No longer lauded as the new kids on the block, questions now abound about where defined contribution (DC) pension schemes are heading. Many of these questions are based on the foundations of these retirement schemes.
One of the biggest themes that needs deconstructing is cost and value. “This has been a cost-driven market, which in investment terms has driven DC schemes down a particular road known as low-cost index globally allocated portfolios,” says Imran Razvi, senior policy adviser for pensions and institutional markets at the Investment Association (AI).
It does mean most DC pensions are cost-effective, partly because the default investment strategy has usually been driven by these cost considerations but has resulted in largely passive solutions.
This therefore needs to change. “I welcome the notion that we need to take an investment-led approach to default pension strategies, especially when in decumulation, and that the focus should be on value for money – not simply the level of charges,” says Euan Munro, chief executive of Newton Investment Management.
But other factors have to come into play as well. “Our view is that DC pension schemes are developing significantly and quickly with regards to investment sophistication through scale, innovation and sponsor interest – this is only going to continue with the focus and drive from the UK government and regulators,” says Stephen Budge, a DC investment consulting partner at consultancy LCP.
Government push
So there has been a big push from government and regulators to get DC schemes focused on two areas. The first is a move towards UK investment. “That is challenging, depending how you go about achieving that,” Razvi says.
“There is a feeling that pension schemes will not get there if left to their own devices when you look at their current investment behavior,” he adds. The impetus therefore for Razvi is for the government to make UK investments more attractive to DC schemes. “That is things like tax incentives which can be applied to pension schemes to get them to invest in particular areas.”
And second, is the focus on getting more DC schemes involved in private markets. “It is this area, where we at the IA have been heavily focused over the last couple of years from the standpoint of trying to make sure DC schemes have access to those asset classes. Should that be a road they choose to go down,” Razvi says.
Private markets allocations within DC are, it seems, going up. Legal & General research shows that for DC schemes seeking to grow their private market allocations, a key challenge is cost and transparency: 57% see high management fees/costs and limited reporting as more of a challenge to DC pensions than liquidity (43%).
“Private markets are a definite trend with our clients,” Budge says. “They appointed well over £1bn of DC friendly private-market funds during 2023.
“However, there remains a lack of choice available to schemes which we believe must be seen as a market failure,” he adds. “Even with all of the interest and focus in this area, certain corners of the provider market still do not offer choices for scheme and member investment.”
For Razvi, it is a slow process. “Some schemes are [involved in private markets] and some are talking about it,” he says. “But it is a slow-moving market.”
Government pressure
The key question that hasn’t been answered yet is whether the government will ultimately deploy a stick to direct investment to help drive the UK economy. It would be an unpopular move. “While this is unlikely, we expect the pressure will remain for the foreseeable future,” Budge says.
But this aside, Razvi still believes there is a private markets investment case for DC schemes to embrace. “Given the amount of activity within private markets and the shrinking size of the listed world, it makes good sense to consider when private markets should play a role in a portfolio,” he says.
However, there are reasons for the current positioning of DC schemes. “Historically, it has been quite di cult for DC schemes, largely due to the fund structures to help them achieve that [wider investment]. The whole daily dealing architecture that DC schemes work around has also proved quite challenging,” Razvi adds.
Moreover, the investment approach has been a simple tried and tested playbook. “In our view, the question of portfolio construction early in the DC lifecycle is a fairly simple one to answer – take as much risk as you can, typically, in equities, and then ride the wave for the next 30 years,” says Chris Parker, head of institutional clients in the UK and Ireland at Man Group. “If you have a big drawdown, it’s generally ne – you are staying in the market for decades to come,” he adds.
However, as people get closer to retirement, this high-risk tolerance naturally changes significantly. “A large drawdown closer to retirement can be extremely di cult to recover from, and an increasing number of DC members are reaching that point,” Parker says.
Classic portfolio
Indeed, many DC strategies are built on the classic ‘diversified’ portfolio, that is, a balance of equities and bonds. For years, its proponents have argued that when one asset class in the mix is affected by poor performance, the other one will pick up the slack.
