How are DGFs being used in DC?

Naomi L’Estrange: One area where I have had concern is around the use of DGFs as the default across the board. Clearly there are pretty substantial charges being paid. And for your younger members, who can wear that volatility, why are you reducing the volatility?

Shuntao Li: Exactly.

Neil McPherson: And they should wear the volatility, I agree.

The inertia out there is absolutely enormous

Naomi L'Estrange

Percival Stanion: It is a behavioural thing. At my last house we did some surveys of how often people looked at their DC scheme, and it was very irregularly. Often they would make the decision at first sign-up as to what they were going to buy and then they would only look at it once every five years, or if there had been a crash. And that often would trigger a cessation of contributions.

So if they had happened to select, say, a passive equity product – by far the most sensible thing if you take the 50-year view and you are a young saver – if they then experienced, X years afterwards, some big drop in value, they would, unfortunately, cease to make contributions. That is entirely human psychology.

Pensions Expert: How are factors such as the charge cap and daily pricing limiting DGF investing within DC?

Murray Taylor: There are two levels in DGF funds these days. You have your ones that evolved in the mid-noughties and you’re typically carrying expenses of anything between 70 and 100 basis points, although some fund managers in this space have been trimming fees to be more competitive. There are also a number of fund managers which have come out with secondary funds focused on the DC market, which are 40–50 basis points, maybe even a little bit less, in order to fit within the 75 basis points market cap.

In terms of liquidity, the vast majority of DGFs I do see are daily priced, there are a few exceptions that are weekly priced, so from that perspective I do not see the deal cycle being too much of an issue.

McPherson: The problem is having to have daily pricing on funds used for DC, so you are paying for a liquidity which you do not need. You do not need, and arguably you should not allow, daily activity.

Taylor: In terms of the role of DGFs and the points that Percival is making around the pure investor mentality of not wanting to put them off in their early years, that is a view I share.

So members could be in some sort of low volatility strategy, perhaps in their twenties and then in their thirties, and then they could be re-engineered back into a more equity-orientated strategy to then come back into multi-asset-type products as they approach retirement, perhaps even through a drawdown phase as well for members with larger pots.

Li: The other thing the daily liquidity affects is that you are foregoing the illiquidity premium. A lot of DGFs that could originally tap into alternative asset classes can no longer do that under the charge cap and daily pricing limit. They have to revert to a watered-down version, which begs the question, ‘Is it worth doing it this way?’ You may as well just invest in a low-cost multi-asset fund that bolts together passive equity and passive bonds.

Taylor: When you look at it from two perspectives – one, the so-called watered-down DGF, the other, combining the traditional DGF manager with some sort of passive equities in order to bring down the costs – the risk of the combined product is actually a little bit higher than the DC-friendly products. So we have been slightly reluctant to go down that route as a result.

A lot of DGFs that could originally tap into alternative asset classes can no longer do that under the charge cap and daily pricing limit

Shuntao Li, Barnett Waddingham

McPherson: One of your competitors did research that I saw recently on their DC portal. They did it by age cohort and proximity to retirement and it just flatlined, one entry a year, which is probably when they log on and register first off, until it gets to within two or three years to retirement and then it goes steeply up to four or five log-ins per year. So that decision is not being taken until it is too late, if a decision is being taken at all.

L’Estrange: The inertia out there is absolutely enormous.

McPherson: And DGFs can help because you have an active DGF manager who is tactically allocating assets within the fund to harness returns. They can do it far better than a lay DC member, or a lay trustee or even a professional trustee. That’s their job.

I do have an issue with fees though. The biggest element of fees for any fund manager is staff costs. There is technology, there is compliance, there are many other costs. But staff cost is the key element, so it is profit margin that goes to staff, which is the major cost component. That is the thing across the industry maintaining fees at a high level.

Li: Do you think there is a place for low-cost DGFs in DC pension schemes?

McPherson: It depends what you compromise in getting the DGF-light that you are getting.

L’Estrange: Yes, if you end up getting one of your old-fashioned balanced funds that is tracking the market but is charging you a lot more.

McPherson: Is there fee pressure on DGFs?

Stanion: Definitely, but we are not particularly in DC. We do see fee pressure across the industry. I think what will inevitably make it grow is that the structure of returns is going to fall.

And when an investor looks at a fund that has produced X per cent over a period of five, 10 years, and they realise the manager has taken, through fees, half or sometimes more than half of the returns generated by the underlying assets, then that leads to intense anger.

I expect what will increasingly happen is that trustees or investment consultants will look at the likely structure of returns and say, ‘Look, we are not going to give the manager more than X per cent of that, if they have done a good job.’

That is how it will be looked at, not, ‘The manager is just going to take 75, 100, basis points’.

Some of the fees on bonds are just insane if you think what the future return over five to 10 years is likely to be. The managers will be taking everything, certainly in the retail sector.