DC Debate Q3: How should schemes invest DC assets in a changing world?

How should default funds be adjusted to take into account possible market effects from Brexit?

John Reeve: Default funds are no different from any other fund in that they need to manage risk in a way that is consistent with their stated aims. If the fund manager believes that Brexit has changed the risks associated with the fund portfolio then he or she will need to make changes to manage those risks.

What Brexit does highlight is the need for clarity in terms of what funds are trying to achieve

John Reeve, Cosan Consulting

Trustees or employers will want to ensure that the fund they choose as the default is managed in the way they expected and with the level of risk they expected when they selected it. They should question managers and, if they do not believe that the risks are commensurate with the aims of their membership, they should look to change the default.

What Brexit does highlight is the need for clarity in terms of what funds are trying to achieve, how they do this and what their mechanism is for doing this in the light of changing circumstances.

Helen Ball: This is a tricky question for those without a crystal ball, and probably more for the investment consultants rather than the lawyers on the panel.

However, if trustees are considering adjusting their defined benefit assets for Brexit effects, in order to be even-handed, they should at least consider whether there are any potential implications for their defined contribution assets. For example, if they take a position or view on DB investments, such as currency hedging or tilting the global profile of the portfolio, they should also consider the appropriateness and feasibility of employing similar techniques for their DC investments – particularly the default fund.

Maiyuresh Rajah: The huge number of unknowns surrounding Brexit is likely to lead to persistent market volatility over coming years. This reinforces the need to remain vigilant about market downturns.

There are a number of ways volatility can be managed in default funds. Firstly, through diversification – by introducing new asset classes into your default you can improve the risk-adjusted returns. One way schemes are doing this is by using low-cost diversified growth funds. These funds are designed to capture opportunities for growth while seeking to minimise downside risk.

Secondly, by using volatility management techniques that automatically reduce equity exposure when volatility moves above a pre-set target level.

Thirdly, through using smart beta – a transparent, rules-based investment process that targets factors that have been shown to improve returns or reduce risk relative to market cap-weighted indices. Many low-volatility indices have shown a 20 per cent to 30 per cent reduction in volatility compared with their cap-weighted equivalent.

Laura Myers: Asset prices in the UK will likely be volatile over the next few years due to the uncertainty around Brexit, with long-term trade negotiations expected to stretch on for many years. Therefore DC schemes should consider their exposure to the UK within their default strategies to ensure it is appropriate. For example, I have seen many DC schemes that still have an over-reliance on UK equities, with many funds having 50 per cent to 70 per cent of their global equity allocation in the UK.

As exit discussions intensify, we can expect UK asset prices, and sterling in particular, to rise and fall at a higher frequency. Consequently, I would also recommend carefully considering currency hedging levels in the default. As more default funds now have exposure to equities much later in time, it is prudent to review if currency hedging could be beneficial to help reduce volatility, particularly in later years.

Simon Chinnery: Flexibility in investment design is important. Some effects from the Brexit vote are already apparent, such as sterling’s depreciation against the euro; a well-diversified, multi-asset default therefore needs the ability to implement tactical decisions in a timely manner.

However, it is a truism that, whatever the short-term effects of Brexit, long-term assets need to be managed strategically, and not buffeted by political winds and short-term views. A disciplined approach to valuing asset classes and their relative interdependence is vital, irrespective of the changing geopolitical or economic landscape. This means being aware of potential risks, including concentration risks and currency risks, by diversifying across multiple currencies and regions.

Andy Cheseldine: The problem with most defaults, at least lifestyle options rather than target date funds, is that they are relatively inflexible. Few trustees would be keen to make active asset allocation calls in response to short-term market views. Having said that, there are a number of defaults that use white-labelled managed funds or target date funds, and they might make some strategic changes to either reduce risk or enhance growth prospects.

A key question is likely to be around hedging (or not) of currency risk in non-UK investments. Do you think the pound will fall further? That sounds like a market timing call and I would be very nervous of making it unless I thought I could take significant risk out of a portfolio.

Another key risk will be around inflation and long-term interest rates. How ‘safe’ are bond and gilt funds in an environment of potential volatile rates? Before you can answer that question, you need to understand what members will do with their funds at retirement.

Do emerging markets have a place in defaults?

Reeve: Any asset has a place in a default fund if it helps to increase the chances of achieving the stated aim of the fund. If emerging markets improve the diversity of the portfolio and thus reduce the volatility of return or if they can improve returns, then they have a place.

The important thing to note is that it is the aims of the fund that are important and not necessarily the underlying assets. Indeed, members invested in default funds are, by their very nature, unlikely to be aware of the underlying investments. This brings into the spotlight the importance of trustees ensuring that the aims of a default fund are clearly defined, whether this be the target return, risk or indeed the investment philosophy of the fund.

Ball: Although these investments may be potentially attractive from a return-seeking point of view, trustees need to consider their appropriateness in terms of charges and liquidity – how much headroom such investments would leave for the rest of the default strategy costs (with the 0.75 per cent charge cap), and how easy it would be to exit such arrangements if necessary.

It would appear more straightforward for trustees with DB investments to switch in and out of emerging markets but perhaps less so in a DC environment.

Rajah: Yes. Typically, emerging market exposure provides diversification and has the potential to improve risk-adjusted returns. Historically, emerging market strategies have mainly featured in the equity portion of defaults. More recently, we have also seen the inclusion of emerging market debt.

EMD is one of the most rapidly evolving asset classes and has become a large, diverse and liquid universe.

