The next big pensions mistake
The government's new pension scheme will be flawed from the start.
I’ve been a strong supporter of the government’s revolutionary pension scheme – known as NEST – since it was first announced. However, I’m now worried that it’s going to get off to a poor start.
The basic idea behind NEST is that all employees will automatically be enrolled in a pension scheme. Both the employer and employee will make annual contributions to the pension scheme and the employee will then have a pension pot to fund her retirement when she is 65.
I like the scheme because I think it will push more people to save for their retirement without being horrendously draconian.
So why am I now worried?
It’s because I’ve read an article by NEST’s chief investment officer, Mark Fawcett. In the article, Fawcett tells us that NEST won’t follow one of the core principles of conventional investment theory.
When it comes to saving for your retirement, most investment advisers will tell you that you can afford to take the biggest risks when you’re young. That means you can afford to put most or all of your pension contributions into the stock market in your 20s. That’s because the stock market isn’t that risky an investment vehicle if you’re able to lock your money away for a very long period of time – 20 years or more. The longer the period, the lower the risk.
If you think I’m talking rubbish, look at things this way. Let’s imagine you invest £2,000 in your pension pot when you’re 25. The stock market then crashes and your investment is only worth £1,000 when you’re 30. Now that crash might upset you but I’d argue that nothing has gone disastrously wrong.
That’s because you’ve got at least 30 years for the value of your investment to recover. And it almost certainly will recover. In fact, your investment might well perform strongly over the next 30 years and give you an annual real return of as much as 6% a year – that’s what happened for much of the post-war era.
A different approach
Fawcett, however, wants to take a different approach with NEST. The majority of NEST members are likely to plump for the default fund and that will mean young members will be following a low-risk investment strategy when they first join the scheme. I think that’s a mistake.
Before I say why, I’ll just explain a bit more about the default fund. I’m pleased to see that it will be run as a series of target date funds. So if you’re likely to retire in 2045, your investments will go in the 2045 fund. If you’re set to retire in 2020, you’ll go in the 2020 fund.
I’m a big fan of target date funds – they’re a simple way for people to adopt different levels of risk depending on their age. But the bizarre thing about NEST’s plan is that young members of the default fund will be investing in low-risk assets for the ‘foundation phase’ of their membership.
Fawcett says in his article that the objective for this phase is ‘to achieve returns that match the consumer price index.’ He also wants to deliver predictable returns with low volatility. That inevitably means that a large chunk of assets will be invested in cash and bonds.
Fawcett justifies this approach on the basis that younger people in NEST’s target market – earning on average £16-18,000 a year – are risk averse and will be put off saving if they see the value of their pension pot fall in a stock market crash. He fears that some members might leave the scheme if they saw that happen.
His plan is to give members a gentle introduction to the world of pensions. Once members have completed the ‘foundation phase’, they’ll go into the ‘growth phase’ which will take greater risk and invest more aggressively in shares. At that stage, the objective will be to deliver growth of CPI plus 3%.
I understand Fawcett’s point that new members will be nervous. But the way to deal with that nervousness is through education. If members are going to achieve the best returns, they should start investing in the stock market at a young age. Long-term success will be the best advertisement for NEST to future generations and that will persuade them to join the scheme when they start work.
I’d also add that if the ‘foundation phase’ solely comprises investments in low-risk assets, NEST may even struggle to deliver an inflation-matching return at that stage. Some risk will be needed to juice up the returns.
I’m also sad to see that the target for the ‘growth phase’ is only CPI plus 3% after charges. If the charges are 1%, that’s a 4% real annual return. Surely NEST can be a bit more ambitious and aim for a real return of 5 or 6% a year?
I still think NEST is a good idea. I’m just concerned that we’ll look back in ten years’ time and say it was a great mistake that younger folk didn’t have much exposure to the stock market during that period – a period when stocks and shares may do pretty well. This could be the next big pensions mistake.