Our panel discusses how DC investment will develop following AE implementation and the completion of master trust authorisation
CHAIRMAN Jonathan Stapleton
Client relationship director
Columbia Threadneedle Investments
Head of private markets
Senior DC consultant
Master trust lead
Dean Wetton Advisory
Now the defined contribution (DC) master trust regime is complete for existing schemes, how do you see investment strategies in master trusts evolving?
Andrea Paxton: From a wider client perspective, we are seeing investment strategies evolving with regard to ESG. We are seeing some interesting opportunities in the market at the moment, with regards to pricing. The frontrunners on innovation tend to be own trust and the master trust. On the contract-based market we are not seeing as much innovation from group personal pensions (GPPs).
Andrew Brown: The rigorous process by which master trusts have attained authorisation did not necessarily concentrate efforts on the robustness of their investment propositions, though that will hopefully come through ongoing supervision by the regulator. It is likely that investment propositions will evolve over time, particularly as assets under management grow and as individuals become more reliant on their DC savings to fund retirement. This will no doubt lead to a greater focus on investment strategies accompanied by a greater variety of drawdown options and glidepaths.
In terms of diversifying sources of return and increasing asset class diversification, there is a clear interest in less liquid and alternative investments, and I know that master trusts are actively seeking the means to incorporate these. I think this will be important in a period where global economic growth slows and valuations become more challenging.
Now authorisation has been achieved and we have some direction in terms of understanding who the main players will be in the market, governance bodies can get down to the business of improving member outcomes through superior risk-adjusted returns and dynamic asset allocation.
Faye Jarvis: Trustees are trying to get to grips with what they are supposed to do in relation to ESG. Some are leading the way and have their own written policies on ESG that then feed into their statement of investment principles (SIPs). However, many are simply taking the words provided by their advisers for the SIPP and that is effectively becoming their policy.
They are looking to their advisers to lead on ESG. I think what trustees do will evolve over time. It will take quite a bit of time for trustees to develop their own thinking on ESG and to push their advisers and managers in terms of what they are doing around it and have the right reporting flows. It is going to be an iterative and evolving process. What you see in SIPs now will not be what you see in five years' time around these issues.
Andy Cheseldine: It is difficult to talk about master trusts as though they are one homogenous group. They are not. Of 37 authorised master trusts, ten are defined benefit (DB) hybrid, which have a different approach from pure DC. There are perhaps up to a dozen ordinary master trusts, run by administrators or consultants, together with four pure AE players
The point is they are all different and trying to do different things. For DC-only master trusts, the key characterisation is that they are cash-flow-positive for the next 20 years. It is an entirely different set of investment problems to a DB scheme. You have to look at ways of funding annuities. Our problem is where to put the money for good value and to mitigate risk for our DC-type members.
As for ESG, there will be a lot of people moving down that route. We have had ten years of bull market and sooner rather than later there will be an adjustment. My biggest concern is how to protect members from the reversal.
Graham Peacock: ESG is one of those aspects we are all talking about. I am not sure actually, in terms of positive asset allocation, who is doing anything significant in this area. Talking about it is a good thing, but in terms of actually doing it, look at it in the master trust environment. It is not about ESG in isolation.
As a trustee you are there to drive member outcomes. That is what this is actually about: improving member outcomes. And what next after a bull market for almost ten years. We could lose all that value.
Of the three things that are important to me in member outcomes, one of them is the investment. The biggest risk is what people put into it in the first place. If you do not put in enough and you do not properly fund it, whatever the investment you are never going to get enough out of it.
It is investment net of charges next and then the time horizon. Time horizons in master trust were looking at being lengthy. In our trustee set, we are talking about a typical 40-year time horizon, which gives you a lot of freedom from an investment point of view.
Iliquids are interesting. How do we get access to illiquid asset classes for a long-term time horizon? It is a challenge and I do not have the answer for that - yet.
Dean Wetton: I would echo the ESG, market volatility and cash flow comments. We are seeing an interest in illiquids. We have had some clients investing in illiquids for almost two years and we are looking to expand this.
Another interesting element is the degree of customisation. A lot of current customisation is by employer. The direction of travel we see is away from that using member analysis to group members into more homogenous grouping and to differentiate investment strategies for those groups.
Although there is not much movement yet, towards more direction of customisation by employee or member scheme.
Allied to that, Financial Conduct Authority (FCA) pathway regulation is going to have some impact. I am not convinced it is the right way to go. We will have four pathways. We will need to think more carefully about how these strategies dovetail with those pathways. That does not directly impact us as master trust but we will feel the crossover from the GPPs that become the industry standard.
