With freedom comes responsibility

26 July 2019
Pension freedoms mean schemes must do much more than simply run a one-size-fits-all default fund says Ewan Smith

Have providers fully embraced pension freedoms?

Unfortunately, many have not. Pension freedoms came in half-way through auto-enrolment and created a completely new world that has not been fully acknowledged by the market. Before pension freedoms a default fund made complete sense because all but the very wealthy were likely to take tax-free cash and buy an annuity. But in the post-pension freedoms world a one-size-fits-all approach is no longer suitable because there are so many potential different outcomes now. Many schemes still think it is their job to offer a single solution right through the accumulation phase and then pass the retiring member on to an annuity supermarket. In today’s world such a scaled-back approach to approaching and transitioning to retirement is no longer tenable, and could lead to people running out of money.

How have pension freedoms changed customer needs?

Our initial thinking was that we should maintain tax-free cash and drawdown as the target for the default and offer options for those wanting to navigate away towards taking more risk. But we now assume that a typical customer will want to retain greater flexibility through drawdown, and take a higher level of risk – at least during the first phase of flexible retirement.

What is the right level of risk for a default fund at different stages of the saving journey?

The fact that customers are making a regular stream of contributions and the mathematics of pound cost averaging mean that short term volatility in the price of assets can work in the favour of the customer. However that does not mean that we should completely ignore the longer term benefits of diversification. Sequencing risk gradually becomes more and more important as retirement age approaches, and so the risk of poor outcomes for members gets greater and greater. The decade of stockmarket growth that we have enjoyed to date means no-one has seen the negative impacts of sequencing risk for quite some time, but it remains a massive risk.

How can schemes mitigate sequencing risk?

We have spent much time debating how to solve sequencing risk and the answer is there is no watertight solution, so structures must be put in place to help savers take suitable steps to protect their position when markets fall. If providers are serious about delivering good member outcomes they need schemes that achieve high levels of engagement, preferably in partnership with advisers, and that also offer a simple range of easily-accessed options that enable individuals to navigate to the right choice for them.

Are defaults suitable all the way through the accumulation phase?

Not really - that's why engaging with members is so important. The idea of a default fund is to not make a choice – and this has been a key part of making auto-enrolment work. Individuals within age cohorts have different needs and goals, and the different cohorts themselves have very different characteristics. Many of today’s retirees have significant DB pots and their DC pots are relatively small. But in 10 years’ time people will have significantly bigger DC pots and will be relying on them for a greater proportion of their retirement income. So engagement is becoming increasingly important as a key to enabling individuals to get to the right solution for their personal circumstances. Good outcomes can be achieved by presenting a good choice of portfolios that engaged members can access easily, preferably with an adviser.

Are schemes being transparent enough about their investment objectives?

Not at all. It is surprising that more emphasis has not been put on compelling schemes to set out the thinking behind the design of the default and how it is managed – alongside the traditional performance reporting. This needs to be linked to a stronger focus on customer outcomes, given the decisions that customers have to make at various stages in their savings journey. The combination of the investment strategies made available - including the default - and the customer engagement that goes hand in hand with this are what will ultimately influence member outcomes.

Is benchmarking useful?

Yes, it is of course always better to have more information than less. But this information should be handled with care. Used in the wrong way, benchmarks can lead to schemes focusing more on each other than on customer outcomes. We saw this in the 1980s and 1990s when managed funds ended up over-exposed to equities as managers chased returns to compete with each other.

About the author

Ewan Smith

Proposition Design and Market Engagement Director

Ewan Smith, Director of Proposition Design and Market Engagement, Royal London Intermediary. Ewan joined Scottish Life in 1986 and has worked in the Marketing, Investment and Actuarial Research divisions. He also spent 3 years at Scottish Life International (SLI) as Finance Director and Actuary before returning to Scottish Life. Prior to his current role, Ewan became the General Manager of the Marketing Division in 2001.

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