DC Debate Q2 (part 1): Are equities best for defaults?

Should more default funds incorporate environmental, social and governance criteria?

Simon Chinnery: Yes. The Pensions Regulator expects trustee boards to take account of any risks that could affect the long-term sustainability of their investments. If 90 per cent of DC assets are in a default, then trustees have a fiduciary duty of care to ensure their members are invested in companies that are best equipped to create resilient and long-term growth.

Employing ESG is about risk mitigation, regulatory compliance, strong governance and sustainable returns. This is not value destroying, as has historically been the charge against ESG, but value enhancing.

The reason why many trustees have not considered ESG is a false belief that it is an issue for asset managers rather than trustees

John Reeve, Cosan Consulting

The funds they choose within a default should have defined ESG criteria. More can and should be done to provide clarity for trustees on definitions and terminologies, but active engagement with members and providers should always be encouraged.

Neil McPherson: Many schemes have incorporated ESG, and ESG principles are (or should be) hardwired into the investment process of most leading fund management firms. There is widespread confusion between ESG and ethical principles. They are not synonymous.

The perception is that ethical funds underperform and the Cowan v Scargill case from 1985 – interpreted as requiring trustees to put maximising performance above other considerations – has dampened appetite.

But ESG, done well, offers alpha opportunities eminently suitable for default funds. ESG is a broad church, and definitions are key to determining which sect you want to join. These should be clear to members through the statement of investment principles, scheme communications and so on.

Laura Myers: Responsible investing makes a lot of sense for DC schemes, as the investment strategies are designed to be long-term and there is building evidence that companies that are well-run and have strong ESG practices have a better chance of sustaining long-term success and profitability.

Historically, it has been a commonly held belief that ESG strategies did not necessarily deliver a true financial benefit, but the tide is definitely turning. We are seeing significantly more schemes include ESG credentials in their manager selection process and ask managers to report regularly on how they are tackling sustainability risks.

Trustees should also ensure they select managers with strong stewardship practices – such as voting at annual meetings.

On the investment manager side, much is being done to improve the way ESG issues are taken into account, both in mainstream funds and in new funds with a specific responsible investment focus, such as low carbon.

Alistair Byrne: Yes, more default funds should incorporate ESG. Increasingly ESG is about managing the long-term financial risks that come from environmental and social issues. Trustees and sponsors should be taking account of these risks as they look after the longer-term financial interests of their members.

Adoption so far has been held back by uncertainty about how trustees can take account of ESG in their decisions, and by a lack of effective products. Both things are changing. It is now clearer that ESG strategies can be consistent with trustees’ fiduciary duties and, at the same time, new products are coming to market, including low-cost index-based strategies that fit within DC budgets. In addition, product structures are evolving.

Finally, it is worth noting that many schemes will already be invested in index funds where the manager conducts substantial governance and stewardship activities, engaging with companies on environmental and social issues and looking to improve outcomes.

Laurie Edmans: I support ESG principles. But when it comes to default funds, I am not clear that it is appropriate for ESG criteria to be imposed on members in the absence of either compelling evidence that to do so would be likely to produce better risk/reward characteristics, or that members would, in the majority, support such a move, regardless.

There is not yet a clear enough risk/reward case, and it is too early in the life of default funds for the views of members – many of whom are currently inert – to have developed to the point where research is likely to be conclusive. If, as members’ funds grow, engagement with investment issues follows, then this may change.

John Reeve: There is convincing evidence that companies with strong ESG deliver better returns. Hence it follows that, if you are setting the manager the remit to maximise returns, they will automatically select companies with positive ESG.

However, there is also evidence that many managers are asleep at the wheel when it comes to taking an active interest in these issues.

DC members’ priorities have shifted. While they do want to earn good returns, they want this to happen in the right way. They want to know their money is invested where it will do good – or at least not do damage – as well as maximise returns. ESG is therefore vital for a successful default.

The reason why many trustees have not considered this is a false belief that it is an issue for asset managers rather than trustees.

Andy Dickson: We are starting to see some DC plans put much more focus on ESG, as well as considering issues such as carbon and climate. Nest is an example of this, and we may start to see more DC plans take similar action in future.

