Retirement income and assets: how can pensions and financial assets support retirement?
The pensions landscape is becoming more complex
Retirement income and assets: how can pensions and financial assets support retirement?
The report’s remit
The report’s broad remit means it contains several important messages for independent financial advisers, asset managers, life companies and pension funds as well as anyone concerned about their own future retirement income.
Here we have summarised the report findings followed by specific issues raised for institutional investors and pension consultants.
Move to DC is driving changes in pensions landscape
The report shows that one of the major reasons for the growing complexity in the pensions landscape is the shift in occupational pension arrangements from defined benefit (DB) schemes to defined contribution (DC) schemes.
In the private sector only around 5% of companies currently offer DB scheme membership to new employees. The report suggests that this change in pension provision could have significant implications for future retirement income levels.
Investment choice will increasingly influence retirement income
Occupational scheme members will increasingly have to take responsibility for managing their own pension assets as DB schemes disappear, with the choices they make likely to have a significant influence on their final pension pot.
Employers may also invest less in DC schemes per employee than in DB schemes, which means DC scheme members may need to supplement with their own contributions if they want to maximise retirement income levels.
Furthermore, DC schemes require members to divest their assets to provide an income in retirement, either through an annuity or some kind of income drawdown option. Once again, this places a high degree of responsibility on scheme members to make the right choice during the decumulation phase.
Auto enrolment may decrease DC employer contributions
Any drop in employer contributions may be exacerbated by the introduction of auto-enrolment and compulsory employer contributions. The report warns that employers could cut their pension contributions to meet the costs of this government legislation, suggesting that if employers take the opportunity to reduce their contributions for all employees to the minimum of 3% of earnings, then annual total pension contributions could fall by GBP 10 billion by 2050.
Of course, employers may maintain existing contribution levels, but there is considerable uncertainty about the outcome here and therefore members of occupational DC schemes should keep a close eye on contribution levels to ensure they are high enough to give them a chance of meeting their future retirement income needs. Furthermore, auto enrolment will lead to many more employees on lower incomes building up pension assets.
State reforms will help address current inequalities
Finally, the report says redistributive state pension reforms are aimed at boosting retirement income for people on low incomes, carers and the disabled. However, all pensioners will benefit from pension reform, particularly plans for the re-indexation of the basic state pension with earnings.
Key points for institutional investors and pension consultants
More guided investment solutions are needed
Many new DC schemes are being established on a contract basis rather than a trustee basis, so the new occupational pension landscape places a lot of responsibility on scheme members to make the right investment choices. Therefore, investors will increasingly demand a much higher level of guidance and support from the investment industry.
This does not mean simply providing more educational material, although this is indeed important. Instead, the new DC landscape will require the development of more sophisticated online planning tools that can quickly and simply help scheme members make investment choices that are appropriate for their needs, investment horizon and risk tolerance.
It’s therefore important for asset managers and consultants to not only design a compelling mix of investment funds for scheme members to choose from, but also to provide the tools and portals to empower investors to build the most appropriate portfolios and also to guide them through the various decumulation options that are available on retirement.
Getting the default right is crucial
Another consequence of the move to DC will be greater scrutiny of the investment options available to scheme members. At the moment, given the complexity of the investment choices available many DC scheme members opt for the default fund option (as many as 75% of DC scheme members according to the report).
It is therefore vital for pension schemes and their consultants to work with asset managers to ensure default options are suitable – the report suggests some kind of lifestyle option may be best. Many schemes are already using lifecycle funds that allocate assets according to the age of their members (target date funds).
Many schemes also use passive equity funds for younger members and these funds can provide potentially strong returns and cheap core equity exposure for those with a long investment horizon. However, choosing assets and funds for older members and those nearing retirement is becoming increasingly tricky. These older members are likely to be contributing most to the scheme to boost retirement funds and, with the new flexibility to defer drawing a pension from occupational schemes, many of these older members will want greater protection and outcome certainty, but they may still also want the potential to maximise the growth potential of their assets to boost their pension pot.
As a result, it may not be suitable for a lifecycle default to simply move assets from equities into bonds and cash as retirement approaches. Instead, schemes may want to look at using total and absolute return funds to provide more risk-averse scheme members with good alpha generation potential while maintaining a higher level of protection.
These funds lack a long-term track record, but have performed well during the market volatility of the last few years. JPM Cautious Total Return Fund, for example, has delivered a return of 3.84% over the last two years (to 30 September 2009) compared to an 8.26% drop for the MSCI World Index (both in sterling terms).