Stephen O'Neill: Master trust authorisation was an important milestone, establishing a benchmark for best practice. But it is not going to be the main catalyst or inflection point for change. The evolution of investment strategies in master trusts is going to continue now we have finally achieved a business-as-usual status following the staging of phasing. People can reallocate their intellectual bandwidth and other resources away from making sure employer and member onboarding all goes safely.
While it is a never-ending process in reality, staging was the really tricky part and making sure things did not go wrong with the volumes of employers was a key concern. At peak on-boarding Nest was taking on upwards of 1,500 employers a day - somewhat of a challenge for any scheme, let along one that is government-supported. If it went wrong, just for a few hours, it could have been a catastrophe for Nest and for the policy as a whole.
The big emphasis was on making sure all worked. We now have a system that works. Now it's about how we reallocate resources to other things such as building up the member experience and the investment strategy.
Alan Pickering: I would like to differentiate between ethical investment and ESG. I always was uncomfortable with ethical, because my ethics are not your ethics. I have not got any ethics; you have. I used to take the view that if it was legal, it was investable. How could I decide otherwise? I hope ESG will be a non-event because it does affect member outcomes. I hope it will be baked into every investment strategy that we have to ensure those who use our money know what risks they are taking. I hope ESG does not crowd out all other considerations. There may be some debate at the margins about how far you go beyond cluster bombs in excluding things.
In future we need investment strategies that look at the needs of particular cohorts. A lot of existing multi-employer DC schemes are still segregated by employer. That may be sensible. However, in future we have to be much more member-centric or cohort-centric, focusing on what that member is going to need during the consolidation and decumulation phase.
At the accumulation phase, most of them want more or less the same thing, which is steady growth without too many shocks. The differentiation will come in later life when a member knows how to fit their pension saving into their wider saving portfolio.
Should there be more regulation around DC investment design?
Faye Jarvis: No. Trustees have broad investment powers that give them a lot of flexibility. They also have to act in the members' best interests. As long as that is the primary obligation, it should give you what you need.
The regulator can give some guidance for trustees who are struggling with things like how they implement an ESG strategy. The more you regulate, the more you tie trustees' hands. There is a risk you end up not giving members the best outcomes.
Alan Pickering: If the government or regulator designs, how do they react when that design goes wrong? I would rather they kept their hands clean and placed all the emphasis on fit and proper people and structures. They should now stand back and let those fit and proper people use the structures that have been approved. The biggest risk they run is that it comes back to bite them if they have designed investment.
The other risk is that we are going to stop innovation. The market should be innovating, not politicians and regulators.
Andrew Brown: I do not believe that current market forces have led to superior and sophisticated investment designs. How much of a differentiating factor is the investment proposition when it comes to appointing a master trust?
Graham Peacock: If that were true, how do you explain the difference between the top performing and the bottom performing default fund? There is a massive difference.
Andrew Brown: The disparity between investment returns is large, particularly during the growth phase, even if we are looking at short-term numbers. I do not see a market that is demanding superior investment design from their chosen master trust. Regulatory intervention is not something that needs to happen, but a spotlight on investment designs and potential outcomes is something that would benefit members, as would more transparency in terms of performance - a framework to compare providers' propositions based on net outcomes and measures such as risk-adjusted returns.
Graham Peacock: Savers have no clue what they are invested in. The trustees build something they hope will do the job. You are right to highlight that it is not about 20% or 30% per annum; it is long-term risk-adjusted returns that we are looking for and steady growth.
If individual members self-select the trustees cannot step back and say, ‘But you chose', because members would turn around and say, ‘But you let me choose.' There is a little bit here of ‘Protect me from myself,' as a member.
I have a GPP, a group self-invested personal pension (GSIPP), an own trust and a master trust in my portfolio. When you look at the GPP it has lots of investment choice that nobody really uses. Trustees have the power to unwind a poor choice by a member but not many use that power although they could unwind an investment if somebody had made a switch that did not actually benefit them.
That is our fear: that if we are moving towards volatility in the marketplace, members are going to move out of a protected, highly governed default designed with the best members' interest at heart, into something that they can self-select and then be like lemmings go over the cliff.
Dean Wetton: It comes down to the fundamental difference in law. GPPs are contract-based, highly regulated and as a result there is limited innovation. For master trusts the onus is on the trustees to act in the members' best interests. It is a different legal structure.
You are seeing what more regulation looks like in GPP. It is less innovative than in the master trust area. Shining a spotlight on what is going on in the investment is going to be useful because selections of providers are seldom made on investment grounds - and are normally made on other factors, predominantly price, brand and service.
