Innovation within the charge cap

The all-in default fund charge cap of 75 basis points has made this difficult, but with most DC members in a default fund, many will feel the cheap-as-chips passive approach is sub-optimal for delivering meaningful retirement income. 

Innovation

Finding alternative sources of return is hard enough in this ongoing low-return, low-yield environment, but not being able to throw money at is makes things that bit tougher. 

Trustees have to consider whether they might achieve similar outcomes at a lower cost to members, or if spending more on the investment strategy might deliver better returns. 

For the vast majority of schemes, the effect of the charge cap has been to keep, or make it, simple – and cheaper. Data from the last Pensions and Lifetime Savings Association survey show the growth strategy of 44 per cent of schemes relies on passive trackers, up from 34 per cent in 2014. 

Stephen Budge, principal at Mercer, says most schemes want simple, long-term asset allocation advice, while others are more proactive on how to run the asset allocation from within the scheme. 

“Whether one is better than the other depends on the governance budget and whether they have the time, expertise, or commitment. Others will delegate to a fund manager,” he says. 

Budge argues against shopping for the cheapest option; instead he recommends setting a fee objective and cutting your cloth accordingly. 

“That could be passive alongside diversified growth funds, but choosing the fund that best suits your scheme,” he says. 

That may not be one of the new, cheaper model funds, because there may be comfort in the longer track records firms like his hold on older ones.

Spread your bets

DGFs are used in 22 per cent of defaults, but 30 per cent use alternative multi-asset funds, according to the PLSA, and many – particularly those aimed at the DC market – have heavier equity allocations. While markets have enjoyed strong returns over the last few years, few expect this to continue.

“Smart beta types of strategy are on the spectrum between passive to active and can allow access to other types of capital markets that passive beta exposures don’t,” says Karen Watkin, portfolio manager in the multi-asset investment team at AB. 

By focusing on factors rather than assets based on, for instance, market cap, these funds might hope to deliver broader return profiles. This means targeting value for younger members and maintaining low volatility for those close to retirement. 

“The return stream and investment horizon are important with target date fund investments,” says Watkin. “Managers can adjust those asset allocations over time and all members will benefit from that.”

Abandoning market weight for more dynamic approaches such as risk premia or smart beta – there are as many approaches as there are in DGFs – is supported by Andrew Cheseldine, partner at LCP.

He is researching combinations of fundamental indices as well as active – but low volatility – equity funds, which might be appropriate as the equity portion of post-retirement portfolios. 

Whatever is decided as the right approach, trustees must not lose sight that what is presented to them is not guaranteed.

“The diversification relies on our assumptions – particularly around correlations – and there are lots of combinations that work in theory,” says Cheseldine. 

“But they all rely on those assumptions, and we need to be very confident that we are not just introducing another, different, set of biases.”

Lack of transparency

For all their popularity, trustees should be sure of what it is they expect an alternative approach that something like a multi-asset fund will do for their default, says Celene Lee, principal and head of investment consulting at Xerox. 

Using the likes of DGFs is “a bit too easy at times”, she says, adding that not all DGFs are equal and some are more transparent that others.

“Understanding why one performs better than another is difficult for professionals, let alone trustees if they are to understand which parts of the asset allocation were correct,” says Lee. 

Using a DGF is not an opportunity to set and forget this part of the strategy, says Lee, as it is critical these elements are continually assessed.

2016 could finally separate the wheat from the chaff, says Lee, as market volatility should crack test many strategies that have so far operated in fairly benign conditions. 

Overstated illiquidity

Liquidity remains a bone of contention and for Budge, it is simply “not on the agenda at the moment” due to other priorities. Despite this, many consultants are looking at the new private equity funds being launched, which may offer some opportunities for schemes. 

But the issue of liquidity is something of a red herring for Watkin.  "The confusion is caused by industry, and is largely irrelevant," she says. "DC schemes don’t need daily liquidity, but daily pricing, as long-term investments won’t be traded daily."

Cheseldine agrees but warns that illiquidity can cause problems during mergers and acquisitions, when transferred members cannot get transfer values due to a property allocation, for instance.

“That wouldn’t stop me using some illiquid funds,” says Cheseldine, “but I’d want to be very clear in my communications.” 

The stomach for it

Ultimately, the more schemes seek to do, the more it is going to cost. In terms of time and fees, but also in terms of governance budgets and potentially, the risk budget as well. 

Trustees do not want to shoot the lights out, and Budge advises the 'softly, softly' approach. 

“We are looking at how we can enhance and eke out investment returns for members,” he says. “Because in the long term, a small increment will make a large difference.”