The increasing breadth and depth of the market has improved liquidity and made it more accessible for DC defaults. In times of seemingly ever lower yields across the full spectrum of fixed income markets, EMD is a market that still offers relatively attractive yields.

Myers: Emerging market investments are well suited for members in the growth phase of a default strategy, due to their greater growth potential over the long term compared with their developed market counterparts.

However, emerging markets have risks that need to be understood. They are more volatile than their developed market counterparts, which is why they should be used in earlier stages of default strategies, when members can bear the short-term volatility, in order to benefit from greater potential long-term growth.

We have also seen some DC schemes use a multi-asset approach, seeking returns from emerging market equities, bonds and currencies. I prefer this, as you gain the potential emerging market returns while also diversifying risk, and hence dampening the level of volatility members are exposed to.

Chinnery: They do have a place, particularly as diversifiers within diversified growth funds. This means emerging market equity, but also emerging market debt, in both local currency and hard currency. But make sure the fund manager of your diversified growth fund has a good grasp of emerging markets.

Cheseldine: Diversification is a good thing when it reduces risk but, particularly in longer-term portfolios, we should be looking for them to add to growth characteristics. Emerging markets, especially equities but also multi-asset portfolios, fit this brief quite well.

However, most analysts would suggest that active management is appropriate in emerging market equity portfolios, so fee levels and transaction costs are limiting factors in a charge-capped environment.

How can schemes and employers best adapt DC defaults to freedom and choice?

Reeve: This is the $6m question. The appropriate default will depend upon what the member plans to do at retirement. This is especially true as the member approaches retirement. Those planning to cash in may want capital protection, whereas those looking to go into drawdown are likely to have a longer-term growth agenda.

It is important to offer members pay-out options that cater to the new choices, while balancing the inherent uncertainty

Maiyuresh Rajah, State Street Global Advisors

The best solution we have seen is a form of segmented default. Trustees select the default according to a proxy for the likely behaviour of the member at retirement. Most commonly, this proxy will be the projected size of the pot at retirement.

Those with smaller pots are likely to cash in, those with larger pots are likely to take the pension commencement lump sum and then continue to invest. While there are still dangers, this approach offers the best chance of meeting member needs but is no replacement for better engagement.

Ball: In many cases, the trustees and employer seek to align their views on retirement options – what members are likely to choose, when and why – based on what they currently know about their members and their pot sizes. They can then work backwards to offer a default investment strategy which dovetails with those options.

Understanding the demographics of scheme membership, for example, if there are many retirements due in the near future, can also be helpful. Schemes with younger members will have longer to experiment and consider market experience than others who have members closer to retirement age.

Rajah: The pension freedoms have introduced a range of new choices for members at retirement – to take a lump sum, purchase an annuity or to keep their savings invested and draw an income over time. It is important to offer members pay-out options that cater to the new choices, while balancing the inherent uncertainty.

Our research shows that members want to keep their retirement options open, with the majority unsure about how they will access their pension pots until they are very close to retirement. As such, the default asset allocation for members approaching retirement should balance capital stability with some growth potential. It should avoid the pitfalls of precisely targeting one single payout choice, thus giving members the flexibility that is important to them.

In addition, using a target date fund structure for the default will provide the scheme with the flexibility to adapt easily to any future changes in member needs.

Myers: I would caution schemes and employers that have too rigid an end point in their default strategy – either for when they expect the member to retire or what benefits they expect them to take.

Since freedom and choice, we have seen annuity purchases decrease and people having a significantly wider age range when accessing their pots. While there has been a lot of publicity around members continuing to work in retirement, many are also taking their pension early. For one of my clients, more than 85 per cent of retirees were accessing their pot prior to their selected retirement date.

Consequently, default strategies have to be flexible. Ideally they should reduce risk significantly before retirement to help those who retire early, but also maintain an inflation-plus strategy beyond retirement to ensure those who work for longer do not see their savings eroded.

Chinnery: Flexibility in design and considering the member journey as ‘to-and-through’ retirement are key features post pension reforms.

A cloud of uncertainty over retirement behaviour, longer working lives, lack of retirement planning and greater choice demands a new generation of investment design. This has to accommodate members in default who may choose to work and/or stay invested for longer, or want a blend of options to reflect their own changing lives.

Keeping growth assets for longer could be part of this, given the uncertainty around when people are going to retire and that derisking too early could lead to a worse outcome through forgoing growth. It is important to think about what happens at the point of, and during, retirement – are your solutions ‘to retirement’ or ‘to-and-through retirement’?

Cheseldine: First try to understand how your members will behave once they reach retirement age, or more accurately, once they get to an age when they can access benefits. Note that I did not say how they should behave or how you would like them to behave, but what they will actually do. If there is a mismatch with members making suboptimal decisions from a tax or risk-planning perspective, that is a communications challenge. The investment challenge, however, is to match actual behaviours.

There are then a number of criteria to meet if you want to align design with needs: when members will first access DC pots, how much of the pot they will access and over what period they will access it. In ‘the old days’ all of two years ago, it was relatively easy - 25 per cent would typically be taken as a tax-free lump sum and the rest would be used to buy an annuity.

There are two key challenges to avoid derisking too early or too late: if members take all their benefits at age 55, a lifestyling option that only starts to derisk at age 60 could leave them horribly exposed to market volatility. But if you start derisking at age 45, or have them permanently invested in a low-risk diversified growth fund, you could be missing significant growth opportunities for someone who remains invested to and potentially beyond retirement age.

Click here to read part two on in-scheme drawdown, platforms, and bundled v unbundled