Now that automatic enrolment has become the centrepiece of UK pension reform, decent retirement incomes should no longer be exclusiveÂ to company veterans and the well-off.
In 2012, low- and middle-income earners will begin contributing to personal accountsÂ – portable -pots’ of savingsÂ – for the rest of their working lives, creating a pensionÂ pool expected to grow up to Â£150 billion, making it the UK’s biggest. Tim Jones, chief executive of the Personal Accounts Delivery Authority (PADA), gave Simon Mumme an insight into how this capitalÂ might be managed.
Â PADA has been charged with delivering personal accounts to about 7 million low- and middle-income earners who have no access to satisfactory workplace pensions. The total sum of the accounts, which demand a minimum contribution of 8 per cent of earnings from workers and their employers, should “settle down” somewhere between Â£100 billion and Â£150 billion, Jones says, eclipsing the Â£37 billion BT Pension Scheme, currently the UK’s largest pension fund.
Jones, a former head of retail banking at NatWest, was hired to lead PADA, a non-departmental body created to design and introduce the defined contribution scheme, and he aims to appoint a trustee company in the first half of this year to run the fund, ahead of its starting date in 2012.
Jones and his team will recommend a comprehensive investment strategy to the trustee. To develop this, it researched its members’ attitudes to investment, and last year consulted pension funds, asset consultants, investment managers, professional bodies, unions, consumer groups and academics about the products and asset mixes that are most likely to satisfy members.
Jones says low- and middle-income earners generally have little interest in finance. As a consequence, their risk appetites are considerably lower than those of members in current UK pension schemes.
“They are generally people who dislike the word, ‘investment’. They don’t see themselves as investors, and barely as savers,” Jones says.
“They have current accounts, credit cards, but for many of our members, this will be the first time they save money,” Jones says.
To avoid spooking its members, PADA will probably recommend a heavily passive investment strategy. In its consultations, pension professionals argued that preservation of members’ capital must be prioritised: their savings’ experiences before personal accounts will be more aligned with building societies than investment funds.
“These folks really crave simplicity. They’re not sufficiently interested to get engaged in the complexity of the industry. For them, pensions is a low-interest topic within financial services, which is a low-interest topic in itself. That’s a triple-low when you get to the details of personal accounts.”Â
The default fund for these accounts has been the focus of PADA’s investment research, since it will manage up to 90 per cent of accounts invested in the default fund, Jones says. Other options will be provided, such as a Sharia-compliant and ethical investment, but have not been finalised.
Although the consultations gave strong support to passive funds, they also gave provided guidance on how active managers should be used. Index funds are appropriate for larger, highly-traded asset classes, such as developed market equities, whereas active managers should be used in smaller, less efficient markets, such as corporate debt, infrastructure and property, since they require skill and experience to identify good opportunities.
PADA will probably invest in alternatives, such as hedge funds, commercial property and infrastructure investment, in an attempt to lower volatility and diversify its portfolio, Jones says. During the consultation, most respondents strongly supported the use of alternatives in personal accounts, particularly property, commodities and emerging market equities. The challenges presented by alternativesÂ – liquidity, pricing and costÂ – can be overcome.
But this will be as tricky as the accounts get. Jones has been given a “political imperative” to deliver the entire scheme at a annual total cost of 50 basis points per member, since low- to middle-income earners should not be expected to pay a higher fee on their personal accounts.
This cost pressure naturally makes large allocations to passive managers attractive. But Jones is confident that active managers will also agree run PADA mandates at a low cost.
“Although we will start small, we should get very big. We are already talking to fund managers and asking them to give us a low price from the beginningÂ – because we will get very big and they will want to be part of this.”Â
These talks have already shown that PADA “can achieve better pricing than what the assets would normally command,” he says.
Another strong recommendation from the consultation was the use of target-date funds. They were pitched as being easier to communicate to members and administer than a diversified portfolio, and more cost-effective and flexible.
But PADA rejected them. The usual retirement age for personal account holders is 65, when they also become eligible for the state pension, but Jones says not all members will finish their working lives at this age and should be allowed to maintain an exposure to growth asset if they choose to do so.
“You don’t have to buy an annuity at that point. You can continue building your pot.”Â
Moreover, due to the risk-averse nature of PADA’s membership, some respondents argued that young people should be exposed to less risk, despite the fact they have their working lives ahead of them to recoup big losses.
Because PADA members are generally uninterested in investment, the default fund should aim to preserve and build capital before investing heavily in growth assets later on, when members will presumably be more comfortable with risk. As members age, the risk in their portfolios will then be trimmed back. Jones calls this investment process “low-mid-low”.
“Traditional wisdom in defined contribution is that people in their early years should be exposed to a lot of equity volatility. We think that persistenceÂ – how many years you save forÂ – is more important.
“It’s no good getting the last 50 basis points of investment return if volatility scared off half your people.”Â
Jones says the minimum contribution rate of 8 per cent should provide a decent retirement income, and is appropriate, given the political debates surrounding the 2007 pension reforms.
“For every person who says 8 per cent isn’t enough, there’s another who says it is a big burden on business. For the politics of the UK market, it works.”Â