(July 15, 2013) — Investment of defined contribution (DC) funds is fast becoming the key concern for fund managers, but in the UK, a divergence of how that money is being managed has erupted.
British DC funds are either looked after by trustees, or managed by third parties in a contract-based arrangement.
Typically, trustee-run DC funds pick up where they left off with defined benefit, managing a governance framework and monitoring fund managers to ensure members get the best possible outcome.
But with contract-based arrangements, the governance can be less obvious. Even where governance committees have been set up to mirror trustee work, there are question marks over whether they possess any teeth.
Increasingly, a binary approach to how DC funds are invested has arisen: in trust-based arrangements, the majority have abandoned traditional passive-only strategies for more dynamic options, such as a diversified growth funds, using a multi-asset approach, or both.
But contract-based DCs are lagging behind, preferring to remain in the passive equity bucket. Why? Because it’s cheaper. At least, that’s the view of several consultants and fund managers aiCIO spoke to.
“As if there weren’t enough gaps already between contract-based and trust-based DC schemes in the UK, we are witnessing an additional gap developing: the Investment Ideas Gap,” said Peter Ball, head of investment at consultants JLT.
“We are glad to see that a growing understanding of investment products that are better aligned to members’ interests has led many trust-based DC plans to change the growth phase of the default option to a diversified growth fund (DGF) from a passive global equity fund.
“This is despite the investment costs being maybe 75bps for DGF, compared to around 10bps to 15bps for the current passive default. However, in contract-based schemes there remains a very clear focus on keeping costs to an absolute minimum.”
While fees are an important consideration, and it is right for the industry to continue pressurising fund managers to keep them in line, using price as the sole starting point for devising an investment strategy is wrong, Ball continued.
“The pensions industry should be aware of this dual direction that DC is taking and that there is a need for all types of scheme to be on the same trajectory–towards the best outcomes for members,” he said.
“There should surely be common trends and I worry that there is too much of a divergence without good cause.”
Design Fault? Or Wilful Ignorance?
Ball is not alone in his concerns. Annabel Duncan, a DC associate at JP Morgan Asset Management (which aiCIO should mention is Ball’s former place of employment) warned: “The cheap argument is winning out, and has been for the last six to 12 months.”
Duncan added that the platforms on which contract-based arrangements are run are possibly to blame for the reluctance to move away from cheap, daily dealt passive equities.
“The daily pricing and liquidity drive comes from the platforms and their need to keep the status quo for their record keeping,” she said.
“But we need to look at the extended asset classes and alternatives too. Asset managers have been clamouring to put those into DC.”
This pressure to keep UK DC investments liquid, and therefore typically passive, has not come from any regulation: it’s a rule UK DC pension funds have put upon themselves.
As touched on by the Defined Contribution Investment Forum recently, there is a historical belief that members like being able to see their pot size’s actual value, want their assets to be realised quickly, and want to be able to switch out-of-market exposure fast; but the truth is very different.
“The reality is DC members don’t check their balance every day, and it would make no sense for them to do so,” continued Duncan.
“There’s a sense that it should be as accessible as a bank account, when actually members don’t need that. They don’t retire on day one, and need access to all of their savings on day two.”
State Street Global Advisors’ head of DC Nigel Aston was more concerned that the downward pressure on fees, which affects both trustee and contract-based arrangements, could ultimately lead to constraints on innovation.
While it’s true that charges have been too high for some default funds that did not deliver what they promised, Aston believes a balance is needed between the three things at the heart of designing a DC default fund: risk, return, and cost.
“This tension has, to date, led scheme fiduciaries to an almost binary choice between low cost passive and what have been seen as more effective, actively managed DGFs,” Aston said.
“However, I sense that schemes and consultants are losing faith with these expensive products and are seeking a third way; new solutions blending the best of active and passive that maintain the advantages of rotation and diversification (that deliver the bulk of a portfolio’s performance) without the excessive cost of active stock-picking.
“These funds, which apply a sophisticated and systematic active overlay to a broad set of good value index building blocks, may offer schemes and their members an attractive middle ground.”
