The DWP links its campaign to consolidate small DC pension schemes to the headline “improving member outcomes”. But what is a good member outcome and how is it measured?
The only measure I know of, that captures the value savers get from a DC scheme, is the internal rate of return (IRR) on contributions. But as this is unique to each saver as it depends on the timing and incidence of contributions, it is generally ignored in favour of proxies such as “net performance”.
In this article I argue that the Government and industry have got it wrong on DC performance and should move to a new and better way of doing things.
The Government is insisting that small DC schemes (those with less than £100m in them) report on the growth of the funds offered to members net of all charges as an annual percentage rate. How approximate this is to what a member got depends on the many factors that influence the size of our pots, most of which are experienced though not evident.
For instance, the slippage created by lifestyle transitioning can lead to quite marked differences between an IRR and net performance, likewise the impact of sequencing in drawdown can materially affect the rate of attrition on the pension pot but isn’t picked up by net performance.
While internal rates of return are the correct way to measure member outcomes, they need something to be measured against. They cannot be measured against other people’s IRRs as that’s comparing apples and pears. There has to be a consistent benchmark- an average return for that set of contributions determined by a theoretical investment in the price track of a theoretical fund that represents average returns over time. Such benchmarks exist.
TPR and the FCA have been threatening for some time to unveil a new way of measuring value for money so that IGCs and Trustees can work to a standard definition. Historically TPR has favored comparing workplace pensions using characteristics of a good DC scheme and they got up to 31 of them. Thankfully these are down to 7 in the DWP’s value for member’s assessment. But while good governance, communications and product features are likely to lead to good member outcomes, they are only predictive. The proof of the outcome is in its measurement.
And the only way of knowing if members have got good value for their money is by measuring their outcomes using IRRs against a common benchmark. If TPR chose to go down this route, they will have a way of comparing all schemes that work on a defined contribution basis.
But I think this is unlikely, not least as DWP’s guidance for completing value for member assessments uses net performance which ironically measures everything but the member’s outcome.
Net performance is a hangover from the days when life offices competed with each other on past performance and it carries with it all the risks of yesteryear. Whereas IRRs are based on money-in, money-out, net performance is an elaborate construct that can produce remarkably different results depending on the minutia of reporting. Getting consistency comparing funds within a single scheme is hard but to get consistent reporting across three different types of scheme is nigh on impossible. Distilling all these numbers into a meaningful comparison of performance is going to be even harder!
The joy of using IRRs is that they are driven by member data not by the quant teams of fund managers. If an IRR is unreasonably high or low (relative to the benchmark) it becomes an outlier and the member record can be isolated and (if necessary) be cleansed. IRRs inform on the quality of record keeping as well as the success of investment management.
But most importantly, IRRs – when properly benchmarked – give a true measure of the value created from the member’s money and – if expressed simply – the comparison between the achieved return and the normal expectation can be explained though an Experian style number.
Complexity is easy, simplicity is hard. We will get there in the end -in the meantime we look like we’ll be trying to improve member outcomes for a while before we know what those outcomes are!