Finding common ground between providers and intermediaries on UK defined contribution (DC) default fund approaches is a tricky business.
In the first camp, there are those who say long investment time horizons dictate that a static approach is necessary. Proponents of a static approach say that short-term volatility and market A movements can be ignored, adding that the traditional lifestyle glidepath is, by its very nature, static – meaning that it is impossible to manage this tactically.
In the second camp, there are those who say that default funds need to be closely supervised, offering a degree of dynamism to respond to shifting market conditions and to ultimately provide a smoother journey for scheme members.
Most agree that there is some validity in both approaches. As a result, strategic approaches – which offer elements of a longer-term asset allocation with a tactical overlay – are becoming increasingly popular, according to consultants and providers.
Julian Lyne, chief commercial officer at Newton Investment Management is among those industry figures making a case for “a combination of both” approaches.
“Default funds need to be flexible to the individual via their structure, but fund management solutions used within those structures – be they active, passive, equity or bonds – also need to be tactical and able to respond to market dynamics,” he explains.
“A fund’s allocation to growth assets will likely be consistent up until a certain age, but then the default fund needs to support a range of journeys depending on the individual, leading up to and through their retirement.”
Some say that the default fund should always be kept under scrutiny to ensure that it constantly reflects the regulatory, corporate and membership profile.
“It should not be necessary to change the structure of the default on a very regular basis, but considered strategy changes should be implemented over time,” says Lydia Fearn, head of DC and financial wellbeing at Redington.
“If new information comes to light, such as a merger, new member or regulation changes, then the default may need a complete upheaval. In terms of the underlying funds, some may well have a static asset allocation and others may be more active.
“The governance around those funds should reflect what they are, how much they cost and how they impact member outcomes.”
In recent years, as DC funds have become more sophisticated, it has become fashionable to employ a tactical overlay, allowing adjustments to asset allocation in ight of market movements. Some employ a fund manager to do this on their behalf, while others control these changes through their chief investment officer or investment committees.
Dom Byrne, director of BlackRock’s Multi-Asset Strategies Group, says schemes opting for multi-asset or diversified growth funds for their tactical asset allocation may see manager selection as critical, but they also should think more broadly.
“There are other critical considerations to be taken into account such as the long-term sensitivity to interest rates or equities, and the use of leverage or derivatives strategies to generate returns,” he explains.
Byrne argues that it is essential to consider when tactical asset allocation strategies are necessary and then closely examine their objectives. As an example, he cites tactical asset allocation strategies that look to dampen risk but may be less compelling at the early accumulation phase.
At the same time, expert opinion on tactical “best practice” has changed considerably over the past 10 years.
A decade ago, there was a focus on maintaining balanced funds of equities and bonds, with tactical views applied through physical assets or futures. But, in the immediate years following the financial crisis, investors embraced complexity, using derivatives to access a wider range of risks and diversify still further.
More recently, however, some nvestors have become disappointed with the performance of some of these more complex solutions.
Understanding the science
Outcomes in DC default funds vary considerably, as evidenced in a Punter Southall Aspire report in 2019. However, the approaches adopted by DC funds are primarily driven by three schools of thought, according to consultants at LCP:
1) Objective-focused approach A default that allocates to one or more asset classes from the outset. Over time, it derisks into a pre-set allocation of assets to meet a retirement objective, such as ncome drawdown, a whole cash ump sum or an annuity purchase. HSBC Bank’s UK DC scheme is structured to do this, with members given an option as to which path they take.
2) Catch-all approach A default that doesn’t target one particular retirement objective and invests in the same asset mix from start to finish. This default may still de-risk but the ultimate asset allocation at retirement will be the same regardless of the retirement objective.
3) Risk-driven approachA default that offers several portfolios, determined by its risk/ return profile. Members are invested and moved between portfolios based on whether they should take more, or less, risk. This decision is based on factors relating to the member’s current pension savings position and future assumptions.
Harry Green, a senior consultant at LCP, says his personal preference is for the so-called “catch-all” approach, but he stresses the need for corporate advisers to pay close attention to the priorities.
“The key question to ask is what is this trying to achieve in terms of future returns and risk levels,” he says. “My key concern is that defaults, however they’re designed, are far too risk averse. I would ask everyone to question if their default is taking enough risk to get even a reasonable outcome in retirement.”
Alistair Byrne, head of EMEA pensions and retirement strategy at State Street Global Advisors (SSGA), agrees that there should be a “strong foundation of research” looking at member needs such as when they are likely to retire, their risk threshold, and how will they access their savings in retirement.
“Most lifecycle approaches – knowingly or not – are underpinned by human capital theory,” he says. “Essentially, that younger workers can take more investment risk as they can offset any investment losses by saving more from future earnings.
“Those closer to retirement have more savings but less future employment income, so should take less investment risk. But, the most fundamental theory for default strategies is that they should be diversified to help reduce market risk.”
The future of default
As the DC market evolves in the wake of auto-enrolment and pension freedoms, advisers and consultants expect technology to play a bigger role, alongside the introduction of new asset classes. The charge cap of 75 basis points can be restrictive for some providers seeking to access more expensive illiquid asset classes. However, as master trusts grow in scale these investments are becoming more accessible, as Nest’s recent investments with BNP Paribas, Amundi and BlackRock demonstrate.
Better use of data and technology is expected to make default funds more personalised and flexible. Martin Dietz, head of diversified strategies at Legal & General Investment Management (LGIM), argues that investors in the future will likely still be allocated to “default-type funds”, but these will be able to reflect “any key features that make specific members unusual”. Increased member engagement will aid data gathering, he adds, helping providers identify individuals’ circumstances and risk tolerance.
However, SSGA’s Byrne warns: “Trustees will be wary of the risk that any personalisation approach produces poor outcomes for some people relative to others. And we need an approach that doesn’t rely on too much input from members – we know inertia is strong.”
The evolving market requires an evolving approach, without losing focus on the end pension savers who are becoming more reliant on default funds.
Understanding capital market assumptions
Capital market assumptions for default funds vary from provider to provider but are typically based on historical market data with other inputs applied.
However, as Newton’s Julian Lyne says, managers “need to be cognisant that they are assumptions and not precise or necessary able to forecast the future”.
“It’s less about capital assumptions being ‘safe’, but more about understanding what the inputs are and the likely reality that they will not always be 100% correct,” he says. SSGA uses medium and long-term forecasts for returns and risks, based on “a combination of economic theory and market valuations”, according to SSGA’s Alistair Byrne.