9th July 2012
No one knows exactly how much auto-enrolment will add to pensions savings – and to demand for equities and bonds. Or what the effect will be on other parts of the remuneration package – today benefits consultants Thomsons warned that some bosses would institute pay freezes so that the money devote to the compulsory employer contribution would really come from the employees. A small minority of firms said they would lay off staff to finance the scheme.
Scaremongering will take time to judge
While that may be scaremongering, the degree to which this warning turns into reality may be apparent for some time. Staff at the big firms who are first in line for auto-enrolment may already be in schemes that are at least as good as the new plan.
Disaffection will come later as smaller firms are forced to join in. Many may not have existing schemes so they will probably opt for Nest – the National Employment Savings Trust. Nest is intended as a no-frills, no-thrills scheme. There are other options but this is posited as the default. The success of auto-enrolment is crucial for investment markets as the final salary pension schemes, once the bed-rock of equity purchases, decline in importance.
A date with a target fund
But the lessons from the United States where default investment options known as target date funds have been around for some five years suggest that many will be disappointed. The target-date fund is a mix of equities, bonds and other assets which changes over time as the plan members get closer to retirement. The idea is to reduce volatility as pension age approaches by reducing equities and increasing bonds and cash.
In the UK, the nearest equivalent for personal pension buyers are lifestyle funds where the asset mix is changed on an individual basis as plan holders age – again moving from perceived higher risk to perceived lower volatility.
The US funds have been criticised as having portfolio mixes that are difficult to discover, opaque charges and indifferent performance. They also stand accused of appearing to offer certainty or guarantees when none are available.
As they are aimed at the financially less sophisticated, just like auto-enrolment, the UK could learn lessons from across the Atlantic. And there is every likelihood that some UK fund managers are considering replicating the American funds. If they do, there is every danger they will copy the problems as well.
Federal regulators want answers
The Wall Street Journal writes that "for about two years now, federal regulators have been reviewing the ways in which providers of target-date funds explain how their products work."
Some $400 billion is invested in these funds, according to figures from Morningstar.
And according to a 94-page report, just published by passive investors Vanguard Group, more than half of all defined contribution (money purchase) plan holders in the US will have their entire retirement savings in target-date funds – compared to just under half now. And 64% of all new participants in these plans in 2011 chose to put all contributions into a single target date fund. Vanguard expects that by 2016, 80% of new participants will make that choice.
According to Vanguard, "what's happening is that more employers are not only offering these funds and making them the default, but revising their plan literature to present workers investment options in tiers-first the target date funds; then core index funds; and then a third tier, where more specialized and managed fund choices are presented. So target dates come off as a respectable-and easy-choice." In the UK, there may not even be that degree of sophistication.
Dangers of ignorance
In underling the danger of not understanding the asset mix, Forbes quotes an Exchange Traded Fund participant saying: "There has been a nearly uninterrupted bull market in bonds for the last three decades, so if one is looking at past returns they appear to be a great investment. But what about going forward? A recent report from Goldman Sachs echoes others making the case that current markets present a once-in-generation opportunity to buy stocks and sell bonds, not only because stocks are attractive in their own right as they contend, but also because bonds are so unattractive. As a result, investors holding near-in target date funds would seem to be loading up on bonds at precisely the wrong time. If bond prices decline substantially in the coming years, near-in target date funds may in fact be much more risky than far-out target date funds-exactly the opposite of what was intended!"
And a number of funds have shut either completely or to new participants or new money including some from Goldman Sachs. Each manager will have different reasons but most cite a failure to garner enough contribution cash, making the vehicles uneconomic. Investors in a fund that shuts will be even further at the mercy of markets and charges.
Will auto-enrolled employees understand the risks? If the US is any guide, the answer is no. A recent Securities & Exchange Commission report discovered 45% of investors believed – wrongly – that some or all target date funds provide a guaranteed income in retirement, while a further 20% weren't sure about a guarantee but probably wanted to believe there was one.
Charges and fees can vary
There will be the question of fees. These can range from 25 basis points (0.25 per cent) or less for passive funds to well over 100 basis points. That makes a major difference over the life of a pension plan.
Equities cost more to manage than bonds or cash and passive is cheaper than active, so a key value for money question in any default fund will be the proportions of each asset class and how they are managed.
A further problem with default funds is one of advice. While the majority of those participating in auto-enrolment will have either no other savings or pension plans or very little, a number will have more substantial assets.
There is a danger that they will end up with the wrong mix for their overall needs. And that is negative for future investment trends.
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