However, research by Man Group shows that when core inflation is persistently above 2.7% per annum, the correlation between equities and bonds – that is, the similarity of positive and negative performance – has historically been positive on average.
“That means, in a shaky equity market during these periods, investors can’t necessarily rely on bonds to provide portfolio stability. Just look at 2022. Equity and fixed-income assets suffered significant losses at the same time,” Parker says.
This assumption that bonds and equities will always diversify one another is changing, and many pension schemes and asset allocators are turning to ‘alternative’ approaches to either enhance returns or provide a diversified-return stream.
“This term captures a wide variety of asset classes, but the focus has largely been on private assets via structures such as long-term asset funds,” Parker says.
This means there is much for DC pensions to ponder – but ponder they must. “While it’s clear that these assets have a role to play, investors should consider broadening their definition of what constitutes alternatives to include ‘liquid alternatives’ too, namely assets that can provide the diversification they need when they need it,” Parker adds. “DC investors shouldn’t just be adding new asset classes, they should also focus on adding different return streams.”
The diversification illusion
Diversification and uncorrelated return streams are important, but they also need to work when investors need them most. “With private equity and venture capital, for example, the promise of diversification can be illusory,” Parker says.
“A valuation lag – the delay in asset pricing, as there is no exchange to offer daily liquidity – creates the illusion of lower volatility, but returns may be highly correlated with the main risk factor in a DC portfolio: public market equities,” he adds. A more liquid expression of a diversifying multi-asset portfolio may then offer more robust portfolio construction benefits than simply relying on expanding the asset mix.
“Using a flexible, market-neutral approach to major liquid asset classes, meaning that the strategy can short sell as well as positively own an asset class, for example, allows investors to target multiple sources of potential returns and increases the chance of accessing a truly uncorrelated source of return,” Parker says.
“And by using liquid underlying instruments – equities and bonds, rather than more difficult-to-come-by and difficult-to-trade real estate and infrastructure assets – helps to make the portfolio more cost-effective, more transparent, and importantly more liquid,” he adds. “DC investors should be targeting diversification by design, not simply by chance.”
Cautionary consolidation
There are other factors to consider, which are set to shape the DC pension landscape in the coming years, says Jayesh Patel, head of DC clients at Legal & General.
“Firstly, regulatory changes will continue to influence DC pension plans, particularly around consolidation and the evolution of investment strategies, following the pensions investment review consultation,” he says.
And, of course, this shadow of scale hangs heavy over the DC world. “That has clearly been the direction of travel for some years now,” Razvi says. “We have coined a phrase ‘sophisticated scale’, which is to say if you are going to make these schemes bigger. Then a bunch of things need to happen alongside that.”
This, Razvi adds, is largely around enhancing governance and expertise of the investment world and the ability to make allocations across a broader range of asset classes and on a global diversified basis. “That is a set of structures that has to be put in place. It doesn’t automatically come from making everything bigger,” he says.
Though as with much of the DC market, things though are likely to take time. “We expect the future will look like a much more consolidated DC market. However, it will and should take time to work through,” Budge says. “We need to be mindful that the overall drive for consolidation doesn’t undermine the good progress being made by single employer trusts – we must consolidate with caution.”
One of the reasons Budge holds this view is because we are already in a consolidated market from a pension provider point of view.
According to LCP’s calculations, more than £620bn of DC assets are managed by a handful of providers – across their product ranges – highlighting a much greater level of consolidation than seen in markets such as Australia. It also indicates the scale we already have in the UK’s DC market at the provider level.
“While the overall trend is to master trusts, we are seeing interest with trustees and employers about running-on their DB schemes as an alternative to buy-out, which creates potential support for DC funding in the short to medium term with hybrid arrangements,” Budge says.
The second theme identified by Patel is as life expectancy continues to increase, there will be a greater need for DC plans to provide sustainable income over a longer retirement period and effectively deliver a ‘paycheck’ in retirement. This, in part, can possibly be addressed by better and wider investment decisions.
