DESIGN SOPHISTICATION FOR THE MASS MARKET

DESIGN SOPHISTICATION FOR THE MASS MARKET How target date funds are gaining traction as a better way to deliver good retirement outcomes. By Sahil Sethi, DC Strategist, State Street Global Advisors There have been seismic changes in the UK s defined contribution market over the last five years. The introduction of auto-enrolment forced companies to review their sometimes neglected DC schemes. A raft of policy decisions has further shaken up the market, especially the government s decision to relax the requirement to buy an annuity at retirement. These changes have radically re-shaped the market. Companies, trustees, consultants and insurance companies have had to re-think their investment strategies. The increase in the number of master trusts has introduced a host of new players to the workplace pension market. Previously held assumptions about the best way to design a DC scheme are being challenged. Target date funds (TDFs) are gaining traction as a better way to deliver pensions than lifestyle products. Consulting actuary Harry Taylor says: Target date funds can bring institutional sophistication to the mass market at low-cost and with good governance. The Anatomy: TDFs vs Lifestyle To explain the difference between the two, let s take a closer look at how a DC pension is built. During the course of an employee s working life, salary contributions are put into a default investment strategy. As the employee approaches retirement money is switched out of riskier assets, such as equities, and into more secure assets, like bonds. This helps to protect the value of the pot from any falls in the value of financial markets. This switching is traditionally carried out by a lifestyle process. A proportion of each individual scheme member s pot is switched between different funds in a mechanistic manner. But target date funds can do this in a more efficient manner. In the run up to retirement, a TDF can take advantage of market movements as a manager is overseeing these changes rather than just switching a set ratio of assets. Robert Holford, partner at Spence Johnson, says: This allows TDFs to get the best deal for the scheme member. 18 State Street Global Advisors DC Strategy

A Challenging Growth Market Despite the fact that TDFs dominate the US pensions market, uptake in the UK market has been relatively slow. The structure of the UK market has made it particularly difficult for providers of TDFs to gain traction. Most schemes rely on the advice of employee benefit consultants. Holford says: There has been significant consultant opposition to the product as it s a competitor to their lifestyle model. This resistance, however, appears to be waning. Holford says: Aon Hewitt, for example, has adopted TDFs for their delegated DC offering. Perhaps the biggest impetus for the growth for TDFs will come from the rise of master trusts, particularly the National Employment Savings Trust (NEST) Corporation. Taylor says: The scale of NEST means the TDF structure is becoming mainstream and members will expect a similar approach and advantages from other pension schemes if they change jobs. Low Costs and Flexibility For the Masses NEST was established to ensure small companies and lowincome savers would have access to a low-cost, transparent savings scheme when auto-enrolment was introduced in 2012. Building a DC scheme from scratch enabled NEST to select the most efficient tools available. Mark Fawcett, chief investment officer of NEST Corporation, says: A target date fund is the best vehicle for us to provide pensions for millions of members. The TDF structure considerably reduces the administrative burden. Fawcett says: It s much more effective to change the asset allocation of a cohort of members rather than individuals. The structure also reduces the likelihood of making an error and the expense of fixing the mistake. A TDF structure, where the glide path is managed from within the fund, also tends to be easier and less disruptive to adapt than administratively-led lifestyle fund approaches. This adaptability is crucial when we consider the need to adjust asset allocation according to evolving member needs, or when regulatory changes like freedom and choice necessitate refining the glide path. But perhaps the biggest impetus for target date funds will come from the growth of master trusts, particularly the NEST Corporation. TDFs also make member communications much more straightforward. Each member is included in a fund which targets a retirement date. For smaller schemes each cohort might target a five-year window for example, 2060 to 2065. But for a scheme as large as NEST it s a specific year. Fawcett says: The purpose of each fund is clear from its name. It is easy for us to say: We are managing your pension as you approach retirement and these are our targets. In contrast, a lifestyle member will simply receive an annual statement showing their funds have been switched but with no understanding of why the changes have been made. Forming retirement age cohorts also makes it much easier for members to change their target retirement date. Taylor says: Members can select to move from one cohort to another if they decide to work for longer. 04 TOP 5 ADVANTAGES OF TARGET DATE FUNDS INTELLIGENCE ADMINISTRATION 1 2 3 4 5 COMMUNICATIONS FLEXIBILITY COST Fund manager guides strategic asset allocation and risk reduction Structure allows asset allocation and fund selection to be changed with no operational impact on members Member communications are more straightforward funds target a specific retirement date and the purpose of each fund is clear from its name Different asset allocations are set for different age groups, with the ability to change allocations as members mature Transaction costs kept to a minimum Contribute Design Sophistication for the Mass Market 19

