Investment commentators are referring to the last 40 years as a ‘super bubble' or even the ‘greatest bubble of all time'.
As we know, the investment backdrop was characterised by declining nominal interest rates, low and stable inflation, and a furious drive for globalisation. Central banks stimulated economies freely, and cheap credit fuelled leverage in the system. A rising tide lifted all boats; the prices of equities, bonds, property and pretty much all assets rose strongly.
With the benefit of hindsight, I find it hard to criticise DC trustees and chief investment officers (CIOs) that chose to invest in low-cost passive balanced funds when everything was going up, while focusing their efforts on other more pressing matters.
Looking forward, however, we are clearly entering a new regime, characterised not only by higher interest rates and inflation than many of us have seen in our working lifetimes, but also by more volatility, given the uncertainties around government intervention, supply-chain problems, climate boundary conditions, growing intergenerational inequalities and the reversing of globalisation. Several of these trends are now well under way. Regime changes are indeed rare, but they do happen and tend to have profound implications for financial markets.
It could be much more difficult to achieve positive returns in the next few decades than in the last 40 years, with passive management at risk of disappointing, particularly in real terms, and as it becomes harder to rely on bonds to protect capital given rising correlations between equities and bonds.
The Pensions Regulator's ‘value-for-money' push may be very timely in encouraging trustees to place less emphasis on cost and a greater focus on value. More active strategies, for example, could be better placed to take advantage of the growing divergence between companies, sectors, styles, strategies and countries. Allocating to more flexible, higher-conviction, unconstrained multi-asset and fixed-income strategies may be a better alternative to classic passive balanced funds.
One way in which larger DC schemes have been attempting to diversify in recent years is by investing in alternatives. However, most have faced difficulties accessing real illiquidity premia, as well as cost constraints. Again, with the benefit of hindsight, I am not sure that DC members have missed out by not being able to access these alternatives.
DC schemes looking to find better future diversification in their portfolios may consider investment trusts to be a good vehicle to enable them to have exposure to illiquid assets such as infrastructure; moreover, given that in recent weeks DB schemes have been forced sellers of these assets, now could be a good time for DC investors to step in. Indeed, those members who self-selected a dynamic multi-asset strategy in place of the default are already likely to be doing so, given the compelling opportunity in this market.
Active, diversified capabilities
While fee caps and cost constraints can limit DC schemes in terms of where they are able to look to invest, what is clear is that there is an urgent need for more active, diversified capabilities, which can deliver real returns for members against a challenging market backdrop. There are already plenty of large, liquid, scalable markets that the industry should be willing to offer at a lower fee for DC clients, whether that is actively investing in global large-cap equities, global government bonds, global currencies or global commodities, especially if done quantitatively, where capacity constraints are not an issue.
While more active default funds may be appropriate for younger DC investors, we need to increase engagement with end-beneficiaries and their advisers as they approach retirement to understand what they are likely to do with their pension, as this will materially change their investment options and strategy. Our parent company BNY Mellon has been conducting extensive adviser research and focus groups - to better understand what members' requirements are once they reach retirement, and to be able to offer more targeted strategies. The insights from this research have been instrumental in shaping our thinking around product development and solutions for the DC market.
Ultimately, amid a painful market regime change, it is important to look forward rather than backwards, because relying on the models, maxims and assumptions of the last 40 years could not only be misleading, but also dangerous. I think time will still look favourably on the actions of DC trustees and CIOs over the last 10-20 years; however, their actions and decisions in the next few quarters will determine their future legacy.