The problem with equities
This has myriad implications for the DC industry. The most obvious is its impact on investment strategy. If price becomes the key metric used to gain market share then schemes will have to use the lowest cost investments.
Passive equities are among the cheapest investment solutions giving scheme providers access to equity markets for just a few basis points. While they are an efficient way to gain exposure, they can, in certain market conditions, be high risk.
Invesco defined contribution strategist Elena Zhmurova says: “Market-cap weighted indices can be over-concentrated in certain geographies and sectors.”
These indices also tend to have high exposure to those parts of the market which are overvalued, potentially leading to sharp losses when the market corrects.
“A portfolio which is over-reliant on equities feels like a late-economic cycle strategy,” Byrne says. It’s easy to feel comfortable being invested in equities when this asset class has performed so well for many years. Byrne adds that bull markets do not last forever.
“Just because it has been a long time since the last crisis doesn’t mean there isn’t another one coming along and members should be protected from that downturn.”
Nazarova-Doyle agrees: “I feel people have really short memories. It’s almost as if the global financial crisis didn’t happen.”
A scheme which has an over-reliance on passive equities could see the value of pension pots fall sharply in a market correction.
Zhmurova says: “If their portfolios have a high exposure to passive equity, we will need to see how members react to the next market correction.”
A multi-asset approach
Given the strength of loss aversion, this could easily undermine scheme members’ faith in auto-enrolment and might result in large scale opt-outs. Even if members are not spooked by a significant market correction, performance could be compromised.
Fawcett says: “Standard Life Aberdeen recently published an article showing a portfolio with lower volatility tends to deliver more consistent outcomes.”
This reflects Nest’s investment philosophy. “We argue a multiasset fund which manages risks through the economic cycle is likely to deliver better outcomes for members with greater predictability than equities alone,” Fawcett says.
To that end Nest uses a variety of equity, credit and bond strategies as well as a property investment. “We are looking to add commodities and private markets to the mix,” Fawcett says.
The key to achieving this investment nirvana while maintaining cost-constraints is to view it as a fee in your budget.
Byrne says: “It’s about using those charges to make the most difference for members and we think it’s worth paying for some additional diversification and active asset allocation.”
People’s Pension chief investment officer Nico Aspinall agrees: “For our members, cost is a particularly important dynamic and that means we have to work hard to deliver a good outcome within our budget.”
But just because costs are constrained does not mean price should be the only consideration.
“Active management is a potential part of the armoury which could be used sparingly to achieve good member outcomes,” Aspinall says.
Zhmurova adds: “Modern portfolio techniques allow schemes to use strategies like factor investing or alternative indexation which could have a better risk-return profile than passive market-cap weighted equities in a cost effective manner.”
The scale solution
Scale helps a provider to deliver high quality at low cost. In Australia, which has a more mature defined contribution industry, large funds deliver good performance at reasonable prices while smaller providers do not provide good value.
“If you want to drive down costs for members without sacrificing value then scale is an important part of the equation,” Fawcett says.
There are, however, reasons to be positive. Charlton says: “The requests for pitches we have received from schemes looking to move to a master trust have a greater emphasis on value to members rather than just cost.”
But this trend is more likely to be found among companies which have a paternalistic attitude and understand the role and importance of the pension scheme to its employees. The danger is those members who are not members of well-governed funds will not receive good value. Over time, however, the emphasis will switch away from cost to value.
Charlton says: “But it might take a fall in the value of equity markets for members and trustees to question whether cost should be such an important consideration.”
There is already evidence more sophisticated investment strategies will be better placed to weather any potential storms.
“In the recent February downturn, the more expensive multi-asset strategies outperformed their cheaper rivals,” Nazarova-Doyle says.
Fawcett says change will come when either employers or trustees look to select a high quality scheme at a sensible price. As defined contribution schemes become more sizeable and assets in defined benefit schemes dwindle, companies and scheme members will pay greater attention to ensuring current employees have a high quality scheme which gives them the best possible retirement, he adds.
But it is possible to move the debate on from cost alone and towards a discussion about value and quality.
Zhmurova says: “Looking at whether a scheme has produced a successful outcome for a member is achieved by examining whether the growth generated is enough to provide sufficient retirement savings.”
