Pensions decoder: seeking unity on default diversity

Diversification has been de rigueur for the investment strategies of occupational defined benefit pension schemes for many years, so it should be no surprise to see the philosophy now dominating thinking in defined contribution schemes too.

The argument that a multi-asset fund can reduce volatility while delivering equity-like returns over time is as relevant for a 26-year-old DC member as it is for a £1bn final salary scheme.

Encouraging this view further is the National Employment Savings Trust (Nest), the state pension scheme launching with auto-enrolment this year.

After considerable market research by the Department for Work and Pensions (DWP) and Nest’s predecessor, the Personal Accounts Delivery Authority, the conclusion was reached that a diversified growth fund should be the main engine of the growth component of their default target date funds.

Nest decided its default fund should be low risk in the early years in order to acclimatise its members into pension saving.

The DWP is concerned that millions of workers might opt out of Nest in the early years and so their acclimatisation strategy could be viewed as driven more by concern over political risk rather than investment risk – certainly few DC consultants or schemes share their view.

But the argument for diversification has been widely accepted by advisers, with trustees and sponsors starting to come on board.

Leading pension schemes are taking this view one step further and are looking to mix up their own blend of managers and strategies, to be white-labelled as their in-house default option.

The DC Volkswagen Pension Scheme, an early adopter of diversified default funds, has built a default fund made up of 50% passive global equities and 50% diversified growth, using two different managers.

That is the central philosophy of consultants LCP. “We focus on risk as opposed to performance,” explains principal Andy Cheseldine.

“Some of our funds have done better than equities, but that is accidental. What is deliberate is that they have had lower volatility than equity funds.”

Multi-asset funds came out glowing in a report on default funds by DCisions last week, in which multi-asset funds returned 7.9% over three years on a risk-adjusted basis compared with 5.6% for passive equity trackers, despite their lower cost on average.

“We are seeing a greater use of alternative assets and diversified growth funds in the investment mix,” says Philip Smith, head of DC and wealth at Buck Consultants.

“The days of default funds with 100% global equities and lifestyling in the past 10 years are disappearing. People are considering a much wider band of assets.”

Already 32% of schemes use multi-asset funds, but that still leaves 48% in passive equity trackers, according to DCisions.

Although the auto-enrolment duties are not prescriptive about default funds, they are clear on the importance of governance and the need for trustees or sponsors to ensure an appropriate fund selection is offered and explained to members.

Consultants believe the onset of auto-enrolment is set to trigger a wave of reviews of default funds over the next few years. But the biggest barrier to more sophisticated funds is their cost.

Passive equity trackers can be as low as 0.15% in annual management fees, while most diversified funds charge 0.65%-0.75%.

With the member expected to swallow the cost of a default fund, trustees and sponsors are understandably wary of burdening employees unnecessarily and that is where advisers are likely to encounter resistance to change.

But advisers are under pressure to offer a service that goes further than just provider selection. So, advising sponsors and trustees on how to blend your own default fund will become an increasingly core part of their offering.

The question for their clients is whether they really need their own bespoke blend, or whether they should choose one of the many multi-asset funds on offer.

The leading DC platforms such as those run by Zurich Corporate Pensions and Fidelity Investments offer access to a wide range of fund options, including sophisticated multi-asset funds.

Group personal pension providers are starting to develop diversified default funds with lifestyling.

Making your own unique blend is more of an art than a science, and the larger investment consultants, such as Mercer, have also used in-house asset allocations teams to create off-the-shelf multi-asset funds-of-funds.

The advantage of using a single multi-asset fund under the bonnet, such as the BlackRock Aquila Life MarketAdvantage Fund for Nest, is that asset allocations can be properly managed by a professional investment team.

The disadvantage is that members are exposed to the decisions of one organisation unless the fund is entirely passively run.

The battle between the single manager versus blended multi-asset funds as a default strategy will be high on the agenda throughout 2012, but only future performance figures will determine the winner.

Bob Campion is a freelance journalist

Off the peg or made to measure?

Richard Parkin, head of proposition, DC and workplace savings, Fidelity Worldwide Investment

The run-up to the introduction of auto-enrolment is seeing a lot of activity around the design of default funds. More than 80% of members are expected to end up in this investment option so it’s imperative it is designed and managed well.

The Department for Work and Pensions (DWP) has issued guidelines that require pension providers to ensure a default is suitable for the target workforce.

This will no doubt lead many plan sponsors to assume they will have to introduce a tailored default option specifically for their scheme. For some, this will be the right thing to do but for many it could be an onerous and unnecessary exercise, and an unwelcome ongoing burden.

A default option inevitably has to cater for a wide variety of members. Unless the plan is targeted at a very specific set of employees, the default option used by one firm wouldn’t necessarily be radically different to that used by a firm in a completely different industry.

Both will want a default option that delivers good growth over the long term while minimising the risk of losses along the way. 

So before rushing in to create a bespoke default option, the relative merits of this against using a pre-packaged default product should be considered.

The product provider will generally take responsibility for the governance of the option and will be regularly reviewing the suitability of the option, not just because of the DWP guidelines, but because it is obliged to do so under the Financal Services Authority’s ‘treating customers fairly’ regime.

Good providers will be regularly updating their default strategies to reflect market best practice; those using these options will essentially benefit from ‘free upgrades’.

Providers will make available a range of communication materials that can be used by plan sponsors and should also provide standard performance reporting to allow sponsors to satisfy themselves that all is as it should be.

Overall, the cost and effort involved in maintaining the default will be significantly less than managing a bespoke option.

But won’t product providers simply push the product that makes them the most money?

Maybe some will, but the best commercial return comes when you’re doing the right thing for your customer.