Auto-enrolment is bringing people across the generations into the DC system. We undertook research to ascertain what motivates millennials and how their values compare with those that have gone before them. We found that millennials’ beliefs about climate change – and whether or not it is man-made – differ from previous generations.

We should consider what this means for DC investment design as membership demographics change over time. Perhaps this is the reason why some DC schemes have yet to incorporate ESG criteria within default funds but may consider this in the future.

When is the next crash coming, and will it have been a mistake of many defaults to invest in equities so heavily?

Chinnery: Our tactical view is neutral, with our medium-term base case getting closer to a late cycle environment, which increases equity risk, therefore leaving little upside in the next 12 months.

However, economic scores stay positive. Valuations are at the upper end of the recent range, but not extreme enough to dominate our tactical views.

A more diversified default has been in focus for many schemes since the great recession. The focus within diversified growth funds for some trustees has moved from risk mitigation (managing equity volatility) to achieving equity-like returns as the bull market from 2008 has matured.

Given that defaults are meant to be designed to provide risk-adjusted returns for the many, rather than high equity exposure for the few (who can always self-select), equity exposure, as part of a diversified growth portfolio, makes sense. 

McPherson: You will need to consult Nostradamus to tell you when the next crash is due (and his predictions will likely be as accurate as the serried ranks of City analysts).

However, whether it is next week, next month or next year: a well-planned default strategy should be robust enough to withstand equity market shocks.

The DC journey is usually 30 years-plus, and equities generally outperform over 10 years plus. Equity investment in the accumulation phase is entirely appropriate (and for many in later phases too, depending on individual circumstance).

Indeed, in the early stages of the member’s DC journey, the risk is not taking risk. Investing too heavily in capital protection strategies in the early stages arguably poses more risk to pension wealth than an equity-based approach. 

Myers: Bear markets are inevitable, and we would all love to have a crystal ball to be able to know when the next crash is coming. But trustees should not make short-term decisions; instead the investment strategy should be set with a long-term time horizon.

Therefore, in order to ensure our members get an adequate retirement, a significant proportion of the default needs to be invested in equities. That is because if you look at long-term data, you can see that over the past century, UK equities have produced an average real annual return that is about 4 per cent higher than gilts or cash returns, needed to get our members adequate outcomes.

As equities are a volatile asset, the key is to use them at the right time, when a member is young, so they have time to benefit from any potential rebound in the market cycle.

Byrne: One thing for sure is that we can be fairly certain that there will be another crash at some point, so it is important to protect members’ savings when it does eventually come.

Equities are the main engine of growth and play an important part in DC defaults, but it is important to balance that with diversifying assets and to manage the asset allocation to fit market conditions.

Some schemes will have exposure to DGFs that can switch between asset classes, and others may use volatility management techniques overlaid on the equity portfolio. In addition, most schemes will use some form of glidepath to reduce the equity exposure for members closer to retirement, where any market crash can do the most damage.

Edmans: If I knew when the next crash was coming, I would be George Soros. Unless the relative returns of the last 100-plus years change for a really prolonged period, it will only have been a mistake to be in equities if, after a crash, many members discontinue contributions as a result – and in the process also lose their employers’ contributions, tax and national insurance relief. 

This concern led to the original investment approach at Nest, which I supported as a trustee. There is little evidence yet, from minor perturbations in the market, that the inertia which applies with regard to getting members into pension schemes is suspended when fund values fluctuate. And to put money into government bonds now – given current interest rates – would seem fairly unwise.

Reeve: If I knew the answer to this I would not be here, I would be on a beach. The problem is that the apathy of members means that a default has to meet the needs of a diverse population of members; those with the time to ride out the rise and fall of the market, and those who may want a more conservative investment strategy.

Indeed, one must ask how long it is before members question why trustees with lifestyle defaults are buying gilts for them at the current historically high rates, especially where members plan to go into drawdown.

I have seen some excellent work from trustees who have created 'segmented defaults', which meet the needs of different populations. These can be targeted at those most likely to benefit from the specific strategy segmented by age, pot size and even salary.

Dickson: A key responsibility for trustees is to regularly review default investment strategies to make sure they are appropriate. Given equity valuations and the geopolitical climate, this is making this task ever more important.

