How to predict member outcomes in the new normal

The landscape for defined contribution schemes has changed beyond all recognition.

No longer an afterthought, the Pensions Regulator is driving up governance to levels equivalent to that demanded of those running defined benefit schemes.

In addition, the major structural changes introduced in the Budget will transform how schemes may choose to run their funds.

Herding cats

DC schemes are being asked to measure not only the performance of their fund, but predict that performance to ensure members receive ‘good value’, that their objectives are achieved and that they receive ‘good outcomes’.

For The Specialist full report on DC investment, click here for the PDF.

None of these terms of reference yet have as yet any technical or legal definition. Tim Gardener, head of institutional clients group at asset manager Axa Investment Managers, warns the employment landscape has also radically changed, making any such definition harder.

The notion that retirement and employment can be separated at the age of 65 was the model for our parents’ generations, but has little meaning now.

“The most fundamental change is there is no single point of retirement,” Gardener says. “For this generation, there will be a transitional period where you may work at Tesco, drive a taxi or perhaps do some part-time non-executive work.”

Growth argument stunted

The removal of this cliff-edge poses problems for schemes planning their investment strategies.

Historically, schemes have emphasised asset growth until a predetermined point before retirement where the individual’s fund is derisked progressively into bonds and cash, in preparation for annuity purchase.

However, the changing market means that emphasis must now shift to providing income, says David Calfo, an independent strategic adviser.

“The sting is predicting outcomes,” Calfo says. “While you can anticipate, target, or aim at [outcomes], predicting them is quite dangerous.”

This makes absolute return approaches more appropriate, argues Calfo. Whether Libor-plus or inflation-plus, the issue will be how to achieve the ‘plus’ component in the markets.

For The Specialist full report on DC investment, click here for the PDF.

The key lies in interest rates to achieve the targeted returns. If global markets become more bullish, as anticipated, then as the bar goes higher, so the plus component becomes harder to achieve.

“To produce income will mean you need to sweat the assets more, particularly when you consider longevity and the wave of babyboomers hitting pensionable age, which creates a huge dynamic,” adds Calfo.

Rough with the smooth

However, sweating the assets implies increased risk. In order to control volatility in recent years, schemes have made use of multi-asset strategies, many labelled as diversified growth funds.

These have, in effect, become the default for default funds.

The latest Spence Johnson report into DGFs says allocations have grown by £22bn in 2013 and are expected to reach £201bn by 2018.

Though DGFs are applied to achieve similar aims – equity-like growth with two-thirds the volatility – there are vast differences between the products.

The attraction of growth with limited downside presents a danger of DGFs and other multi-asset approaches being considered a panacea and used in the same set-and-forget fashion as balanced funds in the past.

The current lifestyle model has been criticised for showing a lack of sensitivity towards an individual’s aspirations, risk tolerance or, often, market price. It has also been accused of failing to take into account an individual’s views over the course of the accumulation period.

While the performance of DGFs can be measured in relative terms year on year, they do not provide the context to be able to assess the journey of a member who might seek a 50 per cent replacement ratio over a 30-year period.

No silver bullets

Implementing multi-asset strategies alone is not a satisfactory way for schemes to help members achieve their objectives, says Stephen Budge, head of DC investment at consultancy KPMG.

Schemes must understand what they are trying to achieve with these funds when building a strategy, he says.

“When we look at the diversification element, we don’t simply implement 50-50 equity and diversified growth as there is no science behind that.

“Diversification will dampen returns even if you improve the risk-adjusted return. You then have to hope you don’t dampen the terms too much and hopefully achieve the outcome that the member is targeting.”

Budge recommends an approach that determines:

• the long-term return target;

• the risk budget;

• the fee budget.

This feels an awful lot like a DB approach and demonstrates the higher levels of governance expected of DC investments. For Budge, the message is clear – investment is complex and will only become more onerous as the 75 basis point charge cap bites.

Schemes will have to become more proactive in their asset allocation and consider the unseen – often undisclosed – charges the regulator is seeking greater clarity over. This will include the monthly rebalancing of the scheme’s fund or funds in order to limit transaction costs, adds Budge.

All change

It may be unpalatable, particularly with the imposition of a charge cap, but though DC schemes are obliged to provide a default fund, they will find it increasingly difficult to make it a simple one-size-fits-all product.

The proliferation of different DC strategies means trustees will require more advice, according to Stephen Bowles, head of DC at asset manager Schroders.

For The Specialist full report on DC investment, click here for the PDF.

“Schemes will require different solutions, with their strategic defaults being their single most important solution.

“They will have to consider the objectives of different member ages, offering different buckets for different needs, underpinned by a process that makes robust decisions,” says Bowles.

This provides opportunities for approaches that are less about dampening volatility than preserving wealth in the latter stages before retirement, he says.

Remaining in growth assets when a member’s fund is at its largest will generate the highest returns, says Gardener, making DGFs most suitable for older members who need the combination of continued growth with downside protection, or even capital preservation of the kind common to the wealthy investors of family offices.

Though the DC market may seem in turmoil, prudence remains the order of the day. Nothing can change until the regulations are published, because no one can be sure their existing solutions – or any on the market – will be suitable for the new paradigm.

However, sponsors, trustees, governance or investment committees and their advisers must understand they will be expected to offer not only growth, but protection, flexibility and security.

That alone requires a review and a reassessment of the governance budget allocated to their DC investment strategies.

Pádraig Floyd is a freelance journalist