Megatrends in default investment strategies
Megatrends in default investment strategies
What can we learn about post-retirement investment strategies from the leading pensions of the world?
Last week at private dinner engagements held in Johannesburg and Cape Town, Lesley-Ann Morgan, Global Head of Defined Contribution and Retirement Strategies at Schroders UK, shared fascinating insights into post-retirement default strategies and drew interesting parallels between SA’s retirement fund industry and elsewhere in the world, specifically the UK and Australia.
Providing a backdrop to the discussion, Morgan explained that the disparate trends in post-retirement default design went back to 2014 in the UK. Says Morgan, default funds are simply investments that employees’ retirement savings are placed into should they choose not to make a decision themselves about where they wish to invest. But following the recent shifts in the UK pensions market, such as the new pensions freedom reforms introduced in April 2015 and auto-enrolment, default investment strategies are now also going through dramatic changes.
What can we learn from our overseas counterparts?
Pensions Freedom Reform in the UK
After a few years of ‘pensions freedom reform’ (the 2015 legislation that gave UK retirees full flexibility over how they spent their pension pots, thus doing away with compulsory annuitisation) the FCA decided to look into exactly what people were doing with their money in retirement.
With the introduction of pensions freedom, individuals could choose their investment strategy, eg: investing in a guaranteed annuity, a living annuity (called a ‘drawdown’) or even taking it wholly as cash. What the review revealed, however, was that instead of using the new choices available to them, most people had simply been taking the entire pension amount as cash, even though they had to pay the tax on a high portion of it.
The survey showed that only 25% of employees would use most or all of their pension pot to buy a guaranteed annuity when they retired. Obviously this was the unintended consequence, as the real goal was to allow people the freedom to invest in other types of products, in order to meet their income requirements. Said Morgan, “It has fast become apparent that annuities were losing popularity, and going forward a mix of drawdowns (including those from a living annuity) might be best, just to keep the flexible options open.”
What worked and what didn’t?
Free advice to all retirees?
When the UK regulator first announced pensions freedom, they committed to offering ‘free advice’ to everyone in retirement. However, this was simply not possible. Firstly, there were nowhere near enough advisors to provide financial advice to everyone as post-RDR (Retail Distribution Review), many of the older, more experienced advisors had pulled out of the market simply because they had grown weary of the increasingly stringent qualifications they had to gain to remain in practice. So the FCA (Financial Conduct Authority) were forced to quickly recant and changed ‘free advice’ to ‘free guidance’. This turned out to be non-substantive and a poor replacement for genuine financial advice.
The takeout is that it is extremely challenging to come up with a single, effective default post-retirement solution. And there cannot be a one-size fits all approach, says Morgan.
Following concerns over the high cost and lack of access to advice, the FCA also carried out a review on the financial advice market, and promoted robo-advice as an affordable, accessible way to give financial advice to a greater number of people.
Although robo-advice has gained some traction in the UK, the take-up has not been as big as anticipated, as many people aren’t sufficiently “tech savvy”. They simply default to asking friends where they should invest!
Default investment pathways
The FCA has proposed that companies should ask their employees what their desired retirement outcomes would be, and then find a default pathway (solution) that most closely matches that retirement choice. These should take into account the “likely characteristics and needs of the target customer group”. The FCA also said that companies would be required to actively review the appropriateness of the different investment pathways to ensure they remain appropriate. This approach may be difficult to implement considering that the average UK citizen had never made a DC investment decision in their life! So when given the choice, people preferred outcomes that were completely impractical: “As much income at retirement as possible, thank you, and lasting forever with no risk at all.”
What about Lifestaging? Is it out-moded?
Default funds in the UK have historically made use of a lifestaging strategy, i.e. commencing when the employee is within 10 years of retirement, their investments are gradually moved from riskier growth assets such as equities towards safer, interest-bearing assets. Historically these designs had large allocations to fixed income because people were being forced to buy annuities. But we can all agree, says Morgan, that a default fund with high allocations to fixed income or cash at retirement is potentially a lousy place to be when one needs to draw an inflation-linked income over an extended period, with less returns than other paths.
Charge caps and the push to passive
Several years back in pre-retirement, the FCA brought in a charge cap for the default for pre-retirement: 75 bps, including admin fees. One unintended consequence of this was a significant move to cheaper passive investments. However, pushing everyone down a passive path would not necessarily lead to better outcomes.
The FCA is considering whether there should be a charge cap for post-retirement too – this is an attempt to ensure that people who did not engage actively with their investment decisions would not be subject to excessive charges. In Morgan’s view, what they are trying to do is to institutionalise post-retirement and bring the favourable pricing from the pre-retirement into post-retirement environment, which should result in improved outcomes for individuals she believes, provided that there are no unintended consequences. Once again, depending on the level of the charge cap (if introduced), this may also eventuate in retirees being pushed down the passive route again. Which could arguably lead to sub-optimal retirement outcomes.
Another unintended consequence of pensions freedom was that some older people in the UK were being subject to fraud by unscrupulous sales people trying to persuade them to invest in products not appropriate for them. The FCA are trying to clamp down on this, which will be far-reaching in terms of what they want to achieve in post-retirement.
So what’s happening ‘Down Under’?
Says Morgan, it was interesting to see the disparity between Australia and the UK in terms of post-retirement trends. While the UK initially had compulsory annuitisation in place, this was completely done away with in 2015. On the other hand, in Australia (where they had just conducted the Murray Review), the popular rhetoric was that because Australians only had living annuities in place, they should be introducing guaranteed annuitisation.
