Imagine; you’ve booked your holiday to celebrate retirement, put the deposit on your new car and ordered that Rolex you’ve always wanted. You notice some stuff in the news about a stock market crash but haven’t taken much notice; you’re too busy celebrating. And then you’re told that the annual income that your pension will buy you has just dropped by say 25%... How did that happen you ask? Who can I shout at? Who do I sue?
It could be you
If you’re an employer, you choose the pension provider for your workplace pension. That means that you implicitly choose what type of default fund is used. You didn’t realise that? That’s the trouble with just ticking a box. You can take on risks without even knowing it.
I’ll try over the next few paragraphs to explain as simply as I can, what the issue is here and then suggest some steps you can take to mitigate the risks.
The workplace pension default strategy
Workplace pension arrangements work in the same way as a personal pension scheme that you might buy yourself. I.e. they are Defined Contribution schemes. They’re really simple. Contributions get put in by the employee, the employer and the government. They are invested in a personal account and then whatever they’re worth when you come to retire will determine whether your evening treat is Marmite or Caviar. For the rest of your life.
I prefer peanut butter to either to be honest. But anyway, I digress.
When you buy a pension scheme yourself you decide, often with the help of a financial adviser, where the contributions are invested. Everyone has a different view of risk, but to date most have probably invested a large part of the fund in the stock markets when they’re a long way from retirement and then moved it to something less volatile as retirement loomed, ready to turn into a fixed income when they retire.
In a workplace pension, you don’t have to decide. That’s because the scheme has a default strategy. Most employees, historically probably more than 80% tend to rely on it, without looking more widely. So, the investment decisions are taken for them. It’s a good job too. Independent investment advice on pensions is hard to find at price that most ordinary staff will pay.
Not surprisingly, the most common default strategy in recent years comprised of a fund with a high stocks and shares component in the early years with an automatic and steady de-risking process over the last 10 or 15 years before retirement. The plan would be to have at retirement around 25% invested in cash (so that you can take your tax-free cash) and 75% in fixed interest investments ready to buy your fixed income. So far so good.
This type of strategy is often known as “Lifestyle” It’s worth noting in passing, that even here no two providers’ default strategies are the same. Even where the objective is the same, the path to that objective in terms of which stocks to invest in, varies considerably.
Times they are-a changing
In case you haven’t noticed, things have changed dramatically. Until 2015, most people had to convert at least 75% of their fund into a fixed income for life, called an annuity, on the day they retired. But that was swept away by George Osbourne in the 2015 budget. Now, you can draw your money all in one go or leave it invested and draw on it only when you need to. You can still buy an annuity of course and that will be more or less attractive depending on interest rate levels at the time you’re thinking about it.
And another thing; the standard retirement age has pretty much gone out of the window. Employees can’t be compelled to retire and many that I speak to are already foreseeing continuing far beyond what might have once been a “Normal retirement date”. Many plan to work on, at least part time.
So, what should the default strategy look like?
To design a default strategy that will serve the typical scheme member well, requires there to be a typical scenario to plan for. Now that there isn’t a typical scenario, the experts disagree on how to do that.
I’ve outlined a typical default strategy, “Lifestyle” that many, but not all providers still use. The other main contender is a “mixed asset fund”. That means a well-diversified portfolio of investments that should produce reasonable returns without the degree of volatility of stocks and shares. For those that don’t know when they want to retire and are unlikely to buy an annuity it makes sense as long as they get some advice as soon as they’ve decided what they want to do, which should really be quite some time before actually retiring.
The two strategies are radically different. Consider two imaginary employees:
Dave and John.
Dave is old school. He’s planned is retirement from the age of 40. He’s going to retire at the age of 65 and commit himself to improving his golf handicap. He wants certainty of income so he plans to buy an annuity.
John meanwhile takes life as it comes and always has. He’s flexible. He’ll decide what suits him when it happens. He may retire, he may carry on for a few years. He’ll see how he feels when the time comes.
Like most people, Dave and John had got on with their lives and trusted that their employers scheme is well managed and not taken much notice of how the money is invested. They received some complicated leaflets from the pension provider which they were too busy to read. They looked like terms and conditions and who reads them!? Their funds were invested in a lifestyle default fund.
Dave has reached age 65 and handed in his notice. John knows that Dave is retiring and is a little envious so they’re chatting about it over a coffee. The stock market has been reasonably buoyant in the last few years but has just dropped significantly. Interest rates are reasonable.
Dave is feeling smug. He won’t suffer much from the drop in the stock markets because the pension scheme has been moving his money out of them. Because interest rates are reasonable, he’ll get close to the fixed income that he was expecting.
Meanwhile, John is thinking about going part-time and drawing a small amount of his fund when he needs to supplement his part-time work. He’d been thinking that the stock market was doing well so his fund was growing. Now he realises, from what Dave has said, that he has missed out on stock market growth and the fund is therefore less than he needed. He has to work on.
Dave thinks his employer is wonderful. John wants to get him by the throat…
If you factor in an increase or decrease in interest rates (which affect annuity rates) then the whole conversation would be different. But I won’t go on about it. You’ll be wanting to do something else by now.
As I’ve said, the experts are still pondering all this. Scottish Widows, a major provider of workplace pensions, has recently changed its default strategy from Lifestyle to multi asset but many are hanging on with lifestyle. But for how much longer? And who is right? What is right?
Where’s the risk to the employer?
That’s a good question.
As far as I know there is nothing in law that compels employers to think about this. But then if the law was always certain, the courts wouldn’t be so busy, would they?
At the very least, there’s a real risk of unpleasantness between the employer and staff member and if that comes after a long period of loyal service by the employee well, it’s not great is it.
So, what do you do to head off the risk? Remember no two schemes are the same. The experts are arguing about what’s best and everything could keep changing as a consequence.
But you’re not financial advisers. You’re probably not investment experts. What on earth can you do to head off the risk of unforeseen problems?
It’s all about governance
You’ll no doubt be doing some risk management in your business already. If you make things for example, you’ll not only be projecting the life of equipment and thinking about costs, you’ll be keeping an eye on maintenance schedules, health & safety, staff training and so on. And keeping an eye on the machinery manufacturers in case a new development makes it sensible to change tack.
Well, having a pension scheme imposes the same requirement for due diligence if you’re to avoid the pitfalls that potentially come with it. Surely, it’s much better that staff see the pension scheme as a benefit and a sign of what a good employer you are?
In pension terms having a governance and engagement strategy is what is needed. It goes much wider than the issues I’ve raised here but I’ll use this issue, about default funds, to illustrate what I mean.
So, some questions about your scheme’s default fund that could be used to start building a governance process:
You could no doubt think of more but I think that makes the point.
When you’ve got answers to all the questions of course, there are several steps you can take, including:
Again, you might think of other options as you go along.
This doesn’t have to be a monthly exercise. An annual meeting will probably suffice. But you’ll write it all down and commit to the actions you decide on. So when, as happens in life, the stuff hits the fan and the question arises “Whose fault is the default”, at least it shouldn’t be you!