In two recent posts I took a helicopter view of the new pension legislation that received Royal Assent earlier this month. I look first at how the Pension Schemes Act 2021 will be remembered by pension historians and what it sets out to do – consolidate and simplify our private pensions.
In this post I look at the Government’s favored measure ,to help consolidation take place- value for money (VFM for short). I look at the work going on at the regulators in creating a new framework for VFM and look at how such a framework could be used in practice.
The DWP, FCA , TPR and the Work and Pensions Select Committee have all called for a common definition of value for money but only the FCA has so far produced one. The FCA have stated their intention
To provide a clear direction for IGCs, we propose to introduce an explicit definition of VfM. In developing a definition, our aim is to make this specific to the role of the IGC and to align it with TPR’s DC code. This definition would be set out as guidance in our handbook.
In its consultation paper “Driving Value for Money in Pensions” (CP20/9), the FCA make a tentative attempt at the definition
The administration charges and transaction costs borne by relevant policyholders or pathway investors are likely to represent value for money where the combination of the
charges and costs and the investment performance and services are appropriate
It may be tweaked but this looks like the basis for a new simplified VFM framework. But this framework is not proving universally popular.
Opposition to comparing different DC pensions.
The FCA’s also suggest in CP20/9 that IGC’s identify failing employer schemes , write to them and compare them with alternative workplace pensions.
We think it is difficult to conduct a meaningful assessment of VfM when an individual provider’s schemes are reviewed in isolation. A review of other options available on the market can provide a point of reference, and may provide better value for scheme members
I understand that the FCA has received several representations arguing that comparisons are invidious and potentially misleading. They argue that simplifying value for money to a point where it can be used to compare different types of workplace pensions, is not practical and could be misleading;
The FCA have told me they are not minded to back down from the position, indeed they told me they were working with TPR on the consultation response which is delayed till the second quarter of 2021
Should we protect the diversity of VFM definitions?
To date value for money assessments have focused on technical details such as cost and charges ,compliance with service standards and complaints. Each IGC and Trustee Chair has had the freedom to create their own VFM framework
A great deal of time and effort has been invested in these bespoke frameworks. They have involved institutional measures aligned to how providers measure themselves. These assessments have been based on the FCA’s requirement to
whether the default investment strategies or pathway solutions are designed and undertaken in the interests of scheme members or pathway investors, and have clear statements of aims and objectives
• whether the firm regularly reviews the characteristics and net performance of investment strategies or pathway solutions to ensure they align with the interests of scheme members or pathway investors and that the firm takes action to make any necessary changes
• whether core financial transactions are processed promptly and accurately
• the level of charges scheme members or pathway investors pay
• the direct and indirect costs incurred as a result of managing and investing, and activities from managing and investing, the pension savings of relevant scheme members, or, the drawdown fund of pathway investors, including transaction costs
I can quite understand why IGCs are unwilling to move to a new framework. But move they must. Basing VFM assessments on these measures alone makes it hard for employers (let alone savers) to make meaningful comparisons as each scheme sets its own benchmark and marks its own homework.
We at AgeWage think that important as these factors are, they are only elements of good pension governance and not the framework for explaining value for money. We need something simpler and more intelligible to ordinary people. Above all we need something consistent that allows employers and savers to compare one scheme with another – and one pot with another.
The current diaspora of VFM frameworks make it impossible for employers or savers to make choices. Pension comparisons need not be invidious, we need a new framework for VFM.
The new framework the FCA are proposing for VFM
The FCA propose to introduce a common definition of VfM and 3 elements that
IGCs must take into account in a VfM assessment. These elements are costs and charges, investment performance and quality of service
For GPPs to be compared with trust based schemes, employers need a common means of comparison for both value and money. In our view such commonality is best measured by the internal rate of return (IRR) achieved by each saver. The IRR shows the achieved investment performance net of costs and charges.
Quality of service can be measured by the quality of data and this can be assessed by considering the plausibility of the data (do the IRRs make sense?).
We argue that while the complex VFM constructs advertised in IGC Chair Statements do a good job in helping IGCs measure VFM on their and their providers terms, they do not serve the greater purpose of helping employers and savers work out what good looks like.
We agree with the FCA that a new VFM framework is needed, it should simplify the assessment and focus on the three elements that form the common definition
What does good look like? – the need for comparability.
So what does a good IRR look like and how can we identify an implausible IRR?
What is needed is a benchmark, a common comparator which defines what good , bad and average is. Such a benchmark exists in the form of an index created by Morningstar that defines the average return a DC saver in the UK would have received since 1980.
Comparing actual IRRs with the synthetic IRRs arrived at by investing contribution histories in the benchmark fund allows each scheme to be measured for the excess value it has given savers/members over time. This can either be measured as a monetary amount of as a score – providing an algorithm can be created that takes into account out performance over time.
