It is often said that there is nothing new under the sun, especially in investment. There are, however, investment ideas and techniques that are present in other sections of the institutional investment world but which are currently absent from the defined contribution (DC) world.
DC schemes, despite offering numerous advantages, also represent a huge challenge for members, particularly when it comes to investment. For instance, they are often required to take investment decisions about their financial futures, the complexity of which are normally reserved for professionals.
Unsurprisingly, therefore, DC schemes strive to achieve a balance between simplicity and effective investment choice, with in many cases the emphasis being placed on simplicity. However, simplicity does not have to mean boring, nor does it have to mean that good investment ideas cannot be utilised in a quest to help achieve members’ needs. What is needed is investment funds that are themselves sophisticated, but that can be presented to members in a simple and easy to understand manner.
Convention in the UK and in other DC markets is for a broad range of asset class-based investment funds to be offered to members from which they can make a choice. This is fine as far as it goes – it certainly permits flexibility, but it also requires members to be able to understand, and importantly separate in their minds, the characteristics of different asset classes.
On top of these single asset class funds, packaged funds have been made available that parcel different asset classes together in an attempt to create funds that can help make the member’s life easier. Balanced funds, with-profits funds and lifecycle strategies all fit into this mould in some shape or form, although each have their problems and limitations.
Traditional balanced funds came to DC as a legacy of defined benefit (DB), and as such were not particularly well geared towards the needs of DC investors. They have suffered in the UK from too high a concentration of domestic equities, and are difficult to build into an ideal DC investment strategy as they are arguably too conservative for young members. With-profits is an interesting concept as it offers the prospect of smoothed long-term growth, but is flawed by opacity and illiquidity for the member. Lifecycle in many ways trumps both, but is itself hampered by an imperfect range of investment funds.
But can we do better?
Just offering more choice is not actually that helpful when the additional choice is similar to what has already been available. Instead, we believe that as they grow and mature, DC schemes should seek to broaden their fund range to utilise better investment funds rather than just offering more funds. Two specific items that would help raise the bar in DC investment are more interesting multi-asset investment products and better availability of appropriate structured funds.
Return-seeking funds with ‘diversity’
As noted, lifecycle remains the foundation concept for DC investing, ie start with a good growth-oriented fund and move progressively to less-risky investments as retirement approaches. But any lifecycle strategy can only make use of the investment funds that are available, which are some way behind those employed in the best DB investment strategies.
The Myners review highlighted the need for trustees to consider alternative asset classes, yet in the field of DC there are few suitable funds available. The term ‘alternative’ is used in this context to describe asset classes that are not categorised as mainstream equities, bonds or cash and that are readily investable for pension funds. The major alternative asset classes for trustees to consider are property, private equity, hedge funds, high yield and emerging market debt.
Other strategies that might also be considered are commodities, active currency management and tactical asset allocation. In recent years, these ideas have permeated into the DB arena, but with the exception of property, the provision of ‘alternative’ investment options in DC schemes in the UK remains very low.
There are significant challenges to making single alternative asset funds available to DC members, not least communication/education hurdles and liquidity needs. What is more achievable, however, is to have ready-made, pre-packaged growth funds that incorporate various alternative assets alongside equity investments. Such funds might be termed ‘growth funds with diversity’, their aim being to generate high long-term returns without placing total reliance on the equity risk premium. Liquidity and communication issues should be manageable, and the end result should be a more efficient lifecycle strategy from an investment standpoint.
In recent times, our firm has been researching such funds, but sadly our findings are that there are few available that fit the bill. Many funds only cover single alternative asset classes, have very high minimum account sizes or suffer very high fees, all of which makes them unattractive in the DC environment. On a more positive front, a number of investment managers we have spoken to say they are taking up the challenge, but there is a certain chicken-and-egg mentality whereby funds are only launched when there is proven demand, and yet without good fund offerings, pension schemes are unlikely to decide to implement.
As suggested by our graphic, we believe the biggest potential area of growth in terms of additional fund choices for members that will make a difference is in the area of structured funds. These are funds that are designed to help members achieve a particular goal, either because they have a particular focus, or because they provide some level of underpin that helps provide a floor to the member’s pension.
Leaving aside for the moment the issue of lifecycles, there are several types of structured funds that are of considerable interest.
In continental Europe and in the UK retail savings market, various guaranteed funds or funds with floors exist, and we feel there are good reasons to suggest these types of fund will also find a home in occupational DC. Some of the funds have explicit floors provided by direct insurance or by the use of derivatives (put and call options), whereas others make use of an interesting investment technique referred to as constant proportion portfolio insurance (CPPI).
How CPPI works
CPPI works by varying the quantity of risky versus low-risk assets in order to at least maintain a specified minimum value of the fund. In good times the fund is free to invest in risky assets and thus garner good returns, but in bad times the fund becomes defensively invested protecting the investor’s account. The attraction to a DC investor is that they have an assurance that the value of their fund will not fall below a specified level, yet there is the prospect of reasonable performance. In addition, there are no lock-ins or surrender penalties that blight other forms of protected savings, eg, with-profits. As a concept, we believe structured funds of this ilk are likely to be worth considering as an addition to traditional single asset class funds and to lifecycle strategies.
Our research shows that these types of funds are not very popular in any of the main developed occupational DC markets around the world. In particular they are thin on the ground in the UK, although this is changing. In general, the current crop of structured funds are relatively immature and have shortcomings, but newer and better variants are appearing all the time.
Both diversity funds and structured funds have disadvantages in common in that they require higher trustee governance due to their relative complexity. They can also involve additional fees, and at least initially they are unusual when compared to the mainstream UK DC investment offerings, leading to potential regret risk. Last, communication and member education should not be overlooked, both of which are likely to be something of a challenge. Nevertheless, as DC grows in importance, it is likely that these issues will be overcome.
Given the basic thesis outlined above, we believe there is an unmet need for innovation in the world of investment funds for DC. Presently it is fair to say that there is both a relative lack of investment ‘product’ and a lack of pension scheme awareness and hence demand. Despite a slow start, progress is inevitable, and as a means of complementing the traditional forms of investment fund that are commonplace today, we hope and expect that both will change, paving the way for a better DC investment future.
Andy Hunt is senior investment consultant at Watson Wyatt