This third way was a common theme with many of the experts aiCIO spoke to. Passive equity funds needn’t necessarily deliver worse results than DGFs, but they are likely to produce a more volatile result, Richard Butcher, managing director of Pitman Trustees, said.
“Contract-based schemes tend to freeze in time. A structure is set and, as a result of the passivity of the majority of its members, it never changes.
“Passive equity funds were the future a few years ago, now they’re the past, but they still widely prevail. This is the difference between a well governed scheme where they are robust and proactive, and a poorly governed scheme were they aren’t.”
This third way was a common theme with many of the experts aiCIO spoke to. Passive equity funds needn’t necessarily deliver worse results than DGFs, but they are likely to produce a more volatile result, Richard Butcher, managing director of Pitman Trustees, said.
“Contract-based schemes tend to freeze in time. A structure is set and, as a result of the passivity of the majority of its members, it never changes.
“Passive equity funds were the future a few years ago, now they’re the past, but they still widely prevail. This is the difference between a well governed scheme where they are robust and proactive, and a poorly governed scheme were they aren’t.”
An Issue of Trust
Andy Cheseldine, a partner at consultants LCP, believed the split between trustee-based funds’ and contract-based funds’ investment strategy could be caused by how trustworthy each system perceives themselves to be in the eye of the plan sponsor.
“Let’s say a trust-based DC and a group personal pension (GPP)–a typical contract-based operation– both start with the same default lifestyle design of passive global equities with some DGF exposure to limit volatility,” he began.
“Both trustees and GPP managers decide it’s a good idea to add 10% exposure to emerging market equities to add diversification without reducing expected growth. Our experience is the trustees are more likely to make that change, whereas the GPP manager is often concerned it will be perceived as only making a change to increase its fee income.
“Contract-based managers typically have more hoops to jump through from a Financial Conduct Authority compliance perspective too.”
An interesting phenomenon that’s arisen from aiCIO‘s conversations is the belief that larger employers with contract-based arrangements have better governance structures in place, meaning the one-and-done attitude of placing everything in passive equities isn’t adopted.
Dan Smith, director of DC business development at Fidelity DC and Workplace Savings, said he didn’t see any difference in the investment strategies between trust and contract plans at the large plan sponsor end of the spectrum.
“This is because these clients have access to advisers, who will help with investment advice regardless of which type of plan an employer puts in place,” he said. “The issue of passive global equity versus more diversified strategies is one of timing rather than trust or contract.
“Up until three or four years ago, most new plans were set up with passive equity defaults. Following the volatility over the last few years, there has been a move to more multi-asset solutions using some kind of dynamic asset allocation.
“Naturally these newer investment strategies cost more and the challenge for clients who have a passive default in place is how to replace this and tell their employees that their pension costs will increase.”
Here’s the real crux of the issue. While it’s an overstatement to say all passive equity funds are bad, and that you need actively managed funds to get returns, there is logic behind choosing a fund that is properly diversified and has lower volatility–even if it costs more money.
Plan sponsors and CIOs’ mantra should be, “How do I get the best outcome for my member first?”–but the best outcomes are not usually the cheapest ones, as Brian Henderson, UK DC and savings leader at Mercer, explained.
“If you focus on being low-cost first, you’ll end up with what the Australians are now facing: members just look at the past performance of managers and the charges before picking funds, which isn’t what delivers outcomes,” he said.
“The worry is that potentially you get this polarised effect where the management of issues such as monitoring the fund managers, negotiating terms and other governance concerns, don’t get done or fall to those who have an invested interest. Getting the right outcome is a price worth paying for.”
As a final thought, Henderson pointed to a recent paper from the European Insurance and Occupational Pensions Authority, which quizzed DC members about what their biggest concerns were about their pension pots.
Were they worried about excessive fees? Not really. In fact, charges were listed eighth on a list of 10 things they were most concerned about, below getting the contribution level right (a far bigger factor in determining the overall pot size at retirement), making sure they had the right level of understanding, the investment decisions, the provision of all necessary information, the structure of the default fund, product development, and mis-selling.
So if members are more concerned about getting the investment strategy right than the fees they’ll be paying, why aren’t contract-based DCs?