In the run-up to the 10th anniversary of auto-enrolment (AE), Professional Pensions assembled a panel of experts to discuss defined contribution (DC) investment strategy.
The panel - chaired by PP editor Jonathan Stapleton and held in association with Columbia Threadneedle Investments (CTI) - included BESTrustees president Alan Pickering; CTI client relationship director Andrew Brown; Mobius Life director of DC David Porter; B&CE managing director of investments Jonathan Cunliffe and XPS Pensions group head of DC investment and multi-asset research Mark Searle.
This roundtable looked at how DC investment strategies have changed over the past decade as well as the investment issues DC schemes are facing in the current economic climate.
How have DC investment strategies evolved over the decade of AE?
Mark Searle: Ten years ago, every DC default fund targeted 25% cash and 75% gilts and bonds at retirement. They now reduce risk relative to how members take their pension income - that is a fundamental change. It is also good to see ESG investing come to the fore.
The industry needs to do more in relation to freedom and choice. Members need greater support, and evidence shows gender and social imbalances. We should target communications to address these imbalances.
Alan Pickering: A pension should not be the default savings vehicle for someone on lifelong intermittent or low earnings - the biggest beneficiary has been the investment management industry. At least DC has become more member focused. As a trustee, I'm very keen for our default fund to access all asset classes. Defaults can be wonderful if properly designed.
David Porter: It was difficult for consultants to change their advice easily within inflexible lifestyle strategies, and the industry remained wedded to them as delivery mechanism. The catalyst was the freedoms, which got rid of the aim for an annuity. The biggest change has been to increase equity allocations as members approach retirement.
Auto-enrolment enabled collectivisation and focused attention on larger pools. As DC pools gets bigger, we can bring in defined benefit (DB)-like thinking. We are already seeing more requests for esoteric return drivers but to deliver these requires good administration and infrastructure.
Jonathan Cunliffe: Central bank policy since the global financial crisis has inflated all markets. We cannot expect central banks to continue putting a floor under markets so asset allocation will become more challenging. This supports our allocation into alternative sources of return such as infrastructure and property.
Elsewhere, ESG is not new - every good investor has always considered non-financial risks. The BP Deepwater Horizon disaster and the VW emissions scandal were both due to poor governance, and highlight that ESG incorporation is key to mitigating risk.
Andrew Brown: Investment strategies have not become significantly more sophisticated over the last decade. Favourable financial markets, particularly equities, have been kind to strategies that lack diversification or dynamic asset allocation. As a result, there hasn't necessarily been a catalyst, perhaps until now, for meaningful advancement in most default funds. Trustees and governance bodies have also been constrained by a plethora of non-investment related regulatory requirements. However, we have seen considerable progress in how ESG risk factors are accounted for along with associated metrics.
The Bank of England warns inflation may peak above 11% and interest rates will further increase. How should DC schemes respond?
Mark Searle: Members expect £1 invested today to be able to buy more tomorrow, so they are implicitly thinking in inflation-plus terms. We should therefore be thinking about inflation-linked targets to help meet members' objectives. DC strategy design often seems to only improve incrementally, and we lose sight of whether the strategy as a whole delivers reasonable outcomes. An inflation-plus mentality should work longer term but short-term periods of high inflation are clearly a challenge.
Jonathan Cunliffe: The challenge is to generate good quality risk-adjusted returns. Academic evidence suggests growth assets generate returns comfortably above inflation over the long run and they should remain the cornerstone of a return-seeking approach. If we switch to the immediate environment I would highlight that The People's Pension (TPP) has a relatively heavy exposure to value stocks, which work well when interest rates are rising. By contrast, growth stocks and fixed income are sensitive to rising rates and we have less aggressive exposure to these asset classes.
David Porter: All the schemes and master trusts on our platform embed ESG and they are increasingly invested in private markets. The cohort-isation of age groups and compartmentalising their assets is critical. The next big deliverable is to build infrastructure able to tweak exposures up and down for different groups.
Alan Pickering: I'm critical of governments making policy through the rear-view mirror, based on Ukraine or what might be transient inflation. Likewise, I'm keen for members to trust the default rather than responding to the latest family finance column via self-select. Ukraine exposed the need for armies and provides a wake-up call for ESG exclusion advocates - if we need soldiers, we must finance their tools.
Should investment strategies be adapted to this market environment?
Andrew Brown: In theory, investment strategies should be designed to withstand bouts of volatility and periods of rising inflation. It is about creating a robust default fund based on fundamental beliefs that incorporate a degree of dynamic asset allocation. Inflation has been low by historical standards for a protracted period and while equities provide a fairly decent inflation hedge over the longer term, real assets such as property and infrastructure should form part of a portfolio to manage this risk, where inflation linkage is often a feature of these asset classes.
