lux in tenebris

The way in which your DC pot magically turns from investing in shares to investing in cash and Government bonds is called lifestyle and it involves hundreds of transactions in 60+ months before you buy your pension.

All of these transactions involve buying units in one fund and selling units in another and the cost of buying and selling is described by the life companies that manage these things as “free”.

It is true that the pension providers are not charging you for the algorithms that drive the process or for instructions to buy or sell or for the programmes that check all was done to time. But that does not mean you are not paying for the switches.

How much you are paying is not disclosed. The Insurers I have spoken to say that they can manage the whole process through “box management” without having to buy and sell anything  – I really shouldn’t trouble my little head about this.

Well that’s what they said before we found out about fund expenses and before we found out about portfolio management costs and I no more believe that you can buy and sell units for free than I believe that active funds don’t pay bid/offer spreads or stamp duty or broker commissions.

I have asked life companies to put in writing that there is no cost to members using lifestyle from lifestyle but nothing has yet arrived so , using my principle that I won’t recommend what I don’t understand, I am looking for alternatives!

Which is why I was rather pleased when this note arrived from my investment team at First Actuarial

You may recall that we (Legal and General Investment Management) wrote to you in November 2012 informing you of the enhancements to our investment approach with regard to our Pre-Retirement Fund.

The Pre-Retirement Fund is an objective driven strategy, designed to meet the needs of investors expecting to buy fixed rate (level) annuities. As the drivers of such annuity prices change, these will be a key determinant of the Fund’s strategy, making it more pro-active than focusing on the investment strategies of existing business for annuity funds.

Our Strategic Investment and Risk Management (SIRM) team reviewed the Fund’s asset allocation and after a considerable amount of analysis, based on their deep insight and understanding of the key drivers of annuity prices, developed a revised investment process that we expect to enhance the ability of the fund to meet this objective. This process led to a decision to adjust the Fund’s allocation to help the Fund to perform against its investment objective more effectively, without increasing the fees to our clients. To hear John Roe, the Head of our SIRM team talk about the enhancements to the Pre-Retirement Fund in more detail please clickhere.

The Fund’s asset allocation prior to and post their analysis is set out below.

                                % wt.           % wt.
                                Before          After
Corporate all stocks                            10
Corporate 15+                                   15
6A Corporate 15+                90              20
6A Corporate Ex-Fin 5+                          12.5
BBB Corporate                                   5
Gilt – all stocks                                       15
Gilts 15+                       10              17.5
2038 Gilt                                       3
2046 Gilt                                       1
2042 Gilt                                       1
I’m pleased to share with you that the new strategy is now fully in place and that the cost incurred of implementing this change was 12bps. To put this cost into perspective, our original conservative estimate of the costs to complete the exercise was c.40bps.

The original 40bp estimate was only half of the c.80bps full cost of selling down the underlying index funds and purchasing the revised index funds. This reflected the benefits of transferring common constituent bond holdings during transition and already made a significant allowance for the benefits of accessing liquidity resulting from other fund flows.

The low implementation cost is a testament to LGIM’s ability to utilise liquidity opportunities resulting from the fund flows across our broader business, as well as the hard work of our Index Funds Team and Dealing Desk to deliver cost savings and efficient implementation for our clients.

For once,  a piece of investment marketing that I am happy to endorse! Well done LGIM for four reasons

1. When the first lifestyle matrices were set up , nobody really knew what fund to use to properly match the risks of buying an annuity. So life companies used a “proxy” (jargon for an approximation). The proxy was a fund investing in long dated giltsor corporate bonds (typically with 15 year duration). This was only supposed to be a short-term fix till something better came along but that was 15 years ago! At last LGIM have done the research and told us what they think the proper matching portfolio should look like. I look forward to this new fund (or funds with equivalent sophistication) becoming the annuity matching fund for all lifestyle matrices. SO BIG WIN FOR LGIM IN DESIGN
2. To get from the old asset mix to the new mix would cost most funds at least 1% of the funds – this is a lot to pay when you are close to retirement – if you have a £100,000 DC pot (of which 75% goes into such a fund), you will be paying £750 of your pot away in charges at 1%. LGIM thought they could do it for 0.8% of the fund (which would have cost £600) but they ended up with a cost of 0.12% which will cost £90. £750 verus £90 – Martin Lewis would be proud of that! BIG WIN FOR LGIM ON COSTS
3. LGIM were prepared to bring these costs to our attention. BIG WIN FOR LGM ON TRANPARENCY

This leads me back to the first part of the blog and begs the following question

If with all their wit  and scale , perseverance and with the incentive of being able to show off in this way, LGIM still had to charge fees- how do the life companies buy and sell units for “free”?

Which brings me to the “G” word – GOVERNANCE.

DC Trustees who employ lifestyling, whether the process is carried out as part of an insurance policy or whether it’s done by a third party administrator, need to know the costs incurred by lifestyle switching, monitor the switches (they need to be timely) and make sure that their is no cost creep. In my experience, DC trustees do not have a scooby about any of the above.

No knowledge no governance

in twitterspeak #governance #fail!

And would you expect most DC trustees to be able to exercise such governance? While they should. most have neither the time, nor the skill, nor the tenacity. Which is one of the reasons we need to have larger DC schemes with professional trustees who can shine some light in the darkness.

And what hope that we’ll get published information to make thier lives easier?

I don’t expect we’ll get answers on this vital issue any time soon. If it takes the insurers 15 months to tell us what the portfolio transaction charges are, how long to get to the bottom of this murky pond?

Which is why we must push hard for a better way to organise pre-retirement fund switching. The good news is that if you are investing into NEST, or the Social Housing Pension Scheme, or Blue Sky Pensions or the Pension Trust, you will be investing into target dated funds which have the capacity to do the switching from equities to bonds and cash within the fund. This means that the fund itself will (provided it is on an insurance platform of one of the ABI 14) be reported on for its transaction charges. We will be able to judge TDF lifestyling from one TDF to another and determine who is doing the job well and badly.

It is vital that mastertrusts like NEST which do not use insurance contracts, report their portfolio transaction charges so we can monitor them against those funds managed by the ABI 14 and it’s particularly important that we get some clarity about the costs NEST and other TDF users are incurring in the switching process.

You may feel that after over 1200 words, you need some light at the end of the tunnel! Well if we can start shining a light on the transactional costs of lifestyle by moving from fund switching to “switching within the fund” then we may start moving to understand what we are really paying!

One thing that we can sure about – this is not “free”!

Related articles

• QE a ‘monumental mistake’, pensions experts say (guardian.co.uk)
• Taking meaningful investment choices off the shelf (henrytapper.com)
• DC Trustees – asleep at the wheel? (henrytapper.com)
• Vertical disintegration (henrytapper.com)
• The dam is full – manage the sluices (henrytapper.com)
• Gilt bubble is bad news for pensions (telegraph.co.uk)
• Annuity rates ‘to rise by 25pc’ (telegraph.co.uk)