Best practice for defined contribution pensions inevitably involves well-designed default options. Multi-asset approaches of some kind are the best fit for most investors but views differ about how to best structure them, finds Gail Moss
At a glance
• Multi-asset approaches in DC include lifestyle and target-date funds.
• Members can continue to be partially invested during the retirement term.
• Pension providers offer innovative ways for DC schemes to invest in illiquid assets.
Multi-asset strategies are a natural lynchpin for default funds in defined contribution (DC) schemes, as they can provide a high level of diversification, leading to consistent returns with less risk.
Within a multi-asset portfolio, pension fund providers shift the allocation over time towards less risky assets, the early stage growth period giving way to ‘safer’ investments such as cash and bonds as the participant nears retirement.
Until recently, the most common way to do this was through traditional lifestyling, which uses automatic and relatively mechanistic methods, treating people with the same age or number of years to retirement as having the same income objectives.
However, target date funds (TDFs) – which build a pension pot towards a specific retirement date chosen by the individual – have been gaining ground. Widely accepted in the US, their European profile increased when the UK’s National Employment Savings Trust (NEST) opted for an investment approach using TDFs in its default funds.
The advantages of TDFs include ease of communication to members, administrative simplicity, greater cost-efficiency and increased flexibility to manage risk across different cohorts.
However, Paul Todd, assistant director of investment policy at NEST, says that while TDFs have these advantages, they are only a delivery vehicle. “The crucial element is how asset allocation and risk is managed within this delivery vehicle, and the principles behind strategies such as diversified growth funds are equally suited to the TDF structure,” Todd says.
Anne Ackerley, head of BlackRock’s US and Canada DC group, says the reason that TDFs have emerged as the best practice in US DC is that they do something that other multi-asset class strategies do not. “They take into account the participant’s future earnings potential,” she says. “This is critically important. The greater your future earnings potential, the greater your ability to recover from market losses. Only TDFs adjust for future earnings throughout a working career.”
AllianceBernstein markets TDFs in the US and has also done so in the UK for a number of years, although the wider TDF market in the UK has been slow to take off. “TDFs offer a robust structure enabling employers and trustees to deliver a well-designed default investment strategy and, in the US, benefit from the ‘safe harbour’ status,” says Karen Watkin, portfolio manager, multi-asset solutions, AllianceBernstein. “They are age-appropriate diversified growth funds, taking into account changing market conditions and members’ changing risk capacity as they approach their retirement date. In contrast, diversified growth funds typically provide asset allocation that is not aligned with a pension savings outcome.”
In Sweden, AP7 Såfa – the state-managed default fund for the DC system – is a lifecycle product with a profile created according to the individual’s age, and therefore not a TDF. Its asset allocation consists of a mix of global equities and Swedish fixed income assets.
Danica Pension uses three open-ended funds with different risk levels: equity, mixed and defensive. The client’s allocation to these funds depends on their risk profile and the number of years left to retirement, employing three brackets: 30-plus, 15 and five years to retirement. It also takes into account whether the clients want a 10-year or 20-year payout profile.
Other investment options include fixing the allocation in one of the open-ended funds, and setting a client’s own risk profile independent of the retirement date.
The ‘to’ factor
Determining the optimal asset allocation per year – or number of years – is a key factor in achieving the best outcome for participants in a TDF.
From the perspective of a lifestyle fund, Ingrid Albinsson, CIO of AP7, says the optimal asset allocation process in Såfa is decided from a holistic approach, using the total state pension as the starting point.
“As the DC portion is small, the policy is set so as to take on a higher risk in the system,” she says. “Given the holistic approach, an optimal risk level is decided both from individual risk preference and also the legal framework within which Såfa is managed.”
AllianceBernstein’s Watkin adds: “The asset allocation at any moment in time derives from our overriding objective to maximise the typical investor outcome at the target date, for a given short-term risk budget, reflected by time remaining to target date. Both in the UK and US, we view the management of the TDF suite as a constant dynamic, and take on a fiduciary responsibility for ensuring the underlying asset allocation is kept fresh through time, always reflecting our best thinking.”
In the US, TIAA-CREF offers low-cost and highly-regarded active and index solutions through its Lifecycle funds. It has adopted a ‘to and through’ retirement philosophy for these funds. For its core 403(b) not-for-profit plan sponsors, it also offers TDFs which include embedded annuities and also a liability-driven investment solution targeting a specific income.
