Although UK chancellor Philip Hammond’s autumn 2017 Budget avoided making further reforms to pensions, the defined contribution (DC) sector continues to evolve at a fast pace as the industry works to implement the multitude of regulatory changes introduced in recent years.
Furthermore, with equity markets having reached record highs during 2017, many schemes will be keeping a close eye on the market outlook for the coming year.
In this context, the start of a new year provides a good opportunity to assess how DC schemes are responding to a changing backdrop.
From April 2018, the minimum level of contribution that must be paid into workplace pension schemes will increase from 2% to 5%. With a minimum of 2% to come from the employer, many employees will have to contribute 3% themselves, compared to only 1% today, which could lead some to consider opting out of their schemes.
The consensus view is that, because there are other changes happening to members’ salaries at the same time, with the new tax year, the rise in contributions may not be that visible, and so the opt-out rate may not change dramatically. However, the change is taking place against a backdrop of Brexit, an uncertain economy and the knock-on effects on house prices, with many employees receiving below-inflation pay increases or no increases at all.
In such an environment, there is a risk that people will be looking at their pay packets more closely and asking whether they can afford increased pension contributions in this environment. While the April 2018 increase is perhaps not substantial enough for many people to take action, the risk of opt-outs is likely to increase, particularly in 2019 when employees will be expected to contribute up to 5%.
Looking at the actual proportion of employer-versus-employee contributions, it is the employee who is bearing the greater share of the increases. Since current contribution rates will in many cases be insufficient to support members through retirement, it may be worth considering whether there should be a greater onus on employers to pay proportionately more.
Ultimately, it will only be possible to judge if auto enrolment is successful much further down the line when contribution rates become more substantial. Once it becomes a more active decision for members to stay in their schemes, it will be possible to properly evaluate if it is working.
The Department for Work and Pensions has recently undertaken a consultation on draft regulations for master trusts (multi-employer occupational pension schemes), with the aim that members of such schemes have equivalent protections to members in other types of scheme.
While some master trusts have been around for a while and have a long history, the majority are newer entities. In this context, they are playing an important role in accelerating consolidation, resulting in a much more professionally run and sophisticated industry. Arguably, master trusts will also be at the forefront of innovation, and could have a significant impact if they choose to go into post-retirement. However, such innovation also creates challenges in that there is more of a risk of rogue behaviour.
In aggregate, it should be a very positive development that there will be greater regulation of master trusts. Should a disorderly wind-up of a master trust occur, the headline repercussions would be significant for the industry, and the faith that members need to have in the stability of the system would be compromised.
The Pensions Regulator recently launched a campaign – 21st Century Trusteeship – to protect workplace pension savers by driving up the standards of governance across pension schemes.
Assessing the effectiveness of a board and its governance arrangements is not a straightforward task, as trustees already have a multitude of factors to consider. However, being open to gaining fresh perspectives can help boards as they seek to identify the long-term risks facing scheme members and their investments.
In this context, we think it could be beneficial for trustee boards to include some sort of member-nominated presence. Experienced, professional trustees are of course vital for a well-functioning board, but a member voice can provide a link with the real world and offer slightly different perspectives. Even in this sphere, however, further efforts may be required to ensure there is truly diverse representation. Ultimately, a board with diversity of views, backgrounds and gender should bring benefits in the way debates occur and are concluded.
While it is hard to define precisely what a ‘good’ trustee board looks like – and moving away from a traditional composition could feel like stepping into the unknown – a well-balanced board with committed and engaged trustees should be well placed to protect the interests of a scheme’s members.
It has now been ten years since the global financial crisis, and it is possible that investors may have been lulled into a false sense of safety and wellbeing. Volatility may be at historically low levels, but there are significant geopolitical risks, such as North Korea and Brexit, while global inflation remains weaker than expected and wage growth is stagnant. Meanwhile, stock-market valuations are at all-time highs, with asset prices having been inflated by central-bank intervention.
It’s not clear what will turn the tide, but we anticipate that something may well happen to cause markets either to correct quite savagely or have a series of corrections; the view that this time is different and that market cycles are no longer relevant would seem a bold assertion.
DC schemes need to design portfolios that will be robust over the long term, and therefore it would seem rash to ignore the potential for possible shocks, especially in cases where members are close to retirement and cannot run the risk of their pots being eroded. Platform constraints and contractual considerations which are administratively burdensome mean that DC schemes are unable to be as nimble as their DB counterparts, and cannot easily adjust asset allocation when market conditions become more stressed. This emphasises the need for careful portfolio construction in preparation for different potential outcomes.
While most DC schemes include diversified growth funds in their default strategies, many may feel disappointed that these funds have not performed as well as pure global equities. However, with a multitude of risks bubbling up in the background, now may be precisely the time that schemes need to focus on such diversification with an eye on capital preservation.