State of the nation: What's going on in DC accumulation?

These concerns may have been well placed. After all, there is nothing like the guarantees enjoyed by DB members should they choose to transfer their pot into defined contribution and strike out on their own. Decumulation is now a risky place in DC, with the previously dominant (if often oversold) option of an annuity now an also-ran alongside drawdown and cash lump sums.

If you think about accumulation in order to get the sort of pots people want you need growth. The only way you’ll really do that over the longer term is with a substantial allocation to equities

Alistair Byrne, SSGA

But for all the risks posed by a decumulation without guarantees, there is another, potentially far greater problem to contend with: what can be done to make sure people actually have a pot worth taking when they retire?

Investment growth is a crucial driver during accumulation.Alistair Byrne, senior DC strategist at investment manager State Street Global Advisors, says the way to significant DC pots is through equities.

“If you think about accumulation in order to get the sort of pots people want you need growth. The only way you’ll really do that over the longer term is with a substantial allocation to equities,” he says.

Investors should diversify widely across different countries, however, to dampen some of the volatility inherent in the asset class.

Alan Morahan, head of DC consulting at Punter Southall, says investors in the early stages of saving will be able to ride out the ups and downs of the equity markets.

“It’s all about the time invested; most commentators on funds will say equities will look volatile in the short term, but over the long term they’ve always outperformed other assets.”

However, some have taken an opposite approach to investment. State-sponsored mastertrust Nest puts members into what it calls the ‘foundation phase’ before they embark on the growth phase in earnest.

In a report explaining how its investment approach works, Nest says: “During our research younger savers told us that they may stop saving if they see falls in the value of their retirement pot. This is true even for a very short-term or one-off loss.”

We don’t want to scare the horses by putting them too much into equities for them to then see the value of the funds jump around all over the place

Alan Morahan, Punter Southall

Therefore, members joining in their early 20s typically spend between one and five years in the foundation phase, where they can see steady increases in their pot.

“Mathematical modelling shows that the impact on final outcomes is negligible for most members, but the impact of stopping saving could be much more harmful,” the report continues.

Morahan also says relying heavily on stock markets to increase pots could scare investors. “We don’t want to scare the horses by putting them too much into equities for them to then see the value of the funds jump around all over the place.”

James Monk, head of DC investment at consultancy Aon Hewitt, points out that other providers are also adopting a low-volatility approach in the early stages, but cautions it is not a proven advantage.

“They think it causes members to contribute more if they see stability. They don’t make any effort to try and monitor the effect of the engagement… I’ve yet to see anyone try and document the value-add it brings. Everyone has a different viewpoint.”

Avoiding a bumpy ride

Pressure on active management through the charge cap is a concern for some because of the threat it can pose to volatility management, but Ashish Kapur, director of institutional solutions Europe at fiduciary manager SEI, says managing volatility is often not necessary until people have accumulated a sizeable pot.

He says: “It is much more important in your mid-career when you’ve accumulated some money; when the amount of money in your pot is the same as your salary your risk appetite changes.”

Volatility management is a complex aspect of investment management, because although it could stop people leaving the scheme, it may also go unnoticed.

Alex Pocock, head of DC investment at consultancy Barnett Waddingham, says a lack of engagement often counterbalances a need for volatility management.

“Over recent volatility we haven’t seen people changing strategy en masse,” he said. “Why incur those kinds of costs?”

He adds that many members do not read their annual statements, so swings in the value of their pension pots could go unnoticed.

However, if there is a risk volatility will lead to opt-outs from the scheme, the price of volatility management is worth it, Pocock says.

“You do have to analyse your workforce and come up with something that’s appropriate.”

Once the decision to pay for volatility management has been taken, there are a number of options. Maria Nazarova-Doyle, head of DC investment consulting at JLT Employee Benefits, says some equity funds offer a trigger overlay at a comparatively low price.

“When volatility gets too high a certain amount of assets just get sold off into cash. It’s normally offered through a fund index,” she explains. “It’s a good way of doing it if you don’t want to pay for a [diversified growth fund].”

Similarly, Byrne says SSgA measures historic volatility and uses it to forecast future volatility, allowing it to move away from equities into lower-return assets when markets get too choppy.

“There’s a high amount of research to suggest volatility is persistent,” he says.

Diluted DGFs vs diet DGFs

Schemes have for some time looked to control volatility through the use of DGFs, but the introduction of the charge cap of 75 basis points for auto-enrolment default schemes has changed the face of the industry.

It has led to a change in the way DGFs are incorporated, says Pocock.

I’ve yet to see a compelling argument about why a low-cost DGF would be better

Alex Pocock, Barnett Waddingham

“We’re seeing a lot of DGF managers falling over themselves to sell a cut-down version of their flagship DGF product,” he says, arguing that this approach only leads to a “not-quite-our-best-ideas fund”.

He says people would be better off with a ‘full fat’ DGF and some passive equities.

Passive equities have come into favour with the introduction of the charge cap, he notes, as they cost far less than their actively managed counterparts.

Nazarova-Doyle says diluting DGFs with passive equity is the main direction of travel for schemes looking to comply with the charge cap. Some providers, she says, have tried to launch “cut-cost DC-friendly DGFs, but most of them didn’t have track records because they were created when the charge cap hit” and so had yet to take off.

Concerns remain among asset managers that the charge cap could yet fall further, creating greater challenges for active management.

Louise Farrand, executive director of the DC Investment Forum, says: “If the charge cap goes down to 0.5 per cent it will really limit active management… the combination of active and passive will be key.”

Balancing cost and outcome

The debate over value for money has been at the forefront of DC for some time now, most recently in the assessment of what constitutes value for money by the independent governance committees of contract-based schemes, which issued their first reports earlier this year.

The charge cap covers one aspect of this by preventing excessive cost, but Morahan says higher prices could be justified for additional diversification and downside protection.

“What they price is up for debate. My general feeling is it’s a trade-off worth paying if you can manage volatility,” he says.

Communication is key to ensuring value for money, Nazarova-Doyle says, as members should understand what they are paying for.

“There’s nothing free in life and you do need to pay a bit more if you want to get a good outcome,” she says. “Anything that’s not plain vanilla passively managed you will have to pay for.”

Illiquid assets and DC

Another solution to the need for growth could be found in illiquid assets. Infrastructure, property and other real assets have been increasingly popular among pension schemes for many years. The long investment horizons of young savers’ pots in particular could make them ideally suited to take advantage of illiquidity, but the need for daily liquidity in DC has stifled efforts.

Despite the challenges, Farrand says many parties are trying to solve the illiquidity problem.

She says: “In DC it’s not been cracked yet, but there are a lot of asset managers working on it. There are some challenges in terms of accessing that from an administrative point of view with platforms demanding daily pricing. There has to be a recognition of the benefits.”

However, she adds that some solutions are emerging, giving the example of a property fund that focuses on lot sizes that are smaller than the usual, and are therefore easier to sell.

Pocock says that alternatively, schemes can invest through a pooled fund or use a blended approach.

“It’s something that’s still in its infancy… [For] my money it’s something schemes should consider adding to a portfolio before they add a DGF,” he says.

However, Nazarova-Doyle says that pension scheme size heavily dictates whether illiquidity is a viable option: “It’s not something that’s particularly relevant to our clients as we have a small to medium-sized book. Most portfolios don’t allow anything that’s not daily traded.”

Some funds claim to hold illiquid assets, but the truth can be less simple, she adds.

“Most multi-asset funds say they have private equity and similar things, but when we look at them it’s actually liquid alternatives.”