The need for DC joined up thinking
Ian Richards, independent trustee, says behavioural finance should not be used to drive DC strategy
Hardly a day goes by without someone expressing their views on what ought to be best practice for DC. There seems to be no aspect that is not being covered.
Unfortunately, however, there is a danger for the proverbial camel to be created instead of the slick horse that trustees and employers might want if all this advice is followed. Too much is being expressed in isolation without stressing the need for the circumstances of a whole scheme and its members to be taken into account.
Good governance with a holistic view is the key. Too many DC schemes are establishing governance structures that put almost all of their emphasis on investment, particularly contract-based arrangements.
A classic example can be seen in the drive from providers and advisers about the need to de-risk, reduce volatility and bring in defined benefit (DB) disciplines.
Assumptions are made that members are going to walk away if they see their accumulated funds going through big swings which means volatility must be reduced because behavioural finance tells us aversion to loss is greater than a desire for gain.
At the same time we regularly hear one of the key reasons for the demise of DB is because of the mark to market accountancy requirements. Pension funds are long term and it is suggested that such requirements are totally inappropriate and have led to sub-optimal short term investment decisions being forced to be made by trustees.
Since there are no regulatory funding or accountancy disclosure requirements in DC, should trustees and employers adopt sub-optimal strategies just because of behavioural finance views especially when others are telling us there is a real problem with members not engaging?
Information is available online but hardly anybody ever looks at their account details. Benefit statements don’t get read. Even when markets crash and it’s main headline news, there is still hardly any increase in member engagement.
Those responsible for DC decisions need, therefore, to take care when they are looking at their investment strategy to take account of the actual behaviour of their members and communication strategy rather than theoretical assumptions.
Do you really need to put in costly volatility reduction funds when members only receive a benefit statement once a year and you have no plans to put members’ real time account values on line?
If a de-risking strategy can lead to higher eventual returns it is worth considering but if it just adds cost for no real gain, serious thought needs to be given as to why it should be adopted. An extra 25 basis points on an annual investment fee will cost many members dearly.
A similar lack of joined up thinking can also creep in when thinking about decumulation strategies. The theory goes that annuities are poor value for money so more and more members should be adopting draw down options and not follow the classic de-risking switch to bonds and cash as they approach retirement.
How does this square with de-risking when you can afford to take risk during the growth phase?
The answer of course lies within the circumstances of each individual. In many schemes it will be years before accumulated funds reach a size where anything other than taking an annuity is possible.
Making sure that a governance structure is in place to pick off the individuals where an alternative to an annuity might be appropriate but for most, emphasis needs to be directed at strategies to maximise annuity income rather focus on new decumulation methods.
Joined up scheme governance to keep new solutions and advice in context must be the way forward.