DC default funds: Does active management have a role to play?

Paul Todd 

There is a role for both index and active management. You need to be clear about what asset class you are operating in and what you are trying to achieve.

For example, our biggest holding is in global developed equities. We think markets are fairly efficient. We know that 50 per cent of active managers underperform the index and 50 per cent outperform. We know their fees are higher than for passive funds. We think there is skill to be found. However, it is difficult to know whether you are finding a skilful manager. In an asset class like that, therefore, it seemed to us the sensible way to go was index management.

By doing a ‘set and forget’, you may be derisking at precisely the wrong moment in an economic cycle

Paul Todd, Nest

One of the things we are looking at closely though is the different ways of approaching index management.

Lydia Fearn

One way of thinking is to begin with the end in mind – so considering the outcome for the member as a first step. Then it is important to think about the risk budgets across the journey, from young members all the way to and through retirement. You have a different risk budget for 20-year-olds versus 50 to 60-year-olds. So you start with what an overall asset allocation might look like for those risk budgets. Then you can start drilling down to which funds fit within that strategy.

Some medium to small schemes would probably like to put some active management in there in some form but struggle because of the cost, and so you end up with, potentially, multi-asset funds that are not as active as you want them to be, or a manager that maybe cannot put on every trade they want to because of cost issues.

Pensions Expert

Is it as simple as saying that for younger members passive is appropriate, as it is cheap, then move into active management as they near retirement?

Fearn

No, it is across the whole journey, to be honest. On environmental, social and governance issues, when you want to be a bit more active and conscious of what you are investing in, that does cost more money as people have to spend more time to do the research. You are not going 100 per cent active in terms of a bucket of 10 stocks that you have high conviction in, but you are doing more work than tracking a market cap index. It is a tough balance.

Some of the larger schemes and mastertrusts can start bringing these ideas to life, hopefully that scale will then enable the medium and small ones to access those better investment ideas in defined contribution.

Todd

To Lydia’s point, all the money that was in defined benefit schemes is now going into fixed income; who is going to be investing in the future of the economy? Who is going to be investing in long-term sustainability? It needs to be DC schemes. There may be barriers to DC schemes accessing some of these asset classes, which perhaps are not there for DB schemes. However, I think those barriers are overemphasised.

Daily pricing and liquidity are issues. But given the amount of money coming down the road because of automatic enrolment and phasing, there needs to be a much better alignment between the people who are allocating that capital and the asset management industry developing products that are suitable for DC, but still have principles of long-term growth and long-term sustainability.

Defaults need to manage risk for a member through retirement. Whether that is through target date or through lifestyle, it does not matter

Lydia Fearn, Redington

Pensions Expert

How can schemes and employers influence the quality of DC offerings?

Keith Stephenson

It is incumbent upon employers to assess the performance of their DC provider, because we have made that choice for our members of staff.

If that provider is falling behind in terms of investment performance or in terms of service quality – my colleagues were constantly complaining that they could not get any information out of the provider, for example – the employer would have a duty of care to make alternative arrangements.

I am not sure how often that happens, how easy it is, or what happens to the investments from the first four or five years. This is probably the early stages of an evolving industry, so we will see what happens. However, it is a review process we ought to undertake, as a responsible employer.

Pensions Expert

How do lifestyle and target date funds fit into default structures?

Fearn 

Defaults need to manage risk for a member through retirement. Whether that is through target date or through lifestyle, it does not matter.

Todd 

I disagree. TDFs give you more control over the asset allocation at different times. The danger with lifestyling is, by doing a ‘set and forget’, you may be derisking at precisely the wrong moment in an economic cycle, so if you are moving out of growth assets just after a big crash, you are locking in those losses. It is really, really difficult to change a lifestyle glidepath because it is all individualised, and that is a very expensive thing, to write out to members to change.

It is also really inefficient in terms of the trading costs and the transaction drag. In our scheme, you would have millions of individual trades taking place as each individual derisks at a different time. Each of those has a drag on performance because you are selling.

The advantage we have with the TDFs, and also because we will be cash flow positive for a long time, is we do not actually have to trade in the markets at all. As we derisk some people, there are younger people coming in who want to buy those risky assets. We therefore create an internal market in which our transaction costs are massively reduced.

Fearn

I agree with all the things you said about what TDFs do. However, you can do that within a lifestyle as well – just in a slightly different way. You can still change it, you can still white-label it. You can derisk in different places, you can do analysis, you can still have active oversight over the strategy.

The way Nest has structured it with the bank has given you quite good control over the different TDFs and the underlying investment strategy. However, for large schemes with a glidepath, they can do all that as well.

Stephenson 

That little exchange between two experts, a slight disagreement about which type of fund works better, leaves my colleagues back at the Association of Commonwealth Universities with their DC scheme way behind, thinking, ‘Well, what sort of fund do I want, let alone which one shall I choose?’

I think it again just illustrates the difficulty that individuals have, even when guidance and expert advice is provided. They are still left scratching their heads, saying, ‘Well, whose vocabulary do I adopt?’ That is, I think, what leaves them sort of shrugging.