If the UK’s defined contribution (DC) pension market is compared to the lifecycle of a person, then it is no longer a baby and has become a toddler. After a strong start in a buoyant market environment, where investment portfolios could simply be swaddled away in passive index strategies, they have now entered a more challenging phase.
This in part is due to more challenging markets, but also the rapid growth of the assets managed by occupational pension schemes thanks to auto-enrolment and growing consolidation in the industry.
As DC schemes grow, new opportunities arise. The watchful parents, in this case policymakers and regulators, are keeping a close eye on this development, as Department for Work and Pensions (DWP) consultations on broadening investment opportunities and value for money illustrate.
These trends mean that such schemes will have to reposition their portfolios to be more active, with inevitable bumps along the way.
Strong start
The birth of auto-enrolment a little over a decade ago could not have come at a better time for occupational pension schemes, which were focused on equity-heavy, low-cost, index strategies. Trustees have been well rewarded for the change in strategy that resulted from the rise in membership.
During the past five years alone, the S&P500 jumped almost 50% to more than 4,000 basis points from 2,700 in 2018. The S&P500’s 10-year rolling average stands at 14.5% and the returns recorded by other major stock indices were equally as juicy over the same period.
Such gains are reflected in the performance of the growth-orientated master trust default funds. National Pension Trust, the Aon Mastertrust and SEI Master Trust reported annualised returns north of 8% in the past three years, according to Hymans Robertson.
Other master trusts also produced enviable annualised returns over the same period. The People’s Pension’s Global Investments fund had a cumulative performance of close to 6%, while Nest’s 2040 fund stood at 8.6%.
If their members had moved their retirement savings to a swanky hedge fund office in Mayfair, they might not have received similar returns over the past 10 years (a fact that is indicative of the mixed performance of hedge funds throughout that period).
It is worth adding that the picture is mixed, with some master trusts returning less than 4% during the same period, and one earning less than 2%, according to Hymans Robertson.
Bumps along the road
But returns last year started to turn sour when stock markets were more volatile. The S&P500 dropped by more than 10% in 2022, which was reflected in the performance of the previously successful DC default strategies. Nest’s 2040 default fund slumped by 9.5% while The People’s Pension’s Global Investments fund lost more than 9% of its value. Other master trusts who are yet to report their figures for 2022 have acknowledged that it was a challenging year.
Alongside economic turbulence was a gilts sell-off in September, as investors with liability-driven investment strategies sought to rm up their hedges. This especially impacted the retirement stage funds and annuities which paid out late last year.
Inflation has been an additional challenge, says Nest’s chief investment officer Mark Fawcett. “2022 was a difficult year for investors. The main drivers for these difficulties were higher inflation, higher interest rates and fears of recessions.”
Joanna Sharples, chief investment officer for Aon’s DC team, acknowledges that this means schemes are now thinking about what changes they could make to their strategy. “It has been a bit of a shock that last year bonds were quite risky and that you need to think about your maturity.
“Even within the index strategies, there have been better places to be. What you did with your currency made quite a difference and depending on the bond maturity in your indices, you could get a fall of more than 20% or positive returns. There has been a massive dispersion,” she adds.
Flexible friends
Another factor driving the trend to re-think investment strategies is the rapid growth of DC assets and the concentration of these assets among an increasingly smaller number of providers. This trend has been accelerated by regulation, such as the rules for master trust authorisation in 2018.
Since 2012, the number of DC schemes with more than 11 members has slumped by 67%. While master trusts do not yet hold the majority of the industry’s assets, they do have the largest membership, according to The Pensions Regulator (TPR).
In January, the 36 authorised master trusts invested more than £105bn on behalf of 23.7 million workers. Nest’s assets alone stand at £26.8bn, which belong to 11.7 million people. This growth in scale means that DC investors now have more flexibility to think beyond conventional assets and index strategies.
A prominent example is Nest launching two private equity mandates last year. For Aon’s master trust that means real estate and infrastructure strategies are being considered, Sharples says.
2022 was a difficult year for investors.
Mark Fawcett, Nest
Regulatory drivers
Regulators and policymakers have been keen to accelerate this trend, judging by the two latest DC consultations put forward by the Department for Work and Pensions. At the end of last year, the department closed a consultation on Broadening Investment Opportunities of Defined Contribution Pension Schemes.
In its introduction, then pensions minister Alex Burghardt did not mince his words: “Enabling our occupational schemes to take advantage of long-term illiquid investment is one of this government’s key priorities.”
