What schemes can do to drive value for members

“The issue with defaults is covering a range of member circumstances,” says Donald Duval, a senior partner with consultancy firm Aon. Those up to the age of 45 or 50 are seeking good returns for the long term, and logically they should not care about equity volatility, but people will still worry.

Duval says the best thing any default fund can do is to offer its members the best it can achieve within its means, rather than minimising costs so the low fee offsets the fears members have with volatility.

“It is best not to patronise them and have them in a suboptimal solution in case you or the markets do something silly,” he says. “You need to tell them we will do the best we can, but prices can go down as well as up.”

This matters, Duval says, because the best long-term returns will come from an equity portfolio. Whether that is global or domestic is less important than the strategy itself, he notes, adding that more focus needs to be placed on the journey’s end – retirement – as members’ circumstances can vary significantly.

Default – your flexible friend

The first step in determining your strategy must be understanding what you are trying to do and for who, says Paul Todd, director of investment development and delivery at mastertrust Nest.

Flexibility is key to Todd’s approach and goes deeper than the desire for diversification, to what he says are “real diversifiers” across assets, regions, and management styles. This cannot be achieved with an overlay, but requires a deep understanding of asset allocation and risk management across each market or regime.

“Everything we’ve seen in the pensions landscape suggests that… the landscape will remain static for some time,” says Todd. “The structures you build need to reflect that reality.”

The need to build a highly adaptable structure for the long-term has encouraged Nest to look closely at illiquid assets, such as private debt, and to consider implementation of environmental, social and governance elements, which are fast gaining ground in the institutional space.

“Our investment into a climate-related fund is less about future-proofing and more about recognising there are many more risks to manage and opportunities to follow,” says Todd, following the lead of DB and sovereign wealth funds that have been looking at carbon and broader risks rather than markets and inflation.

Independent investment adviser Michael Deakin would like to see greater amounts of alternatives used in DC, but not every scheme has the scale and internal resource to do this, and the issues of cost and liquidity remain considerable obstacles to those managing default funds.

Most of his clients choose to keep costs low for members, and one client has elected to minimise volatility, so that new members do not enter into an all-equity portfolio from day one.

“As a diversified fund of equities and bonds, it’s not actively managed and comes in at 25 to 30 basis points,” says Deakin. “It’s a bit different and offers a smoother return profile than equities.”

Scale remains important, as larger schemes get discounts on fees, but he says very few schemes will have the size to demand serious reductions until they have £50m to £100m in a single asset class.

That said, efficient negotiation can drive down fees, and this has happened on a number of occasions, largely due to increased competitive pressure in the DC market.

The only way is ethics?

On the matter of ESG, Deakin has been encouraged by developments over the past year, where managers seek to deliver a component that is both appropriate and affordable for a default fund.

However, he questions whether the addition of an ESG component is a good idea right now. Those who believe in ESG should have a greater allocation, and if they believe it makes a difference to returns, ESG might logically need to be a core element.

It is a conundrum, admits Deakin, and says he usually asks clients whether an uneasy or difficult splicing in of ESG is the right thing to do now.

“There are a range of passive approaches and I have debated this with schemes I work with,” says Deakin. “If you’re going to use a fund with a carbon tilt, is that really the best way to approach ESG? Because in a very short time, we may see better second-generation products that move beyond carbon risk alone.”

Ultimately, what will make the biggest difference to member outcomes is how much members pay in, rather than the finer details of the default, says Deakin.

Andy Cheseldine, a client director at professional trustee company Capital Cranfield, broadly agrees with Deakin’s assessment, as a typical DC scheme will have about 25 basis points for investment, and the biggest driver of return will be asset allocation.

But there are plenty of other factors to consider. If trustees cannot justify active stock-picking, they could choose an 80/20 approach that excludes things a scheme does not wish to invest in.

Much of ESG is currently focused on the financial performance of stocks, so avoid investing in stocks or countries where poor governance is prevalent, advises Cheseldine.

Replace disclosure with engagement

Most people get the big things, like asset allocation, right, says Cheseldine, so the best most DC default funds can do is to look after the small things.

“Look for efficiencies that save one or two basis points a year. You may find five or six areas that account for 10 to 12 basis points a year, which over 50 years adds up to a lot of money.”

Do not be afraid to exploit inertia, says Cheseldine, pointing to the success of auto-enrolment, default investments and Save More Tomorrow campaigns.

Like Deakin, he says the biggest difference can come from engagement, but adds that most of what is done is not much more than disclosure, offering little insight into a member’s individual circumstances – which Duval identified as a key component to good member outcomes.

But things are improving. “We are getting much better at segmentation and applying different media to different groups,” says Cheseldine, pointing to the use of personalised videos, which are having considerable impact at a fraction of the cost of producing written documents “that no-one reads”.

Brian Henderson, a partner at consultancy Mercer and its leader in DC and financial wellness, outlined the success his clients have had with targeted video messages.

The latest figures show that of the 5,000 who have been sent these messages, the view rate is 63 per cent, compared with between 3 per cent and 5 per cent who will read a handout.

“Overall, 32 per cent increased their contributions, but more than half – 52 per cent – had watched their videos,” says Henderson, encouraged by this success. “That’s a big number.”