What is the number one thing members want from their defined contribution (DC) pension scheme?
The number one has to be strong long-term investment returns that are going to give members a bigger pension when they come to retire. There is a lot of talk in the industry about tools, engagement techniques, technology and other soft factors. These are important, but investment performance will have the biggest impact on the pension that members actually receive.
The importance of investment performance cannot be overstated: Over the last five years most DC savers have made more from investment performance than they have from tax relief. With an investment horizon stretching into decades, a 1 per cent difference in performance annually can make a massive difference to a pension saver’s retirement pot, increasing it by almost 50 per cent over a 40 year time span.
How can schemes maximise investment performance?
By getting the right blend of assets in the scheme’s default fund. For younger savers, with a long investment horizon, that means an equity-based strategy.
Our approach is to look at the target return investors would need to see in order to achieve retirement income in line with the Pensions & Lifetime Savings Association’s retirement living standards. For each cohort of members we identify a target return needed to achieve that, and then develop the strategic asset allocation to reflect this target return. That leads to a growth focus for the younger members, which means a high level of exposure to equities.
Why aren’t all DC providers following a high equity approach for younger savers?
Some pension professionals argue that DC scheme members cannot handle the volatility that comes with equities, and fear they could become discouraged from saving when markets fall.
This is a myth – we have not seen any evidence of this kind of behavioural response. Our recent member survey, which we carried out after March 2020’s market fall, found only 7 per cent of members had even looked at their fund valuations. They were right not to be worried – short-term volatility has no significant impact on long-term returns and the rebound was fast.
More cautious providers attempt to reduce the impact of market volatility by investing some of the default fund in bonds. But market data shows that over periods of 30 years, bonds have never outperformed equities. So all this cautious strategy achieves is guaranteeing the member will miss out on necessary investment growth.
What has the pandemic crash taught us about default fund investments?
All strategies fell in March 2020, but interestingly, even supposedly safer strategies with high bond allocations fell by double digit figures. The bounce-back was rapid and strong and 2020 actually turned out to be quite a good year overall. Well-structured defaults were also helped by overseas currency exposure. When markets fall, investors tend to flock to safer currencies, giving a natural hedge against the fall.
What other factors are holding investors back from enjoying strong long-term returns?
Some employees are missing out because their employer’s scheme was chosen on the basis of price rather than quality. Unfortunately, too many people in the pensions industry are overly focused on charges, often to the detriment of performance. Decisions over which provider to use are sometimes made on a single basis point charge difference, when there can actually be a 50 basis point difference in performance between providers.
What innovations can we expect in the design of DC pensions?
In future we can expect more personalisation, with investment strategies better tailored to the specific needs of the individual.
As the focus on environmental, social and governance (ESG) factors increases, we may also see active asset managers better placed to manage some of these trends than passive index funds. We also expect more investments in illiquid assets.
What role will ESG factors play in DC pensions?
ESG is important for managing long-term risks such as climate change, and will ensure members’ assets are not stranded in assets that don not have a place in the economy of the future. But not all ESG approaches are born equal, and care is needed to look under the bonnet to see what they actually do and whether they add real value.
‘Impact investing’ goes beyond ESG, and refers to investing in companies that not only have strong ESG characteristics, but also actually do something positive to make the world a better place – for example, in relation to the environment, healthcare or education.
Aon has recently launched its Global Impact Fund, which is available as a self-selection option for members. We have allocated 10 per cent of our active default fund to it.
This encapsulates everything we believe about responsible investing – the dual objective of achieving both great investment returns and making a positive impact on the world.
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