Analyzing contribution histories using an actual and synthetic IRR, not only shows defines the value created or lost but gives a metric for suspect data where the difference between the IRR and the synthetic IRR is implausible.
The answers to the questions of what good looks like and how we can define VFM so that it provides a common comparator, are to be found in the data of each employer scheme.
Ironically , the answers are startling simple and easy to demonstrate, all that is needed is access to data – something which IGCs have no problem getting and a standard way of analysing it.
If it’s that simple, why has no one tried it before?
A system of marking VFM based purely on measuring returns has two fundamental challenges
- It offers a view of the past which cannot be relied upon to be mirrored in the future
- It is dependent on consensus that the benchmark is representative
The first challenge is fundamental to any outcomes based definition of VFM, but it addresses the concern of savers who in the 2017 NMG research commissioned by IGCs made it clear that what mattered most was the outcome of their saving. This may be a “populist” approach but it should have the advantage of being “popular” with the people IGCs are there for.
The second challenge is peculiar to fiduciaries for whom the benchmark does not represent the investment strategy of their ideal default. Clearly most defaults will not replicate the investment strategy of the default and this will be one of the reasons schemes provide more or less value for money invested.
Other factors include costs and charges, the sequencing of contributions and the demographic of the scheme members where dynamic strategies such as lifestyle are in place. No two schemes are the same but they share a common objective, to maximize outcomes.
Practical measures that allow comparisons to be made.
We have proposed a common benchmark , the Morningstar UK Pensions Index, (UKPI), It was designed specifically to represent the average fund but will not represent all funds or all life-stages of a member’s use of the default fund. The UKPI is 80% invested in growth and 20% in defensive assets, most funds will have different weightings , aiming to take more or less market risk. Some fiduciaries will want to measure value per unit of risk taken.
It is possible to measure value for risk taken by analyzing data and we supply this measure to our clients on request. It is a measure of the skill of the designer of the default but it is not as easy to compare as a measure of nominal returns, nor as easy to explain.
We need to accept that any common definition of VFM will be retrospective and will not take into account value for risk taken. but this should be set against an important consideration which in our view outweighs both challenges. The measure proposed , based as it is on outcomes, takes into account all identified risks whether supposed or realized.
For instance, a member insured against the increased cost of annuity purchase by lifestyling into bonds may be insured against a risk he/she will never take while someone invested in equities in the later stages of accumulation may be insured against inflationary pressures if the fund is left to grow. It is simply not possible to get the right benchmark for every saver (unless savers intervene and choose their strategy – as perhaps they will with investment pathways.
We have to start somewhere and the UKPI is that “somewhere”, no doubt it will change, adopting factor based indexes may be such a change, but until it is challenged, it remains the only pretender to a common benchmark and the AgeWage algorithm and score the only pretender to a common definition of VFM.
Towards standardization
The UK private pension system is very complex and can only be simplified if simple measures are implemented. Necessarily standardization means losing the diversity of VFM definitions in IGC and Trustee Chair Statements and adopting a standard approach.
Our view is that what Government needs is the VFM framework proposed by the FCA and it needs to be reinforced by a VFM standard that enables VFM to be compared between schemes and indeed between pots. We believe that any pot that can offer an IRR that looks plausible against a benchmark can be assessed for VFM, pots that need to be excluded are those with short durations, those with safeguarded benefits and pots where data is suspect (which may fail the VFM assessment for showing a poor quality of service).
Creating a VFM standard would be easier than establishing prescriptive regulations. Standardization would mean that any employer or individual could apply to know the VFM of their pension pot and we would expect in time, that the standard would be used to create VFM assessments disclosed on pension statements alongside the value of the pot the internal rate of return and the amount deducted from the pot for costs and charges.
Standardization will only happen if people are prepared to accept that simplification is needed and that requires trade-offs between delivering something that can be delivered intelligibly and to scale and ensuring that people are not misled.
It will require bold thinking and bold implementation. Until recently, I thought this could not happen, but I sense a change in Government arising perhaps from seeing how we have coped with the pandemic. Britain needs a strong and stale private pension system capable of not just providing pensions but helping Britain towards its sustainability goals.
We can get there but we need to grasp the nettle and now we have the chance to do so!
It should be straightforward to disaggregate the Morningstar UKPI into the IRR achieved by the growth assets and that achieved by the defensive assets. Then you could arrive at a customised benchmark for different funds dependent upon their asset mix, and for different life stages of the same fund.
The question then becomes whether you would want to do this or whether it sows greater confusion. But it would certainly lead to a closer like-for-like VFM measure, avoid enshrining an 80/20 mix of growth vs defensive assets as some form of model portfolio, and be far easier to understand for the non-expert than measuring return per unit of risk.