Improvements in governance are leading to increasing investment innovation in DC. In this roundtable, panellists discuss charges, alternative investments and how schemes are approaching ESG
Q: Do you see a general improvement in DC governance, led by the chair's statement and consolidation?
Chris Inman: In terms of advising the bigger end of the market, people have the time and the budget. Expertise in this area is growing with delegation to sub-committees that have the time and give attention to the right things. We have committees for communications, investment, administration and others. That expertise and understanding is growing from my clients.
There is increasing investment sophistication among trustees and the education that we used to have to do two or three years ago, for example around factor investing and ESG, is now falling away. We can go into a meeting and hit the ground running because we do not have to do all that legwork again.
We see more on that smaller to mid end that do not have the capability and the governance budget. They are looking at delegation, not necessarily of everything, but of the things they do not have time to do, such as compliance.
I have one client that sits in a master trust because they asked what their members cared about and the things they could influence and they were investment and communications. They chose to outsource the compliance and governance to the master trust trustee and are focusing on those things that turn the dial.
In the future, that will be seen more often at the bigger end of the market, with the focus being increasingly placed on investment and communications. I can see the smaller to mid end of the market coming to a master trust as they have not been getting the fee deals, value for money or are able to implement innovative investment strategies for their member. As such, it would be better to outsource.
Andrew Brown: I can offer a different perspective as an investment manager that has regularly attended trustee meetings for many years.
First, there has certainly been a great deal of positive change in terms of the quality and breadth of defined contribution (DC) trustees - this is to be expected as DC pension assets and coverage have grown significantly during this period along with the number of independent professional trustees. It may still be secondary to the defined benefit (DB) scheme in many cases, but that gap has narrowed.
However, there is a disparity in terms of the governance resource within the DC market. Large schemes are well catered for and may have specialist committees - we regularly meet with investment sub-committees and this delegation of responsibility for an aspect of the scheme seems to be an efficient structure in terms of resource allocation. The widest knowledge gap among trustees is usually in relation to investments, so a specialist group makes good sense. This does not necessarily paint the picture for DC governance in the main and that's hardly surprising given there are approximately 1,700 schemes in the UK that have fewer than 12 members and where resources are limited. Outsourcing of governance is perhaps rightly being encouraged, allowing some schemes to benefit from the economies of scale and greater governance resource offered by, for example, an authorised master trust.
However, it seems to me that DC trustees deal with a greater variety of issues relative to their DB counterparts and investment matters sit further down the list of priorities. I believe we place undue reliance on encouraging members to save more and it is concerning to think many DC investment strategies might fall short from a risk-return perspective, ultimately hindering the primary objective for enabling good member outcomes.
Investments need to work harder. Auto-enrolment (AE) and low-cost passive solutions have thrived during the longest bull market in history - future market return and volatility are likely to be somewhat different. The focus is on cost rather than net added value in many cases. Certainly, the master trust market is competing on price as that is important to winning business. As a result, the investment budget - the amount available to spend on investment solutions - is set accordingly low.
Q: There seem to be quite a few things above investment on the agenda - communications, engagement, the chair's statement and regulation - before you get to investment. Is there enough focus on investment?
Kevin Clark: There is a focus on investment but most members are investing through the default fund so most of the energy will be around assessing the default and its governance values.
Q: In some large DC schemes, we are starting to see the exploration of newer default investment strategies. Is this a step change. Are we changing to a new model?
Chris Inman: A lot of consultancies and asset managers have written papers on the investment rationale for accessing these new investment strategies, particularly unlisted assets. It makes a great deal of sense. No one is arguing the point in terms of inflation linkage, natural downside protection and natural yield in particular for the post-retirement area.
Sorting the operational side has been frustrating but hopefully the current consultations out there will help to change that.
On the trustee side the education is done. In terms of the investment strategies we have put in place, a lot has been white-labelled. We have implemented many strategies in terms of real assets where we have blended in listed infrastructure or property. For example, we might use a Columbia Threadneedle fund to get direct access to UK property.
We have built the structures; we have the white labelling and we have the components. What we now need is to move on from the listed side of things and get access to proper illiquid strategies.
The operational side needs to be worked through. As long as we have the structures in place, we can move away from the obsession with daily dealing that does not serve anyone in long-term investment strategies.
Raj Shah: The main thing is the operational side for including private credit. If your cash flow is strong, you can do it. It is a problem when you have people who want to take their money out. If you have strong net cash flows going in, you can manage this. The big master trusts will have large positive net cash flows for many years, which means the liquidity and cash flow elements can be managed.
