Active management of passive funds – a viable strategy for DC?

Recently, one of the main values for defined contribution schemes has been the charge cap of 75 basis points, which acts as a constraint with regard to how much pension funds can pay for administration and investment management.

Even if a DC fund is mostly driven by passive funds, it is possible to have regular oversight and flexibility, so alterations can be made when anticipating market volatility or adapting to legislative changes, for example.

Members need a lot more flexibility, and that makes active asset allocation and monitoring volatility very important

Jignesh Sheth, JLT Employee Benefits

According to a survey conducted by consultancy Willis Towers Watson this year, benefit plan costs make up 33 per cent of employers’ current considerations when it comes to DC decision-making. Moreover, 67 per cent of respondents are looking to review fees, and many want to “make investment work harder”.

There is often a limit to how much schemes can spend on investments, and this can lead to trustees looking at more cost-efficient ways to get greater returns.

Active response

Alistair Byrne, senior DC investment strategist at State Street Global Advisors, says that “it’s asset allocation that offers the biggest opportunity” when it comes to working with budget constraints.

“The value comes in having an asset allocation that can respond and change according to market conditions,” he says.

Byrne explains that when there is volatility, moving to more defensive asset classes such as cash and bonds could protect the portfolio against losses.

Jignesh Sheth, investment consulting director at JLT Employee Benefits, notes there has been a lot of legislative change in the DC world.

“Certainly, there’s a lot more focus on costs with the pension caps,” so schemes are using passive funds when possible, he says.

Source: Pensions and Lifetime Savings Association

As a result of the pension freedoms, “there is a lot more unpredictability in how members are taking their pensions”.

Low volatility is less important for younger members

Working habits are changing, with people working beyond traditional retirement ages, “and therefore members need a lot more flexibility”, says Sheth. “That makes active asset allocation and monitoring volatility very important.”

Ultimately, the main driver for return is going to be asset allocation. However, active asset allocation has less of an impact on younger members compared with those in the middle of their career or nearing retirement.

Sheth notes that volatility is not necessarily a bad thing, particularly for younger members. “If you try and manage volatility with active asset allocation, you might end up with a better return for the amount of risk you take,” but it may not be as high a return as just staying in equities.

“If you’re joining a pension scheme at the age of 25, you’re not really thinking about touching that money for at least 30 years,” he says, adding he does not think that having active asset allocation is as important at that stage.

“Certain building blocks need to be passive” in order to manage costs, agrees Ashish Kapur, fiduciary manager SEI’s head of European institutional solutions. You can then deploy active management where it is best suited, he says.

Dynamically managing the asset mix is the hardest to get right given the challenges of calculating the expected returns and risks

Chris Wagstaff, Columbia Threadneedle

Byrne says a scheme can think about an active asset allocation approach in terms of the stages in a member’s career journey.

“Some schemes are quite comfortable with members taking equity risk when they’re young, and they’ve got a long way to go until retirement, then as a member gets closer to retirement and they’ve got a larger pension pot accumulated, it becomes more important to protect them from loss,” Byrne says.

Paul Macro, director of pensions consultancy Isinglass Consulting, says he does not think asset allocation needs daily oversight, at least not by those who formally govern the scheme.

Having someone to monitor the asset allocation on a daily basis will introduce an additional layer of cost, but combined with lower charges on using passive funds, this “might still be acceptable”.

One option is to use white-label funds, and not to invest directly in the underlying funds in order to avoid extra work in terms of administration.

But if trustees do not want the regular responsibility of making those decisions and acting upon them, the other option is to delegate decision-making to the investment manager.

“I wouldn’t say many schemes are doing it,” says Macro. But he notes that “a number of schemes” have introduced the approach, and this has often been as a result of an investment review following the pension freedoms.

Macro believes these schemes have not only realised they need to make changes to adapt to the freedoms, but they should also introduce something that allows them to make subtle and major changes in the future, without a big administrative impact.

A more sophisticated DC strategy?

Active asset allocation requires more frequent monitoring, but does this make it a more sophisticated strategy?

It depends how you define the term, according to Macro, who concedes the approach is more sophisticated in terms of having a “more nitty-gritty” level of detail.

“There is a danger, however, of assuming that because it’s more sophisticated it is better, and that isn’t necessarily the case,” he adds.

Chris Wagstaff, head of pension and investment education at Columbia Threadneedle Investments, says active asset allocation is difficult to do well.

“Dynamically managing the asset mix is the hardest to get right given the challenges of calculating the expected returns and risks of all the asset classes considered for potential inclusion in the asset mix,” he says.

However, some do manage, according to Wagstaff . “Dynamic asset allocation managers are able to anticipate and swiftly react to changing market conditions, enabling a fund to successfully navigate its way through market shocks and deliver good levels of consistent growth.”