But the key benefit of a TDF is its flexibility. Fawcett says: It allows us to have different asset allocations for different age cohorts and to change those allocations as the members mature. It also allows NEST to change asset allocations for other reasons, such as risk management, changing the strategic asset allocation or adding a new asset to the portfolio. It s very cost effective as it keeps transaction costs to a minimum, says Fawcett. NEST is able to invest in a wide range of assets because of the target date fund structure. In particular, it can invest in illiquid assets, such as property. Fawcett says: This structure enables us to establish an internal market for these assets. Members close to retirement sell their stake in the property fund to those still in the growth phase. We avoid the need to sell these assets in the market which would be much less efficient and more expensive, adds Fawcett. Flexible Fund Structure For Varying Retirement Needs More fundamental changes to investment approach are also made much easier. When the government decided to abolish the requirement for pensioners to buy an annuity on retirement, the DC industry needed to re-think its investment strategy for the latter stages of the default fund. Before this change, it made sense to switch members portfolios entirely across to fixed income assets as these would provide a good match to annuity pricing. But that strategy is no longer valid. Changing the investment strategy of a lifestyle fund can be complicated and time consuming an investment consultant or provider needs to come up with a new strategy, get the trustee board or governance committee to agree to the strategy and then implement it. Fawcett says: Once we had determined that our at-retirement strategy should target inflation rather than annuity pricing, we could easily implement it without having to go back to the drawing board. Holford agrees: These government changes could provide further impetus for target date funds as they underline how much easier it is to radically re-haul the investment strategy in this structure. The Future is Unpredictable, Adaptable Products Are Vital Not only is it easier to overhaul a TDF investment strategy but it s also a much easier vehicle in which to provide an at-retirement fund. Fawcett says: The TDF allows a fairly seamless transition into an at-retirement product. For this to happen, however, the fund would have to have a new target as it would no longer be retirement. An alternative target could be an annuity at the age of 85, which is when scheme members need the longevity protection only an insurance product can provide, he adds. Taylor adds: The inherent flexibility of the TDF structure allows the manager to set up the investment objective according to customer needs and time horizons. Much of current research indicates members want flexibility because they have little idea of their future SMALL BEGINNINGS According to Spence Johnson, lifestyle continues to be the dominant approach in the UK institutional market those trustee and contract-based schemes with more than 1,000 members. Lifestyle products in the UK have assets of 76 billion, equivalent to 84% of the total. In contrast, TDFs have assets of 1.9 billion. This contrasts with the US, an early adopter of TDFs, where growth has been more vigorous. The proportion of US plans offering TDFs grew from 29.1% in 2006 to 69.6% in 2012.Data from Cerulli also projects that by 2020 US target date fund assets are likely to be more than double their level of 2014, with over 70% of contributions expected to be directed towards Total Institutional DC Assets. UK Institutional DC Schemes* Total DC Institutional Assets Lifestyle Target Date 91 bn 81 bn 76 bn 1.9 bn Source: Spence Johnson, January 2016 * Master Trusts & DC Schemes with more than 1000 members US DC Schemes Offering TDFs 29.1 % Source: Brightscope, December 2014 69.6 % 2006 2012 20 State Street Global Advisors DC Strategy

plans. It s too tricky to plan the future when there are so many variables at play. Members can t predict, for example, their own health and longevity or that of their partners or parents, says Taylor. Demand for at-retirement products which continue to manage the investment strategy for the member is likely to be high. Fawcett says: Despite the introduction of freedom and choice, most people do not want to become investment experts. Providers of at-retirement products will take on a similar investment horizon as an annuity provider. Taylor says: These products will have to be robust and durable for maybe 30 to 40 years. TDFs offer the flexibility needed for such a long-term product. While the inherent advantages of TDFs to provide the flexibility needed to build a pension pot and provide at-retirement vehicles will encourage many to use these structures, lifestyle will still have a significant share of the market. Taylor says: It s such a large proportion of the current DC pension market that it is unrealistic to expect it to disappear, especially as operators of lifestyle funds have developed sophisticated systems to run these funds. While both structures will continue to exist, there will be a rapid uptake of TDFs as the go-to default solution for the mass market, he adds. Our thanks to the following contributors for their insights for this article: Harry Taylor Consulting Actuary, Harry Taylor Consulting www.harrytaylorconsulting.com Twitter @HarryRDTaylor Robert Holford Principle, Spence Johnson Limited www.spencejohnson.com Mark Fawcett Chief Investment Officer & Executive Director, Investment & Member Proposition, NEST www.nest.com THE PENSIONS MANAGER PERSPECTIVE Dipak Wadher, Pensions Manager, Telegraph Media Group What features of Target Date Fund design do you find most attractive? The funds are designed to be suitable for the broad range of options members now have at retirement i.e. cash, annuity, drawdown or a combination of these. The de-risking is very gradual and starts 20 years from the Target Retirement Date and an extensive range of risk-management tools are used to provide downside protection in volatile market conditions. Are there challenges communicating how these funds work to members? The fund strategy and structure is very easy to explain. Members stay in the same fund throughout their career and do not have to worry about switching into less volatile assets as they approach their retirement. Because these are brand new funds that do not have a long performance record, recent negative returns have caused some concern amongst members with large pension pots. The risk reduction mechanisms have worked, but are too technical for many members to understand. How do you keep members informed about changes to their pension fund design? We have a dedicated pension scheme website, which allows us to communicate with our membership in a timely manner. We publish various news articles from time to time and have worked with SSGA to produce a quarterly market commentary. Changes to pension fund design are announced online, but important announcements are sent in the traditional manner by letter to members homes. Contribute Design Sophistication for the Mass Market 21

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