Magazine Issues » November 2009


The crisis has made defined benefit pension schemes even less viable than they were. Angele Spiteri Paris talks to fund managers and consultants to see what's being done to make the alternative, defined contribution schemes, more attractive.

decorator.jpgConfronted with billions of pounds worth of deficits that companies faced paying out to fund their defined benefit (DB) pension schemes, the dotcom crash of 2001 all but finished off DB plans in places like the UK. Eight years later, though, and the latest crisis is pushing DB even closer to the brink of extinction.

Emma Douglas, head of defined contribution (DC) sales at asset manager BlackRock, says: “The market crash in 2001-2003 saw DB schemes closing to new entrants. This market crash is seeing DB schemes closing them to future accrual.”

DC schemes, where employees run the pension funding risk rather than the companies that sponsor them, have never quite filled the shoes of DB, but Douglas says: “After having had many false dawns and lots of crying wolf, this is the time when DC really is stepping into the limelight and getting much more focus.

“There are some very big schemes out there that are DC schemes. The focus is shifting more quickly then anyone thought it would.”

Colin Tipping, head of UK wholesale at Barclays Global Investors, says: “A good metric [of the focus on DC] is the amount of time DC is now taking up on trustee agendas. Historically with a combined DB/DC trust board, the DC component might have been barely noticed. Now it’s not unusual for DC to take up a quarter, a third or even more, of the agenda.”

Stephen Bowles, head of institutional DC at Schroders, says: “DC has been the ‘next big thing’ for a long time. People didn’t appreciate how slow the transition was going to be. The transition has speeded up for reasons that people wouldn’t have necessarily anticipated, that is, the recent market volatility.”

Tipping, at BGI, says: “The point where DB assets and DC will cross over in sheer scale and volume is within sight.”

But although DB is fast falling out of favour with employers due to the tumultuous markets of late, the central question is whether DC has the ability to provide sponsors and particularly members with a better option.

Sponsors have shouldered the risk of their occupational pension schemes for decades and DC offered them a way from this. But it was never truly attractive.

Bowles, of Schroders, says: “Nobody particularly wants DC. What [participants] need to do is to find a pension solution that isn’t a DB promise, because the DB promise is now costing twice what it cost when a lot of these schemes were set up.”

He says a watershed point has been reached – the crisis really was the straw that broke the camel’s back. But Bowles still wonders if DC can make itself attractive enough to be the pension vehicle of choice going forward.

Brian Kite, DC specialist at Mercer Investment Consulting, says: “One of the drawbacks is that a number of the ideas that have won favour in a DB market aren’t currently available in a DC-friendly format. For instance, unitised and with prompt pricing.”

Kite refers to investment areas such as alternative asset classes and overlay strategies. He says: “If someone can combine assets like exchange traded funds, alternatives or hedge funds and come up with a DC-friendly product, it is bound to raise interest.”

But there are several structural issues that need to be worked around before this can be made possible.

The liquidity, dealing and pricing cycles in most alternatives are such that they are not appropriate for DC scheme members, who are classed as retail investors by the Financial Services Authority.

Bowles, at Schroders, says: “The regulations [regarding DC members] are very prescriptive. With certain asset classes, if you change that liquidity to meet the needs of a DC member you destroy the investment rationale for going into it in the first place.”

Douglas, at BlackRock, says: “You run into practical difficulties. You could in theory offer a fund of alternatives to DC members, but the trouble is, it isn’t the kind of product that works in a daily dealing environment.”

She explains that unless the fund is included in the scheme’s default option, then it will see very little take-up. Instead, some firms, including BlackRock, have included a small allocation to alternatives within a broader multi-asset fund.

“This way you can still get some of the benefit of these products, by way of some good returns, but you can still have it in a portfolio that has the liquidity that DC investors need,” Douglas says.

Multi-asset funds are fast becoming a major trend in the DC world. Most recently, the DC section of the O2 Pensions Scheme appointed BlackRock as sole manager for its £30m (€33m) in assets and the firm’s multi-asset fund will be part of the new default option for members.

Schroders, meanwhile, has been influenced by large US endowment funds and their multi-asset approach. Bowles says: “We’ll try and reduce the overall level of risk by diversifying across a range of risky assets that in themselves are still very risky. But by investing in all of them at the same time and varying the weights of that, you can manage the level of overall risk.”

He says this type of approach has gained a lot of traction in the DC market.

But is this not old-fashioned balanced mandate investing? John Foster, consultant at Hewitt Associates, a pension funds consultancy, says there’s a difference.

“While they have certain limits in terms of what proportion of the portfolio will be held in what asset classes from a strategic point of view, they are far less constrained by the market median – and therefore far more likely to gain benefits from movements in markets through tactical asset allocation,” says Foster.

Making sure the default DC option produces returns that meet members’ needs is a great responsibility, considering 80% of DC monies go into the default funds, says Douglas.

Results from a Hewitt DC survey carried out in 2008 showed that around 75% of DC schemes offer a default option, and of those options, 80% or more contain predominantly a global equity or UK equity index-tracking fund.

Hewitt’s Foster says: “There is a very real and present opportunity for those responsible for running DC schemes to review their default arrangements.”

As the Hewitt survey showed, the majority of default options currently on offer are not very well suited to DC members.

Douglas says: “The majority [of default options] are still in passive lifestyle-type structures. So as a member you’re in passive equities until you get to five years from retirement when your assets will transition into cash and bonds.

“That’s very much a standard DC process. But it means there is an awful lot of volatility on the way and members generally aren’t very happy with that.”

Things are changing, if only slowly. BlackRock has 15 clients who are currently using its multi-asset fund as part, or all, of its default option. The first client came on board in 2008. Douglas says: “It’s all quite recent in terms of the wins that we’ve had, but we are finding that trustees and employers understand that the way that this type of product works seems to meet member needs a lot more effectively.”

Engagement with the members has always been a bugbear for DC providers, but Bowles believes offering them a well-targeted default option is a way of tackling this issue, particularly as most pension fund members will not be educated enough to run their pension schemes in a proactive way.

Bowles says: “In the short and medium term I don’t believe it’s possible to engage at that level of sophistication. I don’t think you can get the end member to appreciate a credit crunch and then convert that into an action regarding their pension.”

Kite, at Mercer, says: “Trying to turn people into investment experts calls up the old adage of taking a horse to water. For this reason we tend to advocate offering a compact, manageable fund range and pulling all those ideas together to give good risk-adjusted returns. This is especially important for employers with thousands of employees, the majority of whom won’t be interested in investment.”

©2009 Funds Europe