In the second edition of AE Watch, Maria Nazarova-Doyle looks at the performance of the UK's largest DC default funds.
Earlier this year, Professional Pensions teamed up with JLT Employee Benefits to launch AE Watch, an initiative that examines the investment performance of defined contribution default funds in a bid to enhance transparency in our industry.
In this instalment of AE Watch we look at the latest data covering the growth phase of major defaults in the UK market - eight master trusts and nine contract-based providers - and we attempt to answer the important question: what does it all mean for savers
To find out, we analysed the difference between investing in the best- and worst-performing default funds and modelled how this might impact long-term outcomes for savers at retirement.
Risk vs return
The graph and table illustrate the three-year annualised performance of the growth funds investigated as at 30 September 2018.
The results demonstrate a difference in returns between the bestand worst-performing defaults of around 7.3 percentage points per annum, with a difference in volatility between the highest- and lowest-risk funds of around 4.7 points per annum.
There is generally a strong correlation between risk and return, although, in correlation with our analysis six months ago, some defaults have managed to use their risk budgets a lot more efficiently, therefore providing much better risk-adjusted returns than others.
The funds analysed represent the growth phase of lifestyle strategies and are therefore used when members are younger - a time when savers can afford to take on more risk to try and achieve greater returns.
Some of these defaults, however, adopt a very conservative approach to the accumulation stage. We believe that many defaults are taking on too little risk and as a result, many savers could be missing out on greater returns, potentially leading to a very large shortfall at retirement.
A real impact on real people
The three main factors that influence outcomes for DC members are investment returns, contributions and fees. While auto escalation and the charge cap are going some way to tackle the latter two factors, the selection of the default fund will be the main driver of the investment returns. The problem is that percentage returns don't really give a good feeling for what such large differences in returns might mean in the real world for a typical saver.
The impact of default performance on outcomes
We took the highest returns (15.4%) and the lowest returns (8.1%) from our default fund analysis and modelled the impact on Max and Hilary if they consistently received these highest and lowest returns over the period until they are 57 (the age at which both will be able to access their DC savings from 2028).
Note that we think this is very unlikely to happen in practice for several reasons:
- During the past three years covered by this analysis, equity markets have been in an unusually bullish risk-on environment, so the returns over the coming decades are most likely to be substantially lower than this on average. This will mean the pound value of the differences in outcomes should be lower than these assumptions imply.
- The coming decades will include risk-off periods where the lower risk default funds will probably outperform. This will rotate the leadership and reduce the dispersion of end results, so the difference between best and worst will be smaller.
- Finally, we would like to believe that any fund which consistently underperforms for decades is likely to be closed down so will not exist until Max and Hilary reach 57. This will reduce the cumulative difference between the best and the surviving worst.
- As the disclaimers usually say, past performance is not a guide to the future. This is true.
But as we do not have a crystal ball that will tell us what the market returns will actually be or how much the returns from the default funds will vary, it is still useful to consider what the impact would be if the last three years were to repeat themselves many times over the coming decades.
Given these extreme assumptions, the potential dispersion of the savers' outcomes is astonishing, with a difference of over £500,000. Even if the size of the difference were only a fraction of this value, it would still have a material impact on the quality of life in retirement for Max and Hilary. It's also clear that due to the power of compounding, the potential impact can be far greater on Max as he has a longer period to invest. This underscores the importance of starting to save early into a good default fund.
The performance data shown does not tell us which defaults will do well in future, but it does indicate that making a careful choice of default and monitoring the default through the years to ensure it remains appropriate is arguably the most direct way that employers can help influence the investment returns received by members. By the same token choosing the wrong default and leaving it unsupervised could do irreversible damage to a member's future wealth and retirement plans.
Importantly, we continue to only include defaults into the AE Watch where sufficient track record of data is available daily from independent sources and we are again calling for all providers to make the performance of their funds more accessible in order to increase transparency in our industry. It should not be acceptable that data on daily dealt investments becomes available months after quarter ends and can only be obtained via direct relationships with providers of DC products. As an industry, we need to collectively strive for transparent data provision that supports good quality decision-making.
Maria Nazarova-Doyle is head of DC investment consulting at JLT Employee Benefits
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