Default funds are moving beyond plain-Jane equity offerings, as Sebastian Cheek reports
The rate of asset growth in defined contribution schemes is far outpacing that of defined benefit and in several markets across the globe DC is now the dominant pension model.
According to data from Towers Watson, in the seven largest pension markets in the world DC assets grew at a rate of 6.4% per year over the last 10 – compared with defined benefit assets which grew at 1.6% per annum over the same period.
There are so many more products in the market now than three years ago
In addition, DC assets now represent 42% of the total pension assets in the seven largest markets – compared with 32% in 1999. The worldwide split between DB and DC is 59% and 41% respectively, but this is set to change.
Just last month in the UK Aviva confirmed plans to close both the Aviva and RAC final salary schemes to future accrual and switch staff to a money purchase arrangement from April 1, next year. Last year, Barclays took a similar step with its DB scheme.
The fact that big employers with substantial salary rolls, such as Barclays and Aviva, have taken this decision means more and more contributions will be beefing up the total DC asset pool.
To meet such rapid expansion the design of investment strategies in the DC space needs to become more compelling and sophisticated, particularly for the default where the vast majority of members are invested.
Traditional equity-dominated default funds are still the staple because they drive long-term return, particularly for younger members.
In the UK around three-quarters of DC plans have a 100% equity allocation. However, pension funds in the main have shown a growing trend to move away from equities in recent years.
At the UK’s National Association of Pension Funds conference in March, London Stock Exchange chief executive Xavier Rolet told delegates de-equitisation was the greatest single trend of the last 10 years.
State Street Global Advisors head of multi-asset class solutions Andrew Soper said 100% in equities is too volatile for some default designs. He said it can take about 12 years just to get money back from an equity investment and 30 years to achieve a positive return over cash, although admits ultimately equities do drive long-term return.
Speaking at Hewitt’s recent Defined Contribution Forum, chief investment officer in the DC team Anne Swift said more asset managers were now wanting “a piece of the DC pie” and diversified growth funds were a solution investors are looking at “more seriously”.
Among significant employers using diversified growth is mobile phone operator O2, which uses the BlackRock Diversified Growth Fund as part of its default strategy.
At the end of March, BlackRock’s Diversified Growth Fund was made up of 40% equities, 32% fixed income, 18% alternatives (such as commodities, hedge funds and private equity) and 10% cash and equivalents.
According to BlackRock DC director Emma Douglas, some very big schemes are using diversified growth funds either for, or as part of, their default and she said BlackRock has some more big clients in the pipeline.
“We have 20 (UK) schemes that are using our diversified growth fund as their default or as part of their default. It [diversified growth] really is a live existing trend. There are so many more products in the market now than three years ago,” Douglas said.
The make up of diversified growth funds varies across the board and there is no one solution for individual schemes. Redington managing director Ian Maybury said there is “quite a mix out there” and successful funds can have quite a different shape from one to another.
Indeed, State Street Global Advisor’s diversified growth fund at the end of December 2009 consisted of 50% equities, one quarter bonds, and one quarter hedge fund replicating strategies, including commodities and real estate.
Maybury added diversified growth is about accessing beta in the market rather than manager skill using commodities and currency and a small amount of more illiquid assets like property and private equity. However, it is typical for them to also include assets in the alternative space, such as hedge funds.
At Hewitt’s DC forum, Swift said passively managed diversified growth funds are a neat solution for schemes wanting diversification but without the expense of active manager fees.
Industry experts said one of the challenges with DC is to keep the portfolio liquid as you never know when redemptions will have to be met without significantly altering the allocation of the portfolio.
Redington’s Maybury said most default funds need to be traded on a regular basis – daily, if not weekly – so areas like private equity are difficult to access in a liquid form.
SSgA’s Soper said an “obvious” solution to the liquidity conundrum, and a continuing trend among schemes, is to invest in property through real estate investment trusts (REITs).
He said listed property exposures are on DC investors’ radar as an asset class that offers the nice characteristics of property – inflation linked rental incomes and negative correlation with other asset classes – with the liquidity DC schemes need.
Mercer principal and senior investment consultant Brian Henderson said some schemes do have an allocation to property and agrees REITs are a more “DC friendly” option than direct property.
However, he cautioned, REITs can have a period of time built into the funds where you cannot redeem– so that can create difficulties if seeking liquidity.
“It is a balancing act between the ability to redeem and give members money back quickly versus the return expectations of an asset class, and if it is worth having the illiquidity risk built in for the sake of some extra return,” Henderson said.
There has also been talk of investment strategies inherent to DB schemes transferring into the DC market. Experts said the industry is not there yet but liability-driven investment strategies used to hedge against interest rate and inflation risk are expected to become part of the scene in the not so distant future.
Speaking at a DC briefing last month, SSgA senior managing director Kanesh Lakhani said there was now a growing need for more competitive retirement offerings in the DC world – such as LDI, managed volatility strategies, and inflation hedging strategies.
Maybury observed this is because a DC scheme is effectively a one-man DB scheme as it has the same exposure to interest rates and inflation but relating to a member’s specific circumstances rather than across the scheme as a whole.
BlackRock’s Douglas echoed this saying by the time a member reaches the decumulation phase their portfolio looks like an individual LDI portfolio because they also have concerns about inflation and interest rate hedging – especially to better match assets with an annuity.
Mercer’s Henderson said strategies that look to mitigate interest rate and inflation risk will increase in DC because during the protection phase members need two things: capital protection and to move into asset classes that behave like annuities.
However, Maybury warned there could be complications when transferring inflation and interest rate hedging into DC because contract-based schemes are often delivered on platforms regulated by the FSA.
He said: “The leverage you have in some of the inflation hedging and interest hedging type products are difficult to get to work through an insurance type FSA platform.”
Nevertheless, he agreed we are likely to see DC funds invest more with pooled providers for LDI funds, such as target retirement fund ranges with some form of inflation protection.
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