While the government changed rather swiftly, the agenda remains the same. The proposals are aimed at accelerating investments in illiquid assets and facilitating greater transparency through so called “disclose and explain” standards, which would require schemes with more than £100m in assets to set out their allocation strategy. This was backed by most of those responding to the consultation.
Another consultation, launched in January and due to close in March, looks specifically at the challenge to address the divergence in member outcomes through a value for money assessment. These proposals mark a significant move from the focus on costs in the early days of auto-enrolment.
Instead, the consultation, put forward by the DWP in collaboration with the Financial Conduct Authority and TPR, proposes to assess investment performance alongside costs and charges and quality of service.
In addition, Laura Trott, the new pensions minister, also proposed to widen the scope of exceptions from the charge cap, in another attempt to ease DC investors into illiquid assets. But Aon and Nest have said that the existing charge cap has not been an obstacle to invest in alternatives.
While The People’s Pension welcomes the changes to the charge cap, it also warns that this now puts the onus on trustees. “There’s nothing intrinsically wrong with performance fees provided there are sufficient protections for members built into investment management contracts. Exempting performance fees from the cap returns member protection responsibilities back to the trustee. It should not be forgotten that trustees have a legal duty to put the interests of savers above everything else,” a spokesperson for the master trust said.
The combination of these potential reforms could accelerate a trend of DC schemes interacting more with asset managers, predicts Henry Tapper, executive chair of pensions consolidator Age Wage.
But he also warns that assessing outcomes for DC members would require a much more customised approach and should not be based on the investment performance of defined benefit schemes. “Rather than measuring net performance on a top-down basis, we expect to see performance measured against time-weighted returns measured from the bottom up,” Tapper says.
As the government takes a greater interest in the management and asset allocation of DC default funds, a risk to consider is that this could lead to a growing concentration in some segments of the market.
Sharples warns of the danger of simply developing indices for investment strategy or asset allocation. “To what extent is there a basis for this asset allocation and is there a risk of this being arbitrary?” she asks. “Does that then become the norm? Equally, a default strategy might be right for one size of the population but not for other groups, so there are lot of subtleties and there won’t be a one-size-fits-all approach.”
Re-thinking growth portfolios
The sum of these factors mean that schemes are now considering significant changes to their investment strategies.
Aon is one of the master trusts which is considering investing in alternative assets, Sharples says. “It is about thinking of the assets that will be the right fit at different stages in somebody’s lifetime.”
So, for early stage default funds, private equity would probably be a reasonably good fit. “It also involves thinking about inflation and developing inflation protection where real assets such as infrastructure and property could play quite a nice role,” she adds. “These investments also have potentially quite a strong ESG impact.”
Nest committed £3bn across two private equity mandates last year and is considering other strategic changes. This includes increased exposure to investment-grade bonds, at the extent of high-yield paper, in an attempt to minimise the risks of potential credit losses, Fawcett says.
The master trust has also upgraded the outlook for global real estate investment trusts (REITs), predicting that property prices may not fall as much as expected. In exchange, it predicts that the surge in commodity prices will slow down as European economies show signs of recovery and supply shortages are starting to ease.
Re-thinking decumulation portfolios
But the changes do not stop there. Last year’s bond market troubles have forced investors to re-think their decumulation portfolios, Sharples says. The Aon Mastertrust has been fortunate to have reduced its exposure to long-dated gilts going into 2022.
“We have made quite a lot of changes since the end of 2021, thinking about the fact that inflation and interest rates were going to rise,” Sharples says. “This means we have invested quite a lot in shorter maturity bonds and loans which are not commonly used by DC schemes. We had to think about other assets out there and that worked well last year.”
The People’s Pension has also reviewed its fixed income exposure. “Global economic instability, largely caused by the war in Ukraine and the continuing fallout from the pandemic, meant 2022 was a challenging year for investment performance across the board, and we weren’t immune from this,” a spokesperson said.
“During 2022, the main change we made to our asset allocation was reducing the duration and increase diversification of our bond portfolio by selling gilts and sterling corporate bonds and purchasing US treasuries. The gilts and sterling corporate bonds were reduced from 5% to 3% of the portfolio while the US treasury exposure is 4%.”
Overall, the past year has been perhaps the most challenging but also most interesting for the rapidly evolving defined contribution market. While the market is still in its early stages, the changes made now, in terms of policy measures and asset allocation decisions, could potentially shape the UK’s investment landscape in the years to come.
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