I am not going to speculate on the when the next crash is coming, but I do think DC plans that rely heavily on equities in the accumulation stage should re-examine their approach. Any ‘mistake’ in managing investment risks will be borne by the DC member, and consumer research by Nest has shown that “participants suggested they would stop contributing after experiencing – and noticing – losses”.  This is not a new phenomenon – as Mark Twain said: "I am more concerned about the return of my money than the return on my money.”

How can schemes make sure members are not put off saving when markets fall?

Chinnery: There is an argument that stresses that communication to members should always emphasise the importance of keeping contributions going, in all environments. Even though Albert Einstein described compound interest as the eighth wonder of the world, few understand it, as financial education has fallen somewhat below genius level.

Nevertheless, we should continue to endeavour to create good member engagement to combat behavioural biases. We could learn more from other industries in this respect as the industry’s track record on communications has not been great. 

Even though Albert Einstein described compound interest as the eighth wonder of the world, few understand it, as financial education has fallen somewhat below genius level

Simon Chinnery, LGIM

McPherson: This is the perennial problem of the retail investor, bailing out when markets fall and piling in when they are rising and expensive.

Meanwhile the canny institutional investors hold their nerve, buying low and selling high. In a DC context, members cannot bail out, but they can stop contributing, which is the worst possible response.

Contribution level is at least as crucial as investment performance, arguably more so. How to address it? Communication. Engage with members regularly and (where warranted) specifically to reconfirm the benefits of continued saving.

The various digital dashboards available, which show projected pension pots for various investment mixes and contribution levels, might help members avoid short-term jitters.

There is no silver bullet though. It is hard enough for many members to keep contributing even in buoyant markets given more immediate calls on their hard earned wages than pensions.

Myers: It is two things: As an industry, we need to stop focusing on the short term. We should put more focus on communicating the long-term performance and not short-term, or even annual, numbers. It is the long-term return that is the key determinant of the member’s outcome.

We also need to build trust in pension schemes. They are great long-term savings vehicles due to the tax benefits and the additional contributions paid in by the company, but many members still do not realise these great benefits. We must do more to make this clearer. Nowhere else can you get such fantastic return on your savings just for paying into the savings vehicle.

Even if the funds deliver poor returns in the short term, this is likely to be compensated by the benefits of saving in a pension scheme over the long term.

Byrne: Schemes should make sure their investment strategy is designed to protect members from the worst of any market falls, using diversification, volatility management and dynamic asset allocation.

Communications can also try to make clear that the ups and downs of financial markets are a natural part of investing to grow their pot and not a source of major concern for investors some way from retirement.

For investors closer to retirement, it needs to be clear that the investment strategy is designed to protect their savings and prevent significant reductions in value.

Edmans: The contradictory arguments are either by not disturbing the inertia, or through member education.

It is worth taking the risk of educating. To assume that most people are too limited to understand what is in their best interest seems elitist and self-fulfilling to me. It really is not that difficult to explain pound cost averaging or the long-term difference it makes to be invested in real things, even if the value can be volatile. 

There is also the sad fact that getting people to the point where they are sufficiently engaged to understand where they are is not easy to do. It will therefore be some time before education attempts could displace inertia. So the risk should be taken to try to build member understanding.

Reeve: Trustees should consider how they can use the science of behavioural finance to help ensure members get the best possible outcomes. By investing conservatively in the early years, falls in value can be minimised. This enables members to gain confidence in their savings; confidence leads to higher contributions.

While traditional thinking would be that contributions paid early in a member’s career can be invested in more risky assets, falls in value undermine confidence and hence savings for the rest of the member’s career.

The loss in return from a more conservative early investment strategy is limited given the low value of the member’s pot in the early years. Trustees can then build on the increased confidence to enhance communications and help members understand that short-term falls are a buying opportunity rather than something to worry about.

Dickson: By managing investment risk and then thinking carefully how you communicate risk management to DC members. So how can DC trustees manage investment risks appropriately? First, it is important to design a default strategy that is genuinely diversified and robust in a range of market backdrops, including times when equities fall in value. This can mean having investments in areas that have not traditionally played much of a role in DC plans that can provide a cushion in the event there is a downturn in equities.

A challenge can be communicating to members what is a more complex investment approach, so it may be best to do this simply, for example, explaining that it is about delivering a smoother savings journey.

Read the second part