Most modern pension schemes in the UK are not, according to the strict definition of the term, pension schemes at all. Companies typically run defined-contribution pension plans for their staff, which, unlike their elder final-salary or defined-benefit cousins, do not actually pay out any pensions. Instead, workers contribute to an investment fund throughout their career and, upon retirement, this pays out a pot of savings.
The workplace pension plan then waves goodbye to the individual, who takes his pot to an insurer and buys an annuity – a contract that pays out an income for life.
Under this model, most “pension” income is actually paid out by insurers, who hold £193 billion of assets in the UK to back these promises, according to market researchers Spence Johnson.
But efforts to reform this system are well under way, provoked by several years of generally low annuity rates, which have led to widespread consumer dissatisfaction.
UK pensions minister Steve Webb has heaped pressure on insurers to publish league tables of their annuity prices, and thus encourage shopping around at retirement. In January, he dismayed many in the industry by suggesting annuities could be made tradable after purchase, so consumers were not locked into them for life.
Asset managers have already spotted an opportunity. At present, Spence Johnson estimates that about £53 billion is invested in “income-drawdown” funds, which are retail savings funds offered as alternatives to annuities. They pay out income, but remain invested in growth-seeking assets such as equities at the same time.
Spence Johnson thinks these will prove increasingly popular as increasing numbers of well-off pensioners choose to stay invested during the early part of their retirement. The research firm estimates this market could grow to as much as £135 billion by 2023.
The Cheviot Trust, a £335 million mutual pensions provider for the legal sector, is pitching into this fray – in a move that may well be unique for a trust-based pension scheme.
Ellie McKinnon, chief executive of the Cheviot Trust, said: “At first, we thought, ‘Is there a drawdown fund provider that we could point our members to?’ And then we thought: ‘Let’s just do it ourselves’. It was not as complicated as we thought.”
The Cheviot Trust caters mainly to small and medium-sized firms of solicitors throughout the UK. Last year, the not-for-profit trust threw its doors open to companies from all sectors, seizing the opportunity presented by the government’s programme obliging all employers to offer staff a pension.
The drawdown fund initiative is part of this relaunch. It means Cheviot’s members will have the option of remaining invested in the scheme after they leave their jobs, even years into retirement.
Income drawdown funds have big potential benefits for individuals, as they allow pensions to be transferred to inheritors in the case of early death. This is something that cannot be done otherwise.
McKinnon said: “The interesting thing is, employers have always been able to offer this within an occupational pension scheme structure. It’s just that no one does.”
Cheviot’s drawdown offering, like its main pension plan, is underpinned by an unusually active investment process for a DC pension. Its trustees meet once a month – or more frequently, if required – and are not shy of bold asset-allocation calls.
Investment consultant P-Solve provides advice and support. McKinnon said: “We follow it often, but not always.”
This approach was introduced in mid-2011, so it doesn’t yet have a three-year performance record. All three of the investment choices Cheviot offers its members – Cautious, Moderate and Growth – outperformed their targets during 2012 and 2013.
The most aggressive strategy, Growth, has a target of consumer price inflation plus 4.5% a year. It returned 12.1% during 2013, ahead of this target by 4.9 percentage points, and about 11.5% in 2012, 3.5 points ahead of its target.
Britt Hoffmann-Jones, a P-Solve consultant who works with Cheviot on investment strategy, said: “When the more dynamic approach to asset allocation was adopted from 2011, the first change was strategically reducing the exposure to global equity. As an example, the allocation to equity in the Moderate option reduced from 75% to just above 50% in favour of a more diversified range of other asset classes.
“This provided good downside protection through a very difficult third quarter when issues in the eurozone came to a head.”
She added: “Six conference calls were held between P-Solve and the trustees in the two weeks after September 30 last year to monitor progress of US debt ceiling negotiations, in light of a pending decision to increase the strategic allocation to US equities. These calls didn’t change the trustees’ course of action, but demonstrate good governance and the importance placed on asset allocation decisions.”
Cheviot invests its DC funds in a range of assets, from global and regional equities, to government debt, credit, high yield, emerging market debt and property – a wide menu for a DC scheme. Funds are held by the trustees on a retail-funds investment platform, run by Skandia.
McKinnon and Hoffmann-Jones are also exploring options for investing in exchange-traded funds and pooled liability-driven investment vehicles, more commonly associated with defined-benefit plans.
Keeping costs in check
The pension scheme invests through index funds where it can, to keep costs down, but some active managers are recruited in areas like high-yield bonds and credit.
Cheviot Trust charges an all-in fee of 1% of assets a year for its services, a larger fee than some commercial providers, such as Legal & General or the government-approved scheme Nest. McKinnon said this reflected the higher level of governance and investment oversight in the Cheviot scheme.
She said: “The fee cap that the government is proposing [75 basis points on DC default funds] does concern me. I don’t get the logic of doing that without any consideration of what is being done [by schemes] on governance.
“It is interesting that one option in the government’s consultation is for a ‘comply or explain’ approach to the cap – I would certainly be very happy with the opportunity to explain our charges.”
Income drawdown: Managers eye a market opportunity
Income-drawdown funds, which allow savers to remain invested in the markets even after their retirement, could be the next big opportunity for fund managers.
According to market researchers Spence Johnson, assets held in these funds could swell from £53 billion to £135 billion in the next decade – a growth rate more than double that expected in the annuity market.
Cheviot’s move to offer one through a pension scheme is unusual – most of these funds are sold through retail platforms such as Hargreaves Lansdown’s or Standard Life’s. However, other schemes are accommodating themselves to the concept as well.
United Utilities, the UK’s largest listed water company, is introducing a new investment option into its DC pension plan that will cater for older workers planning to invest in a drawdown fund rather than buy an annuity. To do this, it will move them into assets like corporate bonds, diversified growth funds and property as they near retirement, instead of ultra-low-risk gilts and cash, which is what happens in most DC plans.
Steven Robson, United Utilities’ director of pensions, said the firm isn’t looking to offer its own drawdown fund through the pension scheme, but described Cheviot’s initiative as an “interesting concept”.
David Smith, a wealth management director at retail funds adviser Bestinvest, said drawdown funds are already becoming more popular with retirees from workplace DC plans – and his firm was picking up work from companies as a result, advising directors on post-retirement alternatives to annuities.
Drawdown funds can work in two ways, Smith said, capped drawdowns and uncapped drawdowns. UK government rules stipulate that individuals who can show guaranteed pensions income of more than £20,000 a year – from annuities and/or the state pension – are free to do what they like with the rest of their pension savings, and can take income out as they please.
Anyone with less than this can only invest in drawdown funds according to strict rules, and after advice from independent financial advisers. The amount of income they can take out each year is tightly controlled, and reviewed every three years. If markets tumble in the meantime, and the value of the investments falls, the drops in income can be dramatic.
Smith said: “There were examples of people coming up for income reviews in 2008 and 2009, after the financial crash, and seeing their incomes drop by 50%. We always advise clients to leave some headroom. If they think they need an annual income of £15,000 a year, we will advise them not to take drawdown if they can’t get at least £19,000 a year out of the fund, so there is room for it to fall in future.”
Despite that risk, the inheritance benefits of drawdown funds make them popular with some clients, Smith said. Savers who purchase an annuity get a guaranteed income for life – but it perishes when they do. If they die early, the insurer makes a tidy profit.
By contrast, the unused assets in a drawdown fund can be passed, sometimes tax-free, to dependants. McKinnon of the Cheviot Trust said: “The death benefits are a really important part of why people go into drawdown.”
Source: Financial News