Jonathan Cunliffe: We can no longer rely on central banks to print money so correlations will become weaker and returns dispersion wider. Private markets provide an opportunity to harvest illiquidity and complexity premiums - but we need to make sure groups of members are not disadvantaged given infrequent pricing points and the potential use of performance fees
Alan Pickering: We have driven down the costs of administration to the point where we are paying for a commodity but expect a bespoke service. I worry that league tables will lead to us levelling down pensions. In addition, charge caps seem like overkill and can have unintended consequences.
We tend to focus on environmental factors but perhaps need a wake-up call for governance. Are we doing enough?
Jonathan Cunliffe: MSCI scores TPP's default as 'AA' on ESG. It is easy to screen out stocks or dial-up climate tilts without hugely increasing tracking error. Given poor visibility of scope three emission data, there is lots of spurious accuracy and potential for overstatement of progress on environmental factors, and focus on these can come at the expense of social and governance factors.
Alan Pickering: If you get governance right, the rest will follow. I'm also a big fan of social - it is important we do not become ESG colonialists or throw people on the scrapheap when managing the transition. I believe engagement is far more effective than exclusion.
Andrew Brown: As an active asset manager, governance is top of the ESG triangle. DC schemes typically apply negative screening based on historic metrics - I'd like them to think more about engagement and it is not just about equities. DC schemes are also well placed to invest in impact solutions within infrastructure, property and private equity.
Mark Searle: The public's reaction to the Covid pandemic and the ‘great resignation' show people are increasingly making decisions based on lifestyle as well as financial factors. This way of thinking has links to social or impact investing and we're pleased to see fund managers are increasingly reporting against ideas such as the United Nations' Sustainable Development Goals including no poverty, gender equality and sustainable cities and so on.
To what extent should DC portfolios include private assets?
David Porter: Virtually every master trust and DC default on our platform includes private markets. There is an ongoing consultation about impact investing in infrastructure.
Andrew Brown: DC default funds have long investment horizons and positive cash flows so are well placed to allocate meaningfully towards illiquid asset opportunities. That means missing out on the associated illiquidity risk premia that populate the asset portfolios and returns of most DB schemes. With their diverse return drivers, long-term cash flows that are often implicitly or explicitly linked to inflation - and returns that are often less sensitive than equity or credit returns to the macroeconomic environment - illiquid assets (such as real estate and social and economic infrastructure equity and debt) typically offer a markedly different risk-return profile and pattern of returns to that of public equity and credit markets, upon which many DC default funds overly rely.
Mark Searle: Most DC trustees are receptive to the liquidity premium but are worried about the operational risk. Cracking that would push illiquids further up their agendas. But we can't turn a blind eye to illiquidity issues - we saw them during the pandemic, Brexit and Woodford fund closure.
There is a big push from TPR and the DWP on consolidation. Is it a panacea?
Andrew Brown: It is not, but we must acknowledge that AE has been successfully implemented as a result of master trusts. It makes sense for smaller schemes lacking governance capabilities and resource to consolidate with multiple employers. However, increasing regulatory governance has also had the impact of seeing well-run, consultant advised occupational trust-based schemes winding up and moving from a tailored investment approach to an often ‘one-size-fits-all' low-cost default fund.
Alan Pickering: Big is not necessarily beautiful. Good employers want to provide financial wellbeing and good service, and may think they cannot adequately provide DC on a standalone basis. They probably ought to find a master trust that resonates with their values.
What do you think will be the key DC trends of the next decade? What needs to change in DC?
Alan Pickering: If there is a magic bullet, it is employer engagement. A downside of AE and prescriptive government regulation is that pensions become a compliance chore. If we can get employers to engage, they'll have a valuable role to play in making sure DC provides a valuable benefit.
Mark Searle: ESG is gathering momentum and I think assets that can touch on this together with strong inflation linkage, such as property and infrastructure, will be in increasing demand. I've also been having interesting conversations around structured equity, which has benefits that are similar to diversification, such as reduced volatility and reduced risk of capital drawdowns.
David Porter: I would like to see consideration of the roles of liquid and illiquid savings. A member with 30 years to retirement needs a sidecar vehicle for ‘rainy day' issues as they appear. I think we'll see innovation in ‘wealth wellbeing' rise, as it increases engagement.
Jonathan Cunliffe: Central banks are reversing their policies and we need to address this in strategic asset allocation. If returns fall back to the long-term average, or lower, the gap between the good and the bad providers will become obvious.
Whatever happens to the growth outlook, inflation is probably going to settle at a higher rate, and this is a clear challenge to investors as there is a shortage of assets offering protection, unless you want to take interest rate risk in bond markets by investing in index-linked gilts.
Andrew Brown: The industry needs some consensus on ESG - how we report, measure and compare approaches and metrics. The pension dashboard may engage members with greater transparency; perhaps that will be the catalyst for better engagement. Investment decision making needs to rapidly shift from a low-cost mindset to one that is based on net risk-adjusted returns.
This roundtable was held on 11 May in association with Columbia Threadneedle Investments