Stephen O'Neill: Most of the distribution networks Nest faces off against do not prioritise investment design. I spend an inordinate amount of time meeting with the big advisers and talking to them about our investments. Typically, at the end of a 60- or 90-minute conversation, it wraps up with, ‘That is very good, very impressive. Well done, but you are still not going to be on our buy list because you do not offer bespoke solutions for clients, co-branding, a fund range that we can add value by putting together for our large corporate clients.' The quality of Nest's default fund is almost a moot point from the point of view of the consultancy industry and especially the independent financial advisers (IFAs) because it is a one-stop shop and one size fits all. It does not suit that part of the value chain..
Andy Cheseldine: Nest is in a difficult position. What it is really good at is dealing with small employer members. It is the millions of them that are its strength. The employee benefit consulting services (EBCs) are aiming typically at a different market, so that is a mismatch.
We need to think about the fact that what the market is today will not necessarily be what the market is in the future. Today, we are talking about 99% accumulation.
When we get into decumulation it is likely that there might be some regulation over how those are invested because, from a public policy point of view, you do not want a significant number of people in drawdown relying on predominately equity-based investment. What does that do if it goes wrong?
Stephen O'Neill: The FCA's Retirement Outcomes Review warned providers about defaulting consumers into cash, meaning there could be further guidance and rules coming from the regulators and government; such as issuing specific risk warnings or banning defaulting into cash at or near retirement. The far more pertinent risk is that people carry too much volatility into retirement and start trying to draw down 4%, 5% or 6% from a portfolio with 10% to 15% volatility - quite literally the road to ruin.
Alan Pickering: That fills me with horror: Big Brother telling people what asset allocation to have. It is more sensible for people like us to be hauled before Paul Lewis on Money Box on a Saturday dinner time and asked, ‘Why on earth did you offer those people that strategy?' I do not want Whitehall to be getting between me and Paul Lewis because I have a get-out to say, ‘That was not me, Paul; that was those people in Whitehall.'
Andrea Paxton: There are sufficient investment regulations - we just need to make sure that everyone complies with them. In 2018, the regulator wrote to many DC trustees and asked when they had last reviewed their default. This led to a number of trustees running for their advisers because they had not reviewed them in last three years.
We need to recognise that group personal pensions have not necessarily benefitted from the innovation seen in the wider industry and so we are at risk of seeing different classes of pension savers emerge. With personal pensions (including group personal pensions) the individual is the policy holder. We need think about member outcomes and whether the default is the right strategy.
Andrew Brown: The most significant barrier to investment innovation might be cost, which is key to the master trust market. Whilst these organisations are building economies of scale and facing competitive pricing, the amount spent on acquiring investment services, as a proportion of the member borne charge, is relatively low. More innovative investments, particularly those that benefit from an illiquidity premium or active management, are generally more expensive.
Graham Peacock: Unlike some master trusts we have not written at or approached the charge cap limit because we would not win in the bespoke top-end of the marketplace if we said the price is 0.75. Price is a driver, although it is not necessarily the main driver in the marketplace.
We are finding more third-party evaluators (TPE) asking more about engagement routes, wellbeing and nudge theory than expecting it all for a low price. That is the commercial nature of it. You can only play on that and deliver all that value if you are in the large-scale marketplace. Price is definitely one of the factors.
Alan Pickering: I like to think value will trump price eventually because we have seen what driving price down does in the administration markets. That really is an own goal to drive costs down to a point where your supplier no longer wants to be your supplier. I hope we look at cost and benefit in the round rather than award it on the grounds of 0.65 always beats 0.68.
Andrea Paxton: Members do not easily perceive value in investment solutions and so we need to see a big ‘sea change'. Around this table, we are all informed buyers and so we would not go for the cheapest investment unless we thought it to be the best. If you look at the world outside of pensions, cost is the main driver in persuading people to buy products be they the latest fashion, a television, sofa etc. People frequently look for the cheapest rather than consider ‘value' and until we change that perception in the context of pensions and investments then we are going to struggle.
Stephen O'Neill: I have seen a bifurcation in the asset management industry, in terms of what the value proposition is. It is broadly split between the City of London and the West End, to be honest.
The old world is to spin a yarn about, ‘We can deliver you 30 basis points of alpha and we will charge you 50 basis points of a premium for it,' which obviously does not make any sense, and so you will get this story about top quartile, five-star Morningstar ratings and so on and so forth, but net-net you are either no better off or worse off versus the big institutional players which is able to give you the asset class beta at a very low cost and on a scalable platform. I think the latter has to be the route the DC goes down because it is what it can afford, but also it just makes economic sense.
Does the selection process sufficiently prioritise DC investment strategy and how can that change?
