Stock market volatility has sparked a rethink on de-risking defined contribution pension investments, says Ceri Jones
Many pension funds lost a large part of their value during last year’s tough economic conditions. The problem is that at least 80% of members of defined contribution (DC) pensions are in default funds, which were invested in equities more heavily than they may have realised.
Most default funds in DC plans are based on the lifestyling concept, where a member’s assets are moved progressively out of equities and into safer government bonds and cash as the individual nears retirement. This is to prevent people who are about to retire from losing a large portion of their savings in a stock market crash. But it does not stop those who are not near retirement from losing their money.
One response to the volatility of stock markets in recent years has been to develop more actively managed multi-asset investment strategies that do not depend solely on equity prices.
There is also a trend to tactically manage asset allocation to improve returns. Brian Henderson, principal at Mercer, says: “The wrong thing to do last year was to go out of equities and into cash, because equity markets have since come roaring back. But it is hard for members to guess what to do. Somebody else may well manage their assets better. For most schemes, this means reviewing the lifestyle fund, where the de-risking process will be static and mechanistic.”
One group of multi-asset investments that are taking off are diversified growth funds and absolute return funds offered by groups such as BlackRock, JPMorgan, Schroder and Standard Life Investments. The aim of these funds is to avoid over-reliance on equities and to invest in a broad spread of assets, such as property, private equity and hedge funds, using the full unconstrained skillset of the investment manager. The idea is that if one asset class falls, another will hold steady and so the fund will not plummet.
Most of these funds are just coming into a three-year track record, so consultants are more prepared to recommend them. Hamish Wilson of the HamishWilson consultancy, says: “You need to ally absolute return funds with income drawdown. Unlike lifestyle funds that end up in bonds and so correspond to the price of buying an annuity, which is itself based on bond prices, these funds are geared to Libor [London interbank offered rate] plus, so they do not respond to changes in the annuity costs, and an investor might need to use a drawdown strategy until it makes sense to take an annuity at a later stage.”
Product providers are being innovative by trying to design features that deal with volatility. For example, in February, US provider AllianceBernstein announced it was adding a volatility management facility to its target date funds by switching 20% of its portfolios to a component that would invest in a mix of equities and real estate investment trusts in normal markets, but would also be able to shift into bonds and cash when appropriate to reduce risk.
Consultants help monitoring
Another trend is for trustees, perhaps from an organisation’s old final salary plan or a bespoke investment committee, to set up and monitor investments with advice from a consultant. This is increasingly an off-the-shelf offering among group personal pensions (GPP) providers, such as Scottish Life’s Governed range, which allows advisers to tailor an investment strategy and then proactively monitor it in a monthly review process.
Rather than a single default fund, plans can design a range of multi-asset default strategies with various asset allocations, depending on the member’s age and contribution levels.
Even before the economic crisis, there was a move away from offering pension members a wide selection of funds with each invested in a narrowly defined asset type, to offering fewer actively-managed funds with diversified mandates, which can switch between asset classes to obtain the highest returns. Nick Atkin, director at Atkin and Co, says: “This type of fund seems better placed to ride out fluctuations compared with members who are unable to change their allocation easily and in real time. This is without considering whether they have enough expertise and access to information to do so effectively.”
One of the central debates around DC investment is whether poorly-off young staff should try to push on with higher-risk strategies in an attempt to build up a worthwhile pension pot. There is a danger, highlighted in debate around national employment savings trusts (Nests), that the poorest staff could scrimp and save only to find, decades later, that all they have done is replace the means-tested benefits they would have received anyway.
Younger members must simply save
Traditional wisdom is that younger members should invest in an aggressive strategy. But research by Mercer has shown the opposite: that in the early years, the most important thing is simply to save, because the return means less as the pot is still small. “It goes against historical thinking, which was that the young should take as much risk as possible,” says Henderson. “But the reality is the young do not have to take excessive risk.”
But Mark Jaffray, senior investment consultant at Hymans Robertson, says: “My conclusion for young members is they need to set a high-risk strategy and there is no getting away from the fact that unless they do so, they will be very poor in retirement.”
Jaffray says a 30-year-old paying 20% of salary into a pension would not need to put it all into equities but might choose a balanced fund, but another person investing a more typical 5% to 10% of salary would really need a high-risk strategy.
A big mistake members make is so-called ‘reckless conservatism’, becoming over-cautious and choosing a cash fund that may pose little or no capital risk, but will not protect against inflation in the longer term. Another bad habit is to flee from poorly-performing investments once they have already fallen and buy into rising assets once they have already made the lion’s share of their gains.
Meanwhile, member apathy is not easy to change. Despite efforts to engage members, inflows into default funds have been rising, according to Aon Consulting. This is likely to be a result of staff seeking a safe option.
Schemes need to consider how they reflect market fluctuations in their benefit illustrations to avoid members reacting to losses and media hype and transferring to less risky assets that have already seen significant price rises, possibly missing out on a market recovery. Members near retirement should be told they do not need to lock in any recent losses by buying an annuity at retirement, but can defer retirement or take benefits under an income drawdown arrangement.
If members can make extra contributions, now might be a good time to do so, as equity markets are relatively low, says Atkin.
Managing pension investments is a fine balancing act and can be daunting for employees, so it is beneficial for employers to ensure staff are aware of their options.
The problem with lifestyle funds
Lifestyle funds, which switch out of equities and into bonds and cash as the member approaches retirement, are widely seen as the best of a bad lot, doing more or less what people expect, except when staff retire early. Those in lifestyle funds who retired last year were largely protected from equity falls.
But assets in lifestyle funds move in one direction only – from equities to bonds – and right now the outlook for government bonds is dismal. Quantitative easing and fears about sovereign creditworthiness could send gilt prices tumbling. Inflation is likely to rise and this is usually a bad time to buy gilts because prices have to fall to push up yields high enough for income-seeking investors.
Lifestyling is performed through an automatic computer process and involves no active management. Many consultants are therefore warning that the policy of pushing older members into bonds at this time should be reviewed or delayed to avoid a disaster for members who are going to retire in a few years’ time.
Case study: Volkswagen drives diversification
Volkswagen UK diversified its fund in response to concerns that pensions had been too reliant on equities. In November, the company, which is advised by Lane Clark and Peacock, put half of its £70 million default fund with an absolute return manager.
Half of its defined contribution default fund is now run by Standard Life Investment’s Global Absolute Return Strategies fund, which uses a wide range of investments and derivatives, and half by Fidelity in a global equities mandate. Members are switched out of the default fund eight years before target retirement age.
When communicating the strategy, Volkswagen sought to engage members with the increased options, designed to offer greater protection against equity markets, providing greater certainty of final outcome.
Roy Platten, pension manager at Volkswagen UK, says: “After the volatile investment conditions of the last 18 months, the trustees wanted to put something in place that would offer members equity-like returns but with reduced volatility.
“The decision to retain 50% of the default fund as global equities is so members can still benefit from any upturn in equity markets and, hopefully, have a strong long-term performance model.”
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