What does value for money in a DC default look like?

Our recent survey of mastertrust providers revealed a wide range of approaches used as the default investment strategy. The level of risk taken at each stage of the default strategy also varied considerably across the market.

Trustees of both mastertrusts and single-trust occupational schemes will be starting to complete their second chair’s statements.

Focusing on short-term risk mitigation, and therefore not taking enough risk when a member is young, could impact final outcomes at retirement by up to 25 per cent

The independent governance committees of each of the main providers will be updating members on the progress they have made towards improving the value for money of contract-based schemes.

So how can they judge whether default strategies meet their objectives?

Young members can take risk

A proper assessment of value should be not only about cost, and must be rooted in consideration of member outcomes.

Generating sufficient investment returns in a member’s early career is vital to them achieving a good outcome at retirement. During this growth phase the majority of our clients have default strategies invested entirely in equities.

At this point, not only are fund values relatively low but members have the ability to take risk. Short-term fluctuations in performance at this stage have very little, if any, impact on final fund sizes at retirement.

Market falls can actually be good for members at this stage as, by way of pound cost averaging, they will buy into units cheaply.

Passive equities aren’t the only option

Until recently, our focus in the growth stage has been largely on delivering value through the use of passively managed global equities in default strategies – giving high expected returns at a low cost.

However, the industry’s attention is now turning to alternative strategies that could provide a better risk-adjusted return, such as factor-based investment, more specialist areas such as emerging markets, and small cap equities or alternative investments.

In all cases, regardless of strategy, it is important to retain a focus on generating growth significantly above inflation for the majority of a member’s career. In terms of value, equity returns can be delivered cheaply and efficiently.

Despite this, some mastertrust and contract-based default strategies are holding up to 40 per cent in bonds in the growth phase while many single trust schemes hold 50 per cent in expensive diversified growth funds from the start of the growth phase.

Our own analysis revealed that focusing on short-term risk mitigation, and therefore not taking enough risk when a member is young, could impact final outcomes at retirement by up to 25 per cent.

In this case, diversification and risk mitigation comes at a high absolute and opportunity cost.

Higher fees are sometimes necessary

Downside risk does matter in what we describe as the ‘consolidation phase’.

This is when pot sizes are larger and it takes members many years of contributions to recover any significant market losses. At this point, it makes sense to pay for some form of capital protection – but retaining the potential to continue generating returns of 2 or 3 per cent above the consumer price index.

Traditionally DGFs have been used to achieve this, but they are generally expensive and while they have largely delivered on their promise of low volatility, this has often been at the cost of low returns.

Additionally, DC schemes generally can’t access those funds with a greater focus on absolute return in meaningful quantities, due to their high costs.

To deliver more value in this area, schemes could potentially use a more static portfolio, with a mix of traditional and alternative asset classes, which is rebalanced regularly.

This can prove to be more cost-effective, potentially deliver better outcomes for members, and provide better overall value for money.

Should you average costs between age groups?

It is also important to be aware of the charge cap, which can constrain investment choice at a critical time in a member’s glidepath. Target date funds can potentially get round this issue by spreading the cost across the lifetime of a strategy.

However, not all trustees are comfortable with the idea of younger members paying more than they would otherwise have done to deliver a better solution for older workers.

Cost will always be a driver of value for money. But fiduciaries’ attention should primarily be on net outcomes rather than simply finding the lowest cost solution.

Rona Train is a partner at consultancy Hymans Robertson