“Today, retirement can routinely last 30 years or more. Participants need enough equity exposure to support decades of growth, plus diversification to fixed income and other assets to soften market shocks”
There are differing views as to whether a single-year target date is too granular. Tim Walsh, managing director of investment services, TIAA-CREF, underlines the TDF’s simplicity, in that 50-year-olds, for example, understand they are in the 2030 fund because they plan to retire at age 65. But he says plan sponsors as fiduciaries are starting to question whether this simplicity can be maintained while personalising investment options.
“One of the best ways is to offer a managed account solution side by side with a plan-level default TDF,” he says. “Many participants will select the default but eventually there is an inflection point where they will want a more personalised solution. That’s where point-in-time advice or a low-cost in-plan managed account solution makes sense.”
BlackRock offers its target-date suite in five-year increments, with participants advised to pick the target date most closely matching the year they plan to retire. “Offering single-year increments may make a fund a better ‘fit’ but the plan may lose economies of scale by administering 45 or so separate funds,” Ackerley says. “Offering TDFs in single-year increments may make sense if the fund has some sort of guaranteed income component built in. If that’s the case, the cost of the guaranteed income is based on when the participant turns 65.”
Watkin says AllianceBernstein also believes single target years are too granular for most people, who would find it difficult to pinpoint precisely when they are likely to retire. “Our range of TDFs in the UK is structured with three-year vintages, allowing members to express a likely retirement ‘window’. Recognising the uncertainty most people face not only in relation to when, but also how, they will access their pension savings, our investment philosophy has always been to strike a pragmatic balance rather than to target a set outcome at a given date.”
With Europe’s long-term economic landscape becoming ever more uncertain, and the increasing likelihood of big swings in individuals’ disposable income in future years, drawdown strategies have never been more important.
“Just a generation ago, retirement was expected to last an average of seven to ten years,” says Ackerley. “Today, retirement can routinely last 30 years or more. That’s why at retirement, participants need enough equity exposure to help support decades of growth, plus enough diversification to fixed income and other assets to soften any market shocks.”
AllianceBernstein has always managed its TDFs to ensure they allow members to remain invested through retirement. For those UK participants wishing to take an income in retirement it offers a seamless transition from its pre-retirement DC investment strategies, including the TDFs, into a flexible income drawdown strategy.
“Members approaching or in retirement typically want to continue to grow their pension savings whilst starting to draw an income,” says Watkin. “We adapt the investment strategy using a variety of techniques such as fixed income duration management, effective diversification, and avoiding strategies with long market cycles or high tail risk.”
TIAA-CREF believes that greater retirement readiness can be achieved by encouraging participants and plan sponsors to focus more on lifetime income, which it says is best achieved by ensuring plan participants’ access to guaranteed annuities both as an investment option during the accumulation phase, and as an income replacement tool in retirement.
In-plan annuities offer multiple advantages, says Walsh: “First, there is the cost. Participant costs may be substantially reduced as against obtaining protection outside the plan, ie, longevity insurance. Second, there is behavioural change, meaning participants are more likely to annuitise, providing income they need throughout their lifetime. Third is security. They help manage downside risk, dampen volatility, and ensure retirement income.”
Danica Pension’s clients can choose a minimum guaranteed annuity with possible upside if markets perform, or they can choose to keep the overall market risk, which will affect payouts according to market movements. Clients can also change their risk profile or change their allocation between risky and less risky assets.
But what about the practicalities of investing in illiquid assets? While the European Comission’s Capital Markets Union explicitly seeks to encourage and facilitate individual savers to invest in long-term investments and real assets, can this be done in a DC framework?
NEST already invests directly in UK commercial property, and is conducting ongoing research into ways it can earn further illiquidity premia through exposure to infrastructure. NEST’s Todd says this requires market innovation to make it more suitable for DC.
Watkin says some current restrictions such as the investment budget, and the requirement by many pension providers to offer daily pricing and liquidity, can constrain the universe of investments available to DC schemes.
While AP7 considers that a DC framework would not automatically reduce the scope of investable asset classes, Albinsson says: “The UCITs framework within which Såfa is managed requires high liquidity and transparency in all holdings, which reduce the possibilities of investing in long-term real investments.”
For Danica Pension, fund exposure to illiquid assets is not a problem. “A specific portion of each of the three funds is allocated to real estate, infrastructure, and so on,” says Anders Svennesen, CIO, Danica Pension. “The funds are open-ended, so we do not need to sell holdings to buy more long-term assets as younger participants are always coming into the funds.”
In the US, TIAA-CREF offers traditional illiquid assets such as timber or private equity through its asset management group, but also higher-yielding, illiquid fixed annuities and stable value products. For instance, the TIAA Real Estate Account, a variable annuity, provides individual investors access to commercial real estate via a diversified portfolio comprised primarily of directly owned real estate but also provides exposure to real estate investment trusts.
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