Could DGFs deliver a better DC experience?

Inert members with long time horizons could be hooked up to the engine of contributions and equity volatility, and the miracle of compound interest would see them safe to their destination.

But there are signs members may be waking up, or at least becoming more risk-averse.

Nest, the mastertrust provider of last resort, minimises volatility at the beginning of the saver journey, on the back of research suggesting that a sharp fall in fund value might spur opt-outs for young workers.

History is littered with events where stock markets didn’t bounce back quickly

Chris Wagstaff, Columbia Threadneedle

More recently, the Pensions Policy Institute has echoed these concerns about the impact of volatility on saver behaviour, in its 2017 Future Book publication.

“Members tend to be not very engaged but people are more loss averse… particularly with people of low levels of financial capability,” said Daniela Silcock, head of policy research at the PPI and the report’s author.

The report points out that diversified growth funds were around 15 per cent less likely than lifestyle funds to experience a loss within the first five years of saving, and 7 per cent less than low-volatility funds.

At benchmark performance or better, DGFs also delivered the second-highest median returns behind high-risk funds, and were least likely to deliver very low returns.

DGFs to the rescue?

For Chris Wagstaff, head of pensions and investment education at active fund house Columbia Threadneedle, which sponsored the piece, these findings point to the conclusion that a “smoother journey” might be more fit for purpose in DC defaults.

“There’s a strong argument that [a long way from retirement] you should assume equity risk,” he said, noting that equities do indeed make up a large part of many DGF portfolios. “But I think we live in a world now that is incredibly risky.”

Wagstaff was somewhat sceptical that default funds were at risk of mass opt-outs if they did not control volatility in early years, but pointed to another key risk – the prospect of a market downturn.

Such an event has been far from the minds of most investors over the past few years. A rising market and low correlation between bonds and equities has flattered passive strategies.

Supporters of equity volatility usually argue that the relatively short length of market cycles means high risk can be maintained until the saver nears retirement.

“History is littered with events where stock markets didn’t bounce back quickly,” countered Wagstaff.

Risk drives returns

But while few would argue against the fundamental benefits of diversification, DGFs as a product fit for DC defaults have more work to do in convincing the industry.

Nick Dixon, investment director at provider Aegon, questioned the need for any smoothing of the saver journey.

“If you want a smoother ride you will reduce returns,” he said. “The smoothest ride of all is to be in cash, and then you can guarantee very limited retirement incomes.”

Rather than adapt portfolios to suit members’ loss aversion, schemes and providers could always drive for better member education, Dixon suggested.

“It’s about how you educate and inform the investor that risk is necessary and it’s a good thing to drive returns.”

In 2016, a Willis Towers Watson report into DGFs found that average DGF returns mirrored a balanced portfolio of equities and bonds, with those returns driven by the same, otherwise cheap, market betas.

Costs are a problem

Nick Frankland, head of Punter Southall Aspire’s DC consulting team in Scotland, did believe in the power of diversification to give downside protection in troubled times, and extolled the virtues of exposure to real assets.

However, he said most DC employers and schemes will have to content themselves with a blend of DGF and simple passive exposure, as costs remain prohibitive.

“Many employers who don’t have an actuarially attractive membership demographic... may not be able to access those within the charge cap.”