Within that structure you have illiquid assets and a strategy for where that money sits in the interim and where it will then disinvest from, for example, to go into these strategies when needed.
That is all possible and is what will happen. I am probably more optimistic that it is going to happen anyway; it is the cash flow requirement that needs to be handled.
Darren Philp: We have not yet mentioned cost.
We talk a lot about the charge cap and its stifling of innovation. Personally, I do not buy that. It may stop schemes and providers from doing some things, but it is the market dynamic and competition that is the key barrier to spending more on investment.
If providers are competing for a larger client, a good employer with lots of assets, for example, and you charge more than others, no matter how good your investment strategy is, you will not get on the shortlist for that business.
What the charge cap has done is bring a real focus on cost, but it's the overriding focus on cost from employers and advisers that could stifle innovation, not the charge cap in itself.
Andrew Brown: I agree, the charge cap as it currently stands provides further room for manoeuvre, though it has led to a ‘cheaper is better' mindset. If a scheme was to make a 10%-15% allocation to more expensive illiquid and alternative investments, this may result in costs increasing by 0.1 percentage points. It does not sound like much; however this could represent a 20%-30% increase in member charges, starting from a low base for large schemes. Or it could eat into the margins of pension providers. That may be too much to stomach.
The investment case for less liquid assets is clear enough; they are not subject to the same volatility drivers as listed equities, provide stable long-term income streams above inflation and widen the range of potential investment opportunities. The latter point is increasingly important as the number of publicly listed companies has fallen by almost half in the US since the 1990s and by a third in the UK since 2008.
Q: How are DC schemes approaching ESG? Are they allocating to specific ESG funds or taking an integration approach?
Raj Shah: You need to start with an integrated approach by looking at responsible investment from two angles - sustainable investing via ESG factors as well as effective stewardship. Thereafter, approaches to ESG would then depend on the schemes' beliefs and policies around ESG.
We believe it is all about education, beginning with how to help trustees set the beliefs on ESG and responsible investment. Effective stewardship is an important part of this. It's important to understand what your fund managers are doing on stewardship because that is as important to change the ESG behaviours of companies.
We started with education and then formulating beliefs that lead into looking at products. If your investment strategy does not currently meet your beliefs and policy, then you start looking at, for example, investments that align to your beliefs, for example being more climate aware.
Selection starts with the belief of the trustees. It is also important to find out what the membership wants, what is important to them. At the same time, as a trustee you want good value for money for the long term.
Claire van Rees: You need to be careful about the potential for confusion between integrating ESG because you believe it has a financial impact and doing it for non-financial reasons because, for example, you think your members are young and care about the planet and want you to invest in something that they perceive as ethical.
Trustees should understand what they are doing and that non-financial aspects may have a role in the fund range you offer in DC. Historically, where DC trustees have taken account of ESG factors, they have not done it because they expect a long-term financial impact; they have done it because they think it is something members want and is appealing to them.
Hopefully there is going to be more of a move, particularly on the default fund, to look at where you genuinely believe ESG factors are relevant financially over the potentially long-term horizon that DC investments are invested. Trustees should be taking it into account as part of their general decisions about where it is appropriate to invest for members.
From a regulatory perspective, it is on the agenda. There are new requirements starting in October and reporting requirements for DC schemes next year. The trend is in that direction.
At the moment it sometimes feels as if trustees do not understand how to engage with it. They need a lot of help from their investment consultants to make it concrete and understand what they are doing.
There is a genuine risk to trustees in not taking ESG seriously. They are going to have to publish their statement of investment principles (SIPs) on publicly available websites. There are activists who will be looking at what is said and will challenge what is said in their SIP.
Some trustees are not changing their behaviour. They will have a training session and get some standard wording from a consultant to put in their SIP. They are running a risk because they are going to have to report on how they implemented it and if they cannot do that, people will call them out on it.
Kevin Clark: ESG has to be at the heart of investment and you cannot go forward without embracing these values.
Trustees are just beginning to understand what it is they are monitoring and the managers are only just being asked what they are doing on ESG - it is early days but it will evolve.
Andrew Brown: It is interesting that, when presenting investment strategies to trustees, we are increasingly being asked to focus specifically on ESG matters; how we incorporate these factors in our process and how these are reflected in portfolio holdings. This is in response to upcoming regulations and requirements that come into force from October 2019, though I sense there is also a genuine interest.
That interest might stem from the investment case; taking account of ESG factors will lead to better risk adjusted performance over the long-term. I can also sense a desire to do the right thing among some trustees and this reflects the change in attitudes within society at large and borne out through recent climate activism. Moreover, the values and beliefs held by members should ideally be reflected in the investment strategy.
