As Covid-19 batters the markets, are defined contribution pension schemes resilient enough to weather the storm?
Long before a bat was believed to have transmitted Coronavirus to a human, the world of defined contribution (DC) pensions was in a state of constant flux. There was a steady stream of regulation to be absorbed as well as investment decisions to be made in step with market movements.
Then the virus crossed from one species to another and began its fateful journey across populations and economies. DC schemes have not proved to be immune to its effects as it has impacted their members and the markets in which they are invested.
Though we are still in the eye of the Covid storm and as the dust has yet to settle and the long-term effects become clear, some broad industry currents can be discerned. One is a hardening of pre-existing trends, such as the consolidation of smaller schemes into master trusts that can benefit from economies of scale while having a more robust governance structure.
Simon Chinnery, head of DC client solutions at Legal & General Investment Management (LGIM), says the trend towards consolidation is long term, partly driven by The Pensions Regulator, which has made it clear that governance demands on smaller schemes were not going to ease and that their accountability for a range of issues was not going away. “Schemes needed to step up to the plate and if they cannot then they should look to hand that responsibility over specifically towards master trusts,” he adds. “We definitely have seen a strong growth in master trusts.”
Duty versus temptation
Immediate threats to the infrastructure of DC pension schemes appear to have been withstood as operationally the industry has coped well, with business recovery plans dusted off and implemented with speed and efficiency. Philip Smith, director of DC at TPT Retirement Solutions, describes activity in the industry as “very much business as usual”, with staff working remotely and not much in the way of an impact on customer services.
However, as entire market sectors come under intense and sustained pressure and companies teeter on the brink of collapse, there may be a temptation for employers and members to scale back their pension contributions.
Although the regulator will remind companies that they have a duty to continue making contributions to their employees’ pensions, Chinnery can envisage the size of those contributions changing for a period to reflect the challenges that companies are facing. “I think people will feel that something has to give in terms of their savings; while there may be some short term reductions, the Pensions and Lifetime Savings Association, government and the regulator will say to companies and individuals that it is important you continue to save for your future,” Chinnery says.
“If we see a little drop down in contributions that is understandable,” he adds, “but it would not surprise me at all if there is a concerted effort later in the year when we have more visibility about how we come out of this for people to keep on saving.”
The challenge for people at any time of market volatility is when they do not have the benefit of timescale and they are in the wrong investment.
Julian Lyne, Newton Investment Management
Yet in what is surely a sign of the innate resilience of DC pension funds, there are no signs of any defaults in contributions. According to Smith, the impact of Covid-19 on the DC market so far has been quite muted, as markets have rebounded since their initial drop.
“We have seen call volumes into our customer service centre flatten out, so people don’t seem to be particularly worried about the market drop; people have had other things to worry about. This might be a good thing as otherwise people may have taken some poor decisions,” he says, adding: “So far we have not seen any real switching activity beyond normal.”
Another trend that is likely to harden, some industry experts believe, is the drive towards investment diversification, as Coronavirus relentlessly hammers home the lesson that investors should never put all their eggs in one basket. Yet despite market volatility DC pensions’ long partnership with equities is not expected to fracture. TPT’s Smith anticipates a rising proportion of schemes will consider the attractions of alternative assets as the industry achieves ever greater scale but that any move away from equities will be small.
“For the majority of people, low cost equity-driven solutions are probably with us for quite some time and that’s driven by a combination of a pretty ferocious price-driven market and a charge cap,” he says. Dividends have suffered during the crisis too, as almost half of UK-listed companies have or are expected to axe shareholder cash returns. As the situation develops over the next 12 months, those most affected will be individuals in drawdown, for whom income is important. The fate of interest rates adds to the problem.
Julian Lyne, chief commercial officer at Newton Investment Management, believes that the crisis will definitely have an effect on the yield income funds pay investors and on the cash returns made by companies in some sectors. “That period between 55 and 75 years of age when before the virus you would have wanted absolute return, you would have wanted income or an annuity, that whole period is going to become more difficult because of the impacts on income and on interest rates,” Lyne says. “That becomes a pretty big challenge for individuals who are near or close to retirement. This will play out over the next 12 months.”
There may be permanent changes to pension scheme investment allocations arising from the crisis. Feelings of national solidarity that naturally intensify during a time of crisis expressed in such rituals as weekly applause for carers and NHS staff may also affect the world of DC pensions, as industry figures predict an increased demand for ESG-led strategies by scheme members.
Lyne thinks the post-Covid investment environment could be characterised by different attitudes to governance and to dividends with fundamental changes in what is expected from investment managers. Instead of people seeing what funds they are invested in they will want to see those funds take the environmental, social and governance aspects of companies into account when making investment decisions, not just delivering returns.
“The concept that greed is good is now so far out of fashion,” Lyne says. “It is about people perhaps wanting a balance between getting a return, of course, but also thinking about the environment, thinking about the social good, making sure we’re looking after people, making sure we’re doing the right thing for employees.” While there was certainly pre-existing momentum on ESG, the Covid crisis could extend it. The outperformance of sustainable funds possibly benefitting from fluctuations in the oil price would only cement such a trend even further. Simon Chinnery agrees, feeling that the crisis could prompt pension fund members to engage more deeply with ESG considerations.
“Which companies have looked after people well in this time, which companies have behaved badly, these will be important,” he says. So far DC pensions appear to have withstood the buffeting gales of the Coronavirus crisis, for reasons of design and luck, figures in the pensions industry believe.
TPT’s Smith says that the industry has proved resilient in terms of its operational capability and – so far – in its investments but he cautions that that is only because the markets have rebounded. “There’s nothing fundamental that has changed in DC pensions, either pre- or post-Covid,” he notes, adding: “DC pensions are still heavily dependent on long equity strategies and so if we were sitting here in six months’ time and looking at a much worse economic outlook we might be having a different conversation about the resilience of DC investments.”
One of the challenges Covid might pose is what happens if markets have been too optimistic about economic recovery. The macroeconomic effects of Covid on a new generation just entering the labour market for the first time could be significant. Smith believes that markets will continue to show high levels of volatility and that once the crisis is over, people may make poorer long-term decisions about their pensions.
Pension schemes must focus on their individual members and be clear with their messaging during turbulent times, Smith says. They must put themselves in the shoes of individual members and consider how they might be thinking. “Be aware that you as the DC provider have a huge amount of responsibility; you’re a steward of their long-term savings and reflect on that and what we do for people in terms of their long term financial wellbeing,” Smith adds. “This is an extraordinary event and it is going to have a big investment impact over the long term, but I just don’t think anyone knows how it’s going to play out. That uncertainty will be unsettling for people,” he says.
But for all the gloom there may be some slivers of silver lining the Covid storm clouds engulfing pensions and investments. After all, one person’s market in the doldrums is another’s buying opportunity. Newton’s Lyne explains: “If investing is all about buying opportunities, when you have the long-term, you take advantage of the dip. If you are a DC investor and you have between 10 and 20 years to go, clearly you are benefiting from down cost averages. “The challenge for people at any time of market volatility is when they do not have the benefit of timescale and they are in the wrong investment,” he adds. Timing, as ever, is the key to successful investing.