By Henry Cobbe
The move from DB to DC in the pensions market is accelerating owing to Automatic Enrolment, and a breaking down of barriers giving scheme members more freedom and choice.
JP Morgan recently estimated the UK DC market will reach £1.4trn by 2030. The Pensions Institute estimated £1.7tn by 2030[1]. Either way, from a base of around £276bn today the growth is eye-watering.
With scale comes responsibility. DC regulation and governance is growing commensurately, and this is rightly driving demand for transparency.
Key areas where transparency is needed is around the default investment option, as this is where most savers will have their money invested.
Transparency as to what is ‘inside’ the default option is typically good, but there is scope for a more consistent way in how the investment mix over time or ‘glidepath’ is presented.
Where transparency has been lacking to date is that performance evaluation of the default option has focused on the funds inside the glidepath, not of the glidepath as a whole.
This is unacceptable as it is the overall asset allocation and the changes in the asset allocation that drive returns over time for savers, and it is those returns as applied to contributions that determine member outcomes.
From an investment governance perspective there is therefore a need at a scheme level for decision-makers to be able to evaluate whether their chosen investment strategy, and its implementation, is adding value for savers or not.
With the right benchmarks and tools, this can be done using a traditional ‘attribution analysis’ approach, but in a way that captures the changing investment mix for different groups or ‘cohorts’ of savers.
We define value for money as risk-adjusted performance for discrete cohorts of savers net of fees; as with any performance discussion, there is the question ‘relative to what?’
In our view, the past performance of a default option should be firstly compared relative to an absolute return measure and secondly relative to a risk-adjusted performance measure.
In both cases, the analysis should be done for each ‘cohort’ of savers grouped by their expected retirement date (as they will experience varying exposures to the same sequence of returns), and for the strategy as a whole.
For absolute returns, comparisons against inflation as a long-run objective will be indicative of the risk preference decision-makers consider acceptable for savers in their scheme. Schemes typically target CPI+3% or CPI+4% over the long run and this will affect how their glidepaths are designed.
For risk-adjusted returns, the default option needs to be compared both against its policy benchmark (to see how much value the implementation is adding for each cohort), and against a broad reference benchmark (to see how much value the policy benchmark is adding for each cohort).
With this approach we can compare whether the default investment strategy is doing what it says on the tin, or whether as part of the minimum three year review cycle it should be adjusted or even replaced.
While there are many other aspects to investment governance, having a transparent and consistent approach to evaluating value for money and good member outcomes, from an investment perspective, and the DC benchmarks and tools to do this is a first step in enabling decision-makers to ensure they are getting outcomes for scheme members.
Henry Cobbe is managing director of Elston Consulting.
[1] http://www.pensions-institute.org/reports/ValueForMoney.pdf
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