ensure their member communications are consistent with these fresh plans.
Throughout, it’s important to remember that this is the start of the journey. Investment strategies are likely to evolve in line with members’ decision-making.
Today, we are in a transitionary period where many people still retire with a defined benefit (DB) entitlement, ensuring that they have a degree of secure income in retirement. FCA research suggests that 94% of consumers fully withdrawing their DC pension pots had other sources of private income, according to the Retirement Outcomes Review: Interim Report.
But this is changing. A generation will soon be retiring that will be increasingly reliant on their DC pension pots. For that reason, it’s vital to make sure the right building blocks are in place today, and that trustees keep revisiting them to make sure they stay relevant.
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This article does not contain advice in respect of actions you should take. No decision should be made based on this information without obtaining prior specific, professional advice relating to your own circumstances.