[The 2014 Murray Review described an approach to building a default product for managing income in retirement. “The pre-selected option should be a comprehensive income product for retirement (CIPR) that has minimum features determined by government. These features should include a regular and stable income stream, longevity risk management and flexibility. CIPRs would be low-cost and include a ‘cooling off’ period”.]
How could two countries so similar in terms of their mortality rates come up with solutions so completely opposite, muses Morgan?
In truth, Australia had never really embraced annuities, primarily because it just didn’t make sense considering Australian tax laws. This in stark contrast to the SA and UK experience.
Frugal living and inheritance tax planning
Because people typically don’t use guaranteed annuities in Australia, they worry that they might live longer than expected. As a result, all the evidence shows that Australians are living a lot more frugally than they need to. And the additional result of this is that they are using their DC superannuation funds as a tax-efficient way to pass on their legacy to their children and grandchildren when they die.
So Australia too is planning default regulations to provide some income certainty. It’s likely they won’t go the full annuity route, though, says Morgan. Instead, the major funds will essentially self-insure. Super funds are so big in Australia that they don’t need to use an insurance company. Another benefit to self-insuring is that they probably won’t be subject to Australia’s solvency regulations that fall under insurance laws and don’t need to allocate the capital required under those laws. We will see an entirely different set of dynamics come into play for Australia, reflects Morgan.
Of course, the difficulty in South Africa and the UK is that we don’t have deferred guaranteed annuities to provide for longevity risk management due to stringent solvency regulations.
Deferred longevity risk
The common consensus is that default design in Australia will probably be delayed to 2019, and people will in all likelihood be placing their money in a living annuity with a portion going into a deferred longevity risk-sharing arrangement.
One of the issues about designing something with deferred longevity risk hedging built in, is when do people have to make that choice? If it’s early on, at say 65 when they first retire, people complain that they’ve locked that money away and would therefore rather defer that decision to say, age 80. The problem with deferring is that cognitive ability starts to fade well before the age of 80 and if you leave that decision to someone in their 80s, there is an implied moral risk that a ‘well-meaning’ family member may attempt to assist in an ‘unethical’ way under the guise of beneficence.
Resolving the underfunding conundrum
Says Morgan, all we ever hear about is preservation preservation preservation. It’s a universal problem in South Africa that individuals do not preserve retirement savings when they change jobs and is widely accepted to be a major reason why we are all underfunded at retirement. The concept of underfunding implies that you have insufficient capital at retirement to support your future withdrawals. So, how do we deal with this issue in an investment sense, asks Morgan? The obvious options are:
- You can take as little capital risk as possible, put it all into bonds, and eke out a living (risk: it won’t last me my retirement but at least it will be safe)
- OR maximise your risk and put as much as possible into growth assets such as equities (75%) and put rest into something else and hope for the best (risk: you could suffer potential irrecoverable capital losses if the markets fall in the early stages of retirement).
- OR you can take a punt on multi-asset active management and hope to close the funding gap (risk: attempting to time asset class switches can similarly erode your nest egg).
- Or do you take the certainty of an income from a guaranteed annuity (risk: it gives you a level of income below the level of consumption required by most people).
The trick here is trying to juggle two directly opposing objectives: trying to achieve a suitable level of income, while minimising the probability of bankruptcy prior to death.
What we’ve come to realise, says Morgan, is that investment alone is never going to save the day. At best it can help make up some of the shortfall. People have to recognise that saving is important. The most successful financial education has been shown to happen at the point of decision (ie, close to retirement) rather than early on when you sign up to a job, and it is important to note that many young people currently don’t grasp the basic fundamentals. This education should also include an essential element that creates an awareness of the role debt plays.
How to encourage saving from a young age
There are basically three ways to do this, says Morgan:
- You can enforce compulsory savings into a pension fund (regardless of what you earn, you contribute to a pension fund). To help, employers can incentivise people by subsidising the contributions.
- ‘Save more tomorrow’: using behavioural economics (the classic financial nudge) to increase employee savings. One way to do this is every time someone gets a pay rise, employers take an additional amount from the top-up to put into their pension fund. 60% of US plans have adopted that principle. It’s a matter of giving people a form when they start work, and agreeing to sign away a specific portion of their pay rise into their pension as an annual top-up, and a forced saving mechanism.
- Allocate to alternatives to maximise returns/reduce volatility.
We concluded by asking Morgan to depict her ideal state for post-retirement defaults:
“Obviously, contributions have to be a big part of the picture and we cannot escape the fact that we’re all hopelessly underfunded. But there are problems with compulsory savings due to the low socio-economic status of some. So the ideal would be to introduce ‘compulsory with opt-out’, like in the UK. Interestingly, this has been a popular option and opt-outs have been surprisingly low. This could be especially favourable for those at the lower end of the income scale who may not be able to afford to contribute at all stages of their life. You have to start, but at least you can choose to opt out. Clearly we all have to work longer and defer retirement, but the reality is that while we can keep on extending the retirement age, we just never catch up because we’re too far behind.”
So the obvious answer, says Morgan, would be to maximise returns prior to retirement age, ie getting people to take as much risk as possible when they are younger, and this could mean allocating to non-traditional asset classes and perhaps even using leverage in pre-retirement years.
“Ultimately, my passion lies in designing hybrids,” concludes Morgan, “because they help you to continue growing your assets when you haven’t saved enough”. For example, the ‘with-profits’ concept might also be a viable answer. We might even consider solidarity risk sharing, the concept of pooling and sharing losses.
Or should it be each for his own? Culturally, there is no obvious choice. And the ultimate question remains, can a default be designed in post-retirement? Or are there just too many variables?