FREE KIC - NO. 97 MARCH 16
INVESTING IN A WORLD OF DEFINED CONTRIBUTION PENSIONS
My wife is a member of an occupational pension scheme. As is the norm, in this day and age, it is a defined contribution (DC) scheme with a set of trustees who have appointed a pension consultant and a pension provider to help them meet all their legal requirements.
The three funds are as follows:
So why is it that the trustees of this scheme have gone for this approach? Having done some research on the issue it appears that the trustees are following a very narrow interpretation of the guidelines set down by the Irish Pension Authority.
On the Pension Authority website (www.pensionauthority.ie) there is a whole section dealing with trustees and this includes a set of guidelines on investment.
The introduction to the guidelines states the following:
The purpose of these guidelines is to assist trustees of defined contribution (DC) pension schemes and their advisers in deciding on the investment choices to be made available to scheme members. This is one of the most important responsibilities that trustees exercise in overseeing pension schemes. Because schemes differ in terms of their membership size and profile (including, for example by reference to age and proximity to retirement) and other features, these guidelines are not prescriptive. Rather it seeks to identify the issues that trustees need to consider from the perspective of helping scheme members to make decisions appropriate to their circumstances and to maximise retirement benefits for a given level of contribution.
The Pension Authority clearly state that "these guidelines are not prescriptive". In other words trustees have to be allowed a certain degree of flexibility in order to "maximise retirement benefits for a given level of contribution." The guidelines then go on to describe how they believe maximum retirement benefits can be achieved.
In one way I suppose I should not blame trustees because many in the world of academia are still teaching "Efficient Market" theory and only a minority are slowly beginning to discuss behavioural finance and neuro-economics to explain why Value Investing can work.
The only way, therefore, that my wife could become a Value Investor is if she could convince all the other staff members in the hospital to petition the trustees to make a Value Fund available because as the guidelines also state: "If trustees are satisfied that members are comfortable with a wider choice, this can be made available." From a practical point of view I just cannot see this happening. I just cannot see my wife's colleagues having the time or interest to learn about Value Investing and therefore for the foreseeable future my wife is going to have to stay a passive investor with her biggest source of long term savings.
Rather than trying to convince a few hundred doctors, nurses and support staff that Value Investing is likely to be better than passive, I think there is a greater chance of convincing the Pension Authority that they should recommend Value Funds be made available by trustees. All I have to do now is try to make sure the next time the Pension Authority looks for submissions, I am ready to make the case.
Investment options in practice - worked examples.
The following scenarios set out two worked examples of the issues trustees should take into account when they are setting the investment strategy for their scheme. The reasoning of the trustees in choosing the investment strategies for these schemes are for illustrative purposes only and are not intended to be prescriptive. Rather they seek to illustrate what application of the guidelines might mean for a typical scheme.
Scheme 1. The first scheme is a small scheme with between 10-15 members. The members earn salaries of €20,000 to €30,000 per annum. The employer pays 3% of salary into the scheme on behalf of the employees with no matching employee contribution. Despite trustee encouragement few if any members are contributing to an AVC. There is very low, if any, member engagement with the scheme. Two members have recently retired from this scheme and both members drew the entirety of their benefits as a tax-free lump sum.
With this salary band and low contributions being made, it is likely that no members will meet the requirements to pursue an ARF option.
Based on their knowledge of the membership, the trustees decided that investment knowledge is relatively low and therefore decided that a smaller number of fund choices is appropriate. In setting the default investment strategy for this scheme the trustees took into account the salary of the employees, the contributions being made to the scheme and the likely value of the fund for members at retirement and decided that the most likely form of retirement benefit would be cash and therefore a lifestyle strategy targeting cash at retirement was appropriate. Because of the likely lack of investment knowledge and the low level of engagement, the trustees decided that the default strategy should be lower risk, as they decided that the tolerance for investment losses would be relatively low. With this in mind, the trustees choose the following fund options as being most appropriate for the membership:
Scheme 2: This scheme is a large scheme with 500 members employed in the financial services industry. In this scheme there is a wide salary band reflecting the various roles within the company. The employer contributes 10% which can rise up to 15% if the employee contributes 5%. The majority of employees make the 5% contribution which is matched by the employer resulting in a 20% contribution overall.