Illiquid investments can have a positive and tangible impact, investing for example in social housing and wind farms - that also plays well to member engagement as they can relate to these types of investments that contribute positively to society.
Darren Philp: You can never crack the engagement challenge - but you need to have conversations with people about what they are interested in and long-term factors like climate change and impact investing.
We did our annual pension webinar about a month ago and were amazed by the results. There were over 600 people on it over two sessions. This was unprecedented in terms of engagement.
We had around 300 questions and a number of them were on ESG and how we were looking after the money. People were interested.
There is another reason for trustees to look at ESG: ticking the box. That is a real danger. Trustees need to understand their membership and have a view. If you are going to do it, do it seriously. It is a long game. It is not something you can flick a switch and do - and all the greenwashing that is going on will be called out.
Q: How important are tilts in an ESG approach: tilting away from lower scoring companies and towards the highest scoring ones?
Raj Shah: Tilts can be an effective way of increasing the weight to more sustainable companies and vice versa. However, data and how the scoring methodologies work is key. A lot of houses have developed their own proprietary scoring methodologies by combining a lot of things. For a trustee board, if they want to do some tilting, they should understand how the scoring methodology works. That is important.
Andrew Brown: I think when it comes to looking at tilts within an ESG approach, the time horizon of DC members' savings should also be considered. If an individual is investing for 40 years, it might make sense to tilt their portfolio towards long-term trends such as carbon reduction, electric cars, phasing out of fossil fuels. A challenge might be the current focus on short and medium-term performance track records - the one, three and five-year returns.
Ultimately, an awareness of ESG factors makes good financial sense, particularly if you can achieve exposure to companies or projects at an early stage. This is connected to the argument for investing in private equity and infrastructure: growth comes in the early years of these companies while investment opportunities in the US or UK stock markets are more limited relative to history, as I mentioned previously.
Q: What are your key takeaways from this discussion?
Chris Inman: The most important bit for me is achieving good member outcomes. To do so, we need to clearly define what retirement adequacy means. As an industry, investment consultants and trustees, we have a much easier job if we can define what retirement adequacy is for different groups of retirement savers. With this we can build bespoke and individualised investment strategies, using the investment innovations we have discussed today coupled with more engaging member communications that achieve the retirement lifestyles that our members deserve.
Claire van Rees: From the legal perspective, my takeaways would be in terms of regulatory action - there is a trend very much towards making people report about what they are doing as a way of forcing them to focus on whether or not they are actually doing it.
That is supporting, in a soft way, a trend towards a lot of DC single-employer trusts moving to master trusts because of the recognition that consolidation has lots of benefits in passing over the governance burden.
Darren Philp: DC trusteeship used to be the poor cousin of DB trusteeship but the issues faced by DC trustees are growing and are more challenging. Progress has been made. We are not coming from a great starting point as an industry when it comes to regulation but a lot is happening in terms of regulator consultations and master trust authorisation to raise standards. This will get us to the point where a trustee can be a trustee and acting in the best interests of members rather than worry about being sued.
Engagement is always going to be a challenge. Strong governance around the default is important.
Let us not talk about pensions as some sort of far-off financial thing that happens in the future. Let us not talk about investments in terms of stock and shares, gilts and bonds. Bring it to life. Speak to people about the impact of their investments. Tell stories.
Rather than giving them a load of vague disclosures, tell stories around pensions and investments. That will give us more chance of engaging people and getting them interested.
Raj Shah: In terms of investment background, I am positive and excited about building scale. It is going in the right direction in terms of investments. We are seeing access to alternative investments within DC. That plus responsible investment and ESG is going to be good to develop sustainable investment strategies but also to engage and connect with your membership. That is going to be key, especially for the young members.
Kevin Clark: We need to build on the success of AE. We have more people saving into pensions. Trustees need to make this successful. As such, they need to focus on the risks and on the future goals, which will be to improve investments and overall member outcomes through good communications and enhancing contributions.
We will see what comes from government in future. Trustees need to be positive about this and to help members in these areas.
Andrew Brown: The industry is moving in the right direction in terms of understanding the need for more sophisticated investment designs to improve outcomes for DC members.
Perceived barriers such as cost constraints and administrative complexity need to be overcome through an acknowledgement that investment requires more governance resource and a greater share of the member-borne charge. The low-cost mindset may not necessarily lead to good value in the long-term.
Providers should be assessed and scored on net risk-adjusted returns they have achieved for members, accepting some have will have relatively short track records. That is how business should be won or lost. AE has been hugely successful in terms of coverage though a significant market drawdown could be damaging - we should look to avoid that being the catalyst for meaningful change.
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