Nest investments reveal a blueprint for DC provision

The National Employment Savings Trust (Nest) scheme is due to be open to some members on a voluntary basis from next year and the publication last week of its first five investment mandates has caused a buzz within the fund management industry.

Here we look at what the investment mandates tell us about the final structure of the scheme and how it could be replicated.

What demographic is Nest aimed at?

Nest Corporation acknowledges it will have one of the most diverse memberships of any pension scheme, but its research suggests there will be some key characteristics.

As the scheme is aimed at the unpensioned, it expects to initially take in high numbers of younger members, have a higher proportion of women than most schemes, and have about 11% of membership coming from ethnic minority groups.

Three quarters are expected to earn less than £25,000, with a third earning less than £15,000. Only 9% are expected to earn more than £33,000.

“Most of our members will not have invested before and a lot will not have saved before,” says Mark Fawcett (pictured), chief investment officer of Nest Corporation. “This is a part of the market which the financial services industry is not designed for.

“Wealthier people tend to have a bigger appetite for risk. We will be conducting more research on reaction to loss in the new year.”

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However, Fawcett concedes he expects the level of acceptable risk for this group to be too low for them to reach their retirement goals.

The membership is also expected to experience high levels of job churn (changing jobs every six months), with many women taking career breaks. The research suggests 16% will be employed on a part-time basis – compared to 8% of those currently contributing to a pension.

Nest Corporation also expects the membership to have little understanding of investment risk, and warns an increase in awareness could lead to a loss of faith in pensions.

So how will defaults funds be constructed to cater for this group?

Anticipating 80-90% of members will opt for the default fund, Nest Corporation believes this needs to be as robust and simple as possible. It has opted for target date funds, which have experienced considerable popularity in the US.

There will be 53 separate target date funds, each targeting a specific year. Members will be automatically assigned a fund which matures at their normal retirement age.

If their circumstances change and they need to retire at a different date, they can switch to a different target dated fund.

Each fund is invested in a portfolio of underlying funds and designed to provide different levels of risk at different parts of the cycle.

In the accumulation phase, when members are building up their savings, the fund is invested in growth-seeking assets. But as the fund gets closer to its target date, the portfolio switches to less risky assets.

Fawcett says the simplicity of the system makes it easier for members to understand.

He also says the use of many target date funds means Nest will be able to switch investments in the underlying funds from one target date fund to another as the older funds derisk. Using the underlying strategy means Nest will save on transaction costs.

Nest Corporation will effectively become a fund of fund manager.

Fawcett says Nest will be using white labelled funds to make sure they are easily understood by members and any change in the underlying funds would not lead to a large-scale communications process.

What are the underlying funds Nest will be based on?

Nest Corporation has advertised for five investment fund mandates and expects to have the contracts signed by January.

These are:

• A passive global equity fund, based on the MSCI All World (Developed) or FTSE Global (Developed) indices
• A passive UK gilts fund, based on the FTSE Actuaries All Stocks index
• A passive UK index-linked fixed interest fund, based on the FTSE Actuaries over 5 years IL Gilts index
• An active low-risk cash management fund or product, based on seven-day LIBID
• And a mostly passive diversified beta fund, with a UK risk-free rate of 2%-4%

Fawcett reveals Nest Corporation is also looking at adding one or two more funds in Q2 next year.

Based on these underlying funds, and in addition to the target date funds, Nest Corporation is likely to offer a higher risk/return option, a lower risk/return option, a socially responsible/ethical option and a religious compliant option.

Fawcett has initially ruled out the use of hedge funds, private equity and even property in the early stages as Nest will be made as simple and as cheap as possible. He reveals he also considered buying deferred annuities, but felt the current pricing was too expensive.

In terms of fund managers, Fawcett says: “We are looking for long-term relationships with fund managers and we want to work with them to make sure they know what they are doing.

“There will be a lot of focus on risk and how they are controlling it.”

He adds: “We have got some cost constraints but we also think we can benefit from economise of scale and we hope this will be recognised by the fund managers.”