Andrew Brown: The investment strategy is of great importance to the outcomes achieved by members and the fact that we are even asking this question in relation to DC pension provision highlights a systemic issue. The Office of Fair Trading in 2013 found that the ‘principal-agent problem' applied strongly in DC, whereby the employer as agent in choosing a pension scheme on behalf of the principle (their employees) lacked an intrinsic long-term interest in scheme outcomes. This misalignment of interests goes some way to explain the different approach to defined benefit investment design.
We do, however, see larger trust-based schemes with greater governance resources and investment budget seeking to do more with their investment strategies. This highlights a potential disparity in member outcomes, dependent on the size (or paternalistic nature of the employer) of the scheme in which the member belongs. This seems unfair.
Alan Pickering: Administration must come top of the employer's priority list. Employees might not be with them that long, so if the investment does not deliver, it is not as painful as if the administration goes wrong. However, as we scale up, the trustees will fill that intellectual void created by the regulator and take a longer-term, balanced view between the needs of the individual and potential.
Engagement is a double-edged sword, because it is one thing to engage people, to know they ought to pay more money. It is good for them to challenge what we are doing with the money. A certain level of engagement can turn into day trading based on what the Saturday morning paper says. Be careful what you wish for.
Andy Cheseldine: Your question presupposes we should put more attention onto investment. In the old days as a consultant, investment tended to get anywhere between 40% and 60% weighting. That is too much nowadays. If you are given a list - pre-retirement, post retirement, administrative efficiency, management information, communications, engagement, timeliness, reading age, accuracy, security, flexibility of contributions, flexibility of benefit retirement, governance - in all of those do you really want to spend most of your time on something else?
Dean Wetton: If you have good governance you are unlikely to have a poor investment strategy. We monitor the master trust universe and by and large they all do things pretty well. There are valid reasons for some differences but there are few absolutely poor players because there is good governance. Authorisation has driven some of some of that. It is difficult to differentiate yourself on investment when little of it is poor.
Graham Peacock: It very much is ongoing. In terms of the regulator's focus of ‘When did you last review your default fund?' every three years you are doing that formally. If you are a decent trustee, you are doing it constantly, and you are getting constant input from your investment advisers, feedback from the membership, looking at the demographics, looking at the contribution profile and driving member outcomes to that.
Stephen O'Neill: As you approach the end of the cycle, the obvious option is to de-risk or move out of less cyclical assets. It does not necessarily need to be a move away from a low-cost strategy. You can make small changes so you are in a more defensive position while still keeping the cost base extremely low.
Andrea Paxton: When I am talking to clients, the biggest desire for change is around engagement. The employer wants an engaged workforce, not necessarily in terms of the daily trading but rather someone who is actually interested in their savings.
I am seeing that employers want member engagement throughout their careers and not just at retirement. Employers are keen to promote but short, medium and long term savings and this is driving product design in the industry. For example, we are seeing master trusts who have put in additional savings products onto their platforms alongside more traditional retirement products.
What are your key takeaways?
Faye Jarvis: Decumulation. That is where the biggest risk for the market is. We give members all the risk warnings but they either do not understand them or do not engage with them properly and think about what it means for them.
There is scope for people to not understand their options at retirement and do the wrong thing. There is a risk that we could see a lot of litigation and claims around that in the future.
Andy Cheseldine: Not all master trust populations are the same. They have different needs that we need to recognise. Investment is not the only thing we need to be considering, but it is probably the most important.
Graham Peacock: For me it comes back to the fundamental principle that it is not all about investment; it is all about what you put in and your time horizons. The investment has to do some kind of delivery. If you are not putting in enough, you will not get out as much as you need.
Stephen O'Neill: If we wind the clock forward ideally there would not be any need to have ESG carved out as a separate conversation topic because it would be so ingrained as best practice or basic practice in DC risk management and pension risk management.
Alan Pickering: In DB land if we did a good job, the beneficiaries were, to some extent, shareholders; there is nothing wrong with that.
If we do a good job in DC land, we do make a real difference to ordinary people's wellbeing and peace of mind in later life. Being involved in DC at this stage is an exciting challenge. If we get it right, lots of people will have much to be grateful for.
Dean Wetton: I would echo what Alan says about it making a real difference to people's lives and therefore urge more transparency and publication of mastertrust information.
Andrea Paxton: We need to focus on the member as the ultimate buyer in order to help them to save the best they can for the future.
Andrew Brown: Investments need to offer good value to members and work to maximise the contributions they make. DC in general lacks clear targets or obligations in the same way that DB schemes and insurance companies operate (to meet liabilities). We should be looking to reduce the disparity of outcomes and hope, through the significant efforts being made, increased engagement leads to greater levels of contributions.
This is an edited write up of a roundtable held in November 2019