Third, is the role of technology in shaping the evolution of the DC landscape. Advancements in AI and machine learning can help personalise pensions further to better engage members and drive action.
“As retirement patterns change in the future, so too should investment approaches evolve,” Patel says. “DC schemes should look at investment – particularly decumulation investment solutions – as a key component to improving outcomes for DC savers. We see market consolidation and the evolution of investment strategies as a key driver in helping to grow retirement savings.”
Indeed, one of the major challenges Patel sees – and one likely to continue being a challenge for a while – is around adequacy. “Meeting the adequacy challenge and helping savers meet their retirement objectives should be one of the main priorities for the industry,” he says.
Addressing and eliminating pensions gaps is another significant challenge DC schemes face. Notable groups that face a larger pensions gap are women, those with illnesses and minorities.
A point of focus of innovation is post-retirement, which is now referred to as ‘guided retirement’. “We expect to see significant improvement in this area over the coming years with the focus of government and regulators as well as the innovation we are seeing in the market,” Budge says. “This is a critical step for members in delivering better outcomes through income. Yet, it has been an area where focus and attention has been lacking. We are pleased to see this is a priority area for the regulator.”
End of cheap money
Then there have been wider economic changes. Over the past two years, we have witnessed shifts in important economic and investment conditions, as several multi-year or even multi-decade changes came to an end.
The end of so called ‘cheap money’ has led to higher and less stable correlations between asset classes, which makes diversification of investment portfolios more challenging. “These dynamics pose new challenges for DC schemes to deliver superior investment returns,” Newton’s Euan Munro says. “The correlation between equities and bonds has shifted from risk-mitigating to risk-additive for DC schemes, meaning that more needs to be done to equip portfolios for the market context we face, and ultimately to meet individuals’ retirement expectations.”
This means being more dynamic and embracing new sources of return, which have traditionally been overlooked in the world of DC asset allocation. “Liquid alternatives have the potential to meet this challenge,” Munro says. “Equity income has also been overlooked as an approach. Ultimately, this is something DC schemes will have to prove capable of doing far more than has traditionally been the case.”
Broken DC
Although offering another and far more provocative piece of analysis, consultancy WTW says DC pensions are broken. Senior director Edd Collins says: “There is an issue that has been brewing and hidden from view and it needs greater attention than we see today. The fundamental challenges are around the retirement piece: how do you help people through retirement?”
Instead WTW offers four alternatives to the DC market. The first is based on whole-of-life collective defined contribution (CDC). “This is effectively the solution the Royal Mail has launched. For me this is the purest design that allows you to share risk for the longest period of time and gives the best out- comes, because you have the greatest freedom and the longest period of time to invest,” Collins says. “Although there is the challenge of the variability of the pension to go down.”
The second is what he describes as defined benefit with variable increases. “This is a bit of a build on CDC, providing a guarantee that pensions will never be cut. But employers are on the hook for increased costs. The downside is the existence of that guarantee means DB funding leads to taking not as much risk. So if you are not taking as much risk then you are not going to get as much return,” he says.
The third is DC pots used to buy CDC retirement incomes. “This takes the line of in the post-retirement phase buying CDC. It gives the employer the chance to say that they do DC and that is their bit, and you go and buy the CDC at retirement.
This gives a separation between any decisions to cut pensions down the line,” Collins says. “Although it doesn’t do as good a job as whole of life CDC, as you have a shorter timescale.” The fourth option is a variable cash balance with CDC in decumulation. “This tries to provide a more stable version of DC,” Collins says.
Scanning across these, he says: “The majority of employers prefer the third option. But we need regulations from government to allow that, and other innovations, to happen.”
But it is interesting to note that a great deal of the necessary changes to DC comes down to simply greater knowledge. “DC schemes and their investment managers need to do more to educate members about the role of diversifying strategies, like liquid alternatives, and why it is beneficial to invest in them as end users,” Munro says. “Risk needs to be better understood, including as to why sticking with the status quo may represent a significant risk in itself.”
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