NEST has invited all of us to play “fantasy CIO” and create a default investment strategy for its members to and through retirement.
If you’re prepared to get to page 118 of the consultation paper, you are asked as question 18 of the consultation…
If you were designing a default drawdown strategy for NEST members, how would you do it?
We believe such approaches will require innovation and are therefore interested in solutions that address the following issues:
governance – including setting pay-out rules
asset allocation and risk management flexibility for members
incorporation of insurance for market and longevity risk
An answer to these questions requires a great teal of time, intellectual energy and the skill and knowledge collected over a lifetime. It is reasonable to expect that NEST, with its £600 DWP loan, might have the financial resources to pay for advice on this.
In our formal response to NEST ,which Pension PlayPen has published and sent to NEST, we stated we would not answer these questions.
But perhaps I can break ranks with the Pension PlayPen and put down my personal views here! To be fair to NEST- the questions are the right ones, they underpin the establishment of a collective drawdown arrangement and could equally be the foundations of a CDC strategy.
So here is the Pension Plowman’s bid to be Fantasy CIO of NEST!
We need to start with a statement of investment philosophy; what are we trying to do with the money at our disposal?
Statement of investment philosophy
We aim to provide a regular income stream which targets pre-agreed payments (a target pension) and meets its target in normal circumstances. In exceptional circumstances, regular payments can be higher or lower than targeted.
We aim to provide this income for the whole of a member’s life. We will provide this insurance from within the fund if possible but members will have the opportunity to buy a guaranteed annuity to secure this certainty at any time. Members will have the right to take their money from the fund either to another qualifying pension or to their bank account.
We will invest the money on the basis that the fund has no end-point. Payments to members will be met from cashflows from those moving into the investment pool and from the income from the assets into which the fund is investing. Typically these assets will be equities which we intend to hold for the long term. Other income producing assets which have similar properties to equities (property for instance) may also be considered.
The fund will not aim to buy and sell its assets, its intention will be to allow the assets to provide the income to meet the objective of the fund. Because these assets participate in the real economy, we would hope that they will participate in the growth of the economy and produce an increasing income stream which will allow the target pension to increase in time. The hope is that these increases will protect people’s spending power.
We will set the level of target payments (pension) at an initial amount that we (as managers) feel confident will be too high 50% of the time and too low 50% of the time. Put another way, in a perfect world, it would be our best guess of what we could pay out.
We are expecting to be wrong 99% of the time- only one year in a hundred, might we be absolutely right. So we will ask people to accept tolerances. Providing we are 90% or more right at any time, we expect our payments to be on target, it is only when we see the fund more than 10% below or above target, that we may make an adjustment to pay-outs and even then , these adjustments will be temporary.
Risk sharing and risk pooling
The assets of the pool are discreet to the people receiving the pension, they are not sharing the risk with those accumulating the pension. We favour a discrete pool because of our concern that those coming from behind may have to subsidise those receiving payments today. Of course the opposite may turn out to be true. In any event, we prefer not to share the risks between generations, this has caused trouble in other countries (Netherlands).
Ideally, we would hope to meet the payments for those living beyond the normal life expectancy of those within the investment pool from the funds bequeathed by those who die younger than expected. This needs to be properly explained to people joining the pool. Undoubtedly this explanation will mean that some people who have short life expectancies won’t join the pool and perhaps some with healthy lifestyles will be enthusiasts- this is unavoidable and a healthy state of affairs.
Nonetheless, there will be losers in the pooling as well as winners and we can only manage this by being quite frank about the way the pool operates.
Governance and Communication
This brings us on to the Governance of the scheme. Obviously this needs to be expert and should draw upon the investment , actuarial and communicative expertise of a high quality management team.
It is absolutely critical, that the progress of the fund – both in terms of its investment performance and in terms of the solvency from the pooling, is clearly stated so that public confidence- at all levels – is maintained.
The publication of statistics on the numbers joining the pool and leaving the pool either through death or through voluntary transfer is of critical importance. There should be no attempt to hide these numbers to protect confidence, a run on the fund is more likely to happen because of opaque governance than transparent.
This simple approach to managing the fund must not be mistaken for a naive approach. The governance of the fund must be every bit as rigorous with this simple strategy as it would be were it more complex. Attention to detail- the costs of transactions, the management of key metrics such as life expectancy and the proper accounting of the fund must be to the highest standards.
This approach is not in itself designed to give members the flexibility of the “Pension Freedoms”.
This approach aims to provide people who want a pension with something more than they would get by selling their pot to get a guaranteed annuity. It does so by being more flexible in its payment system which allows it to invest in assets that should provide better long term returns.
People who are not happy with this “extra risk” can leave the pool and buy an annuity.
Similarly some people will want to withdraw all or some of their money to spend the money as a lump sum. The right to your property is key – people will be able to withdraw money, at reasonable notice, to spend as they please.
For many “investors” who like to choose how their money is allocated and perhaps make their own investments, this pooling approach will be too restrictive. They will either not join or leave to “go their own way”. We anticipate these outflows will be matched by people joining the pool who have decided not to self-invest any more.
For many people, the idea of being in a pool where others may benefit from their dying early will be unacceptable. This is of course how defined benefit pension schemes work and how annuities work , but we accept that there are people who will want to manage their own longevity
Insuring the financial risks surrounding long-term care.
Finally, we are aware that for some people , the prospect of long-term care is extremely frightening and the prospect of not being able to afford to take care of oneself financially, unbearable. For such people we consider insurance the best solution. Within the payment system operated by the scheme, a deduction for long-term care will be available. This separately insured arrangement will be entirely voluntary and can be entered into by the individual as part of the pension scheme, or as a free standing arrangement arranged outside the scheme.
The invoice is in the post boys!