It is possible to invest smartly, efficiently and creatively under the 0.75 bps charge cap, Natasha Browne hears
The long-awaited charge cap on defined contribution (DC) default funds used for auto-enrolment (AE) takes effect next week. It comes amid a raft of reforms currently sweeping the DC landscape.
Industry bodies, including the Society of Pension Professionals (SPP) and the National Association of Pension Funds (NAPF), have expressed serious concern over the timing of the cap. Many were worried DC schemes faced too much change in too short a timeframe. Nevertheless, the 0.75% limit, which covers administration and investment costs, is implemented on 6 April.
Although the member-borne cap excludes transactions costs, this is up for review in 2017 alongside talks to consider whether it should be further reduced to 0.5%. Speaking at the NAPF investment conference in Edinburgh last month, experts warned of the dangers of including transactions costs in the cap.
Lloyds Banking Group head of investments for group pensions Simon Lee described a transaction charge cap as "unworkable" given the difficulty in predicting future transaction costs. State Street Global Advisors senior UK DC strategist Alistair Byrne said such a limit could end up "tying the manager's hands in terms of his ability to respond to changing market environments".
While the experts agreed it was right to exclude transaction costs from the charge limit, they discussed in detail how schemes could continue to invest smartly within 75 basis points (bps). Multi-asset strategies were highlighted as compatible approaches, but active management was seen as largely unachievable.
Byrne said: "The charge cap is a budget constraint that we need to work with and it's about making tough decisions and focusing on value for money – where we can best spend that budget in order to improve member outcomes.
"Although there is potentially a role for it, active stock selection may not fit within the cap and may be one of the sacrifices or the things that has to be looked at as not being possible within the budget or not being possible to a significant degree."
Lee added: "Active investment management has a key role in defined benefit (DB) schemes where portfolio construction is important and alpha can be secured over the long term. But this requires significant governance and an ability to effect and implement changes.
"I'd not suggest that it's wholly incompatible with DC, and I'm not personally averse to active management. But in the DC world, simplification and consistency of approach may be much more important and more appropriate due to the general governance and communication constraints."
A timid approach
Passive investment strategies like index funds and exchange-traded funds (ETFs) could curb fees, Lee noted. However, the benefits were limited by some inefficient markets. It was also difficult to access alternatives at a low cost, although a multi-asset approach could be a cost-effective way of gaining this exposure, Lee said.
He also observed the increasing role diversified growth funds (DGFs) played in DC default funds. He said: "They can include a wide range of underlying asset classes. Access via internal, external, passive, active, management processes, and also include listed vehicles, replication strategies, structured notes and other derivatives.
"However, asset allocation is usually the key driver of returns, and the extent to which this will change dynamically, will vary dramatically between funds."
Byrne described equity beta as the engine that would take schemes to their investment destination. And while equities were not without risk, reducing exposure would result in lost returns.
He said: "You could have a look at having less volatile equities using some sort of smart beta type approaches in order to reduce volatility. It's worthwhile but has too limited an impact in crisis situations. But there are some alternatives around hedging risks, and you've got potential to do dynamic asset allocation or to use other top volatility management techniques."
According to Lee it is critical to understand the needs of the majority of DC members before designing the investment strategy. He said: "Remember, many members are on low to average salaries. It is likely the majority in most DC schemes may not need to take a disproportionate amount of investment risk if they commit to make adequate contributions for a long enough period.
"The crucial assumption in all of this is that state provision remains largely as is, and as part of their overall retirement income. The charge cap at its current rate or at some lower future level shouldn't disrupt this optimal DC scheme design and nor should the cap be seen as a target for exactly those reasons.
"I think my basic principles are that the default design should be targeted at the majority of scheme members and those for whom the DC assets are going to be most essential. Some limited additional choices should be provided for those members for whom the default is less appropriate, and/or who are more engaged, reflecting their more specific circumstances."
Still, small schemes would struggle to create enough scale to gain access to efficient costs. For those that could not achieve scale internally, Lee recommended looking externally for help. He said: "You should consider outsourcing to either a multi-employer arrangement or a master trust.
"Greater pooling of assets should provide increased purchasing power, and other economies of scale, to the benefit of both members and employers. These arrangements are expected to grow rapidly as DC assets increase and regulation becomes mostly more expensive and more costly."
But Lee warned schemes that provider selection was critical given that not all would be successful over the longer term, as witnessed in Australian.
He said: "My view is that some form of passive DGFs and blends thereof may be an effective way of addressing the charge cap while still delivering the investment efficiency and the required returns you need to support the default. In the absence of scale, master trusts and other multi-employer schemes may well be a good solution to these issues."
Byrne added: "You're not going to be able to afford within the charge cap everything that you'd ideally want. You can get equity beta, the engine, quite cheaply. We think it's worth paying for devices and features than can help smooth the journey or provide protection should anything go wrong. Dynamic asset allocation and target volatility triggers are a couple of examples of that."
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