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Across Europe, assets in defined contribution (DC) schemes are increasing. In the P7—the seven largest pension markets—the compound annual growth rate between 2002 and 2012 was 8% for DC assets, more than the rate of 7% for defined benefit (DB) assets, according to Towers Watson’s latest Global Pensions Assets Study, released in February. And in the UK, the continued decimation of final salary schemes combined with the introduction of auto enrollment has led JP Morgan to predict that DC assets will reach £829 billion by 2022.
This shift has forced employers and providers to consider what the outcomes of this DC provision will be for their members—and they’re worried. Lifestyle funds are falling out of favor after they produced disappointing results, leading to a wave of alternative default funds. So is this the death of lifestyle as we know it?
The high level theory of what a default fund should do hasn’t changed. What has changed are the schemes’ objectives—one size does not fit all.
By using a mechanistic process reliant on the member’s retirement age and having a constrained investment option due to the structure of the funds, lifestyle isn’t providing the flexibility members want, and need. “Lifestyling is better than doing nothing, but only just,” says Tom McPhail, head of pensions research at Hargreaves Lansdown. “The basic principle of de-risking on the run in to retirement clearly makes sense; the problem is that it is increasingly difficult to achieve this on a default basis. Individuals’ retirement plans are unique.”
This hits the nail on the head: The major problem is, and always has been, that this is not a homogenous group—members of pension schemes are from a variety of ages, have differing levels of existing assets and alternative pension provisions, and the clunkiness of traditional lifestyle funds doesn’t allow for different allocation strategies between those different groups of members.
The rise of target date funds (TDFs) in the UK market in particular has gained traction because of their ability to offer different strategies for different cohorts. This flexibility allows for different glide paths. Nigel Aston, head of DC at State Street Global Advisors (SSgA) explains: “If you know a section of your workforce also has a DB scheme, you could give them a steeper glide path, whereas those under 30 who don’t have a DB scheme would have a less steep one. It’s that degree of customization that you simply can’t do with lifestyle.”
Another major problem with lifestyle is that most take a cliff-edge approach at retirement age. “The danger is most people don’t retire at their expected retirement age. I’ve seen figures saying only 40% of men retire at their expected retirement age today,” says Dean Wetton, founder of Dean Wetton Advisory.
That’s not to say TDFs are a panacea for the world’s default fund woes—far from it. The recent flight to quality has seen a rush into gilts, helping those heading toward the end of their lifecycle in traditional lifestyle funds outperform TDFs by 25%. But, some would argue, that outperformance isn’t the name of the game with TDFs, which focus on a steady, reliable income. So here we outline the debate: to TDF, or not?
Lifestyle Is Dead-Long Live TDFs
Rotating members out of riskier assets in preparation for an annuity purchase is not what’s now needed, argues the anti-lifestyle brigade.
“Members will need a more flexible, phased retirement addressing a need to continue working part-time, for example—and lifestyling is not really engineered to cope with that,” argues Simon Chinnery, head of UK DC at JP Morgan Asset Management. “Lifestyling has run its course. There’s a Darwinian requirement for natural evolution, and you need to define what you are going to evolve into. The UK DC market has made it on to the land and out of the trees, and now we are working out why we are here and what we want to do.”
The open architecture of TDFs is also a plus—early models restricted schemes to one underlying fund manager, but now schemes can use any fund manager's pooled vehicles as a component in building the TDFs. Indeed, the number of managers coming around to the TDF way of thinking has increased: A few years ago Alliance Bernstein was the only manager banging the TDF drum for default schemes; now SSgA and JP Morgan Asset Management, among others, are coming on board.
AllianceBernstein's Tim Banks, head of DC sales, believes customer demand, not managers joining the space, that is driving the interest in TDFs. "It makes sense to pro-actively manage the strategy throughout the 30- or 40-year savings journey," Banks says. "Trustees and plan sponsors understand this point and are slowly looking to adopt the new techniques available."
The other major plus cited by both schemes and providers is that TDFs are easier to understand. The theme was echoed by two mastertrust schemes that both recently decided to move away from lifestyling and into TDFs.
David Atkins, chief investment officer of the Pensions Trust—which only went live with its 41,000 DC members in March 2013—says TDF was attractive from a member's point of view because of the simplicity of the communications. "All of the detail is left under the bonnet; you don't get that with lifestyling as you have to talk about shifting asset allocations; you end up describing a product, instead of a vehicle to help you get to your retirement goals," he says.
BlueSky Pensions chief executive Paul Bannister tells aiCIO that the decision to move his £250m mastertrust into TDFs was driven by his feeling that lifestyling "wasn't doing the job" and because BlueSky wanted to take on more employers beginning in January 2014, when many of its target market will have their auto enrollment staging date.
"We know we're going to take on a lot more employers and a lot more members—we already knew the level of admin for switching in lifestyle funds was heavy," Bannister says.
Lifestyling Is Here to Stay
For a nation still obsessed by annuitizing, it's unsurprising that many believe lifestyle funds will remain part of the landscape for the foreseeable future, at least in the UK.
But asset managers need to start looking at whether people will put all of their DC pot into an annuity straight away. Stephen Bowles, head of institutional DC at Schroders, says: "For someone my age that won't be possible as it'll be too expensive. We might see more choosing to annuitize much later—so the question then becomes how do we manage the investment process before annuitization but after 65?"
Proponents of lifestyle funds say they are adapting to members' needs and are mindful of the fact that not everyone will want to annuitize.
"As DC pots grow larger and more people move into retirement, we'll see an element of people taking their annuity while saving into another pension pot. We're looking at flexible drawdown actively at the moment," says Ann Flynn, head of corporate marketing at Standard Life. "Lifestyling is more sophisticated than before—if something changes we can change the basis of the fund—for example, if the chancellor was to change the limit of tax free cash you can take at retirement, we could adopt the lifestyle strategy to adapt to that," Flynn says. She also stresses the levels of corporate governance are far greater than before, driven by providers' taking on more responsibility for members' outcomes.
Scottish Life was similarly bullish—90% of its pension clients opt for its lifestyle fund. Investment marketing manager Lorna Blyth says auto enrollment has raised the bar for default funds, meaning lifestyle managers have had to up their game. "The Department for Work and Pensions' guidance on default funds is clear on what a good default fund should look like; it should be appropriately named, take into account the retirement profile of members, use an appropriate and diversified asset allocation, be affordable, and include a review and communication process," Blyth says. "All of this can be delivered either through a TDF or a lifestyle strategy, so rather than focusing on one over the other, the focus should be 'what is the client trying to achieve?'"
It's not just providers who are in favor, however. Peter Dean, investment consulting director at Broadstone Corporate Benefits, remains adamant that rumors of lifestyle's death are premature. "While perhaps not ideal, lifestyling will continue to offer a pragmatic solution to the issues facing default strategy design and is likely to remain popular for some time to come."