Pádraig Floyd assesses how master trust providers are shaping the design of defined contribution default funds 

Defined contribution (DC) is the new world order of UK occupational pension provision, and is fast becoming dominated by master trust structures. 

NEST is the best known, founded on money loaned by the UK Treasury to create a provider of last recourse. It has gathered assets and now manages £830m (€971m; see table).

It runs retirement-date funds that cover four different phases of risk management for members depending on how far they are from their retirement date.

NEST’s approach is not unique – a number of master trusts have favoured the target date fund (TDF) structure. 

In fact, there are considerable differences between the master trusts in the auto-enrolment marketplace. 

B&CE’s The People’s Pension, which amassed £2.3bn to the end of March 2016, employs three equity-biased funds with global asset allocations. They sit under the categories balanced (85% equities), cautious (60% equities) and adventurous (100% equities). 

The plan uses a 15 year lifestyle glidepath into a pre-retirement fund with options for ethical, sharia and cash funds. 

Another pure auto-enrolment provider, Now Pensions, operates a different approach. It offers only one investment option, a diversified growth fund with allocation on the basis of four risk factors – equities, interest rates, inflation and commodities.

“In a traditional balanced 60/40 funds, about 90% of the risk is in the equity portfolio,” says Robert Booth, director of investment and product development at Now Pensions. 

This balanced risk approach – not risk parity but “in the same family” reduces the concentration risk seen in balanced funds and other structures typically used in DC defaults, says Booth, particularly 100% passive equity, which he considers “a bit much for the demographic of brand-new savers”.

Booth is confident of the investment approach as it relies on the research and skills of its parent, Denmark’s national labour market pension fund, ATP, which offers the kind of scale many other master trusts cannot achieve.

“If you can achieve scale, you have a bit more flexibility with the investment,” says Booth. “Cheap and cheerful is not necessarily in the best interest of members and on that basis it is very difficult to manage that portfolio with a dynamic approach for the long term.”

selected uk master trusts and their investment strategies

The industry has finally understood that accumulation – particularly in the early years – is a crucial period in pension saving, but not the only one. The period in the run up to retirement is equally crucial as the wrong type of approach can destroy value. 

Booth says the industry – particularly the auto enrolment sector – has been slow to adapt lifestyle approaches into what members do in the real world. “There is still a lot of annuity hedging in the auto enrolment market, but why are we protecting annuity buying power for these new savers when they are not likely to buy an annuity?” 

Many have gone for the easy option as changing the lifestyle approach may have been too difficult or expensive or they lacked the agility to shift their investment strategy.

However, Now Pensions has not seen the levels of growth of either NEST or The People’s Pension (see table). It is also not the only provider doing something different in the auto-enrolment master trust space. 

Legal & General Investment Management (LGIM) now has almost £2bn on its master trust platform split between ‘governance’ (default) and ‘joint governance’ approaches (where schemes have some discretion over investments).

LGIM has abandoned its previous default approach and is using a multi-asset fund not only for the accumulation phase but also retirement. 

“The old world approach of derisking to protect a built-up pension pot is all very well, but now there is a great risk from taking risk-free assets into retirement,” says Emma Douglas, head of DC distribution at LGIM. “If you are in a sensibly-run multi-asset fund, you have some protection built in.”

There are alternatives – there is a cash fund with an annuity tracking element and a retirement income multi-asset fund. Douglas feels these will cover most member requirements. 

“People don’t know when they will retire so long glidepaths with fixed retirement dates are no longer realistic,” says Douglas. 

Taking these decisions on behalf of members means LGIM must engage earlier and more frequently to understand members’ preferences. 

Employers will also make choices based on the demographics of their employees. Retailers’ members will have smaller pots and investment bankers may not draw down much so the defaults have to be fit for purpose. 

Master trusts, particularly in the auto-enrolment space cannot be concerned with having numerous features. In fact, it is right they should focus on the needs of the many, not to satisfy an average of needs, says Andrew Cheseldine, partner at the consultancy LCP

“However, this means there’s no chance of set-and-forget as used to happen in DC, but must be adapted,” says Cheseldine. This makes communication one of the most important elements of auto enrolment.

“Cheap and cheerful is not necessarily in the best interest of members and on that basis it is very difficult to manage that portfolio with a dynamic approach for the long term”
Robert Booth

The regulators have become focused on value for money, but without any clear definition of what this means. The conundrum facing the industry is how it should be interpreted. 

In the absence of any indication, Natixis Global Asset Management has worked with investment governance committees to determine what value for money should look like from the master trusts’ perspective. 

It found that investment and communications were considered important elements contributing to value for money (polling 24.3% and 22.8% respectively from participants).  Customer service and governance were considered next (15.7% and 15%), while product was considered relatively unimportant, at 11.4%. 

Charges were considered the least important value for money component at 10.7%, yet much of the debate on auto enrolment defaults has focused on the 75bps charge cap imposed in 2014.

“People don’t know when they will retire so long glidepaths with fixed retirement dates are no longer realistic”
Emma Douglas

Graham Peacock, managing director of Salvus, says there is a long way to go before providers and regulators hit upon a suitable definition for value for money. 

“I don’t imagine value for money is even possible, as we haven’t even got transparency at the investment fund level,” says Peacock, who says he is keen to disclose as much as possible to employers and members. “We will therefore always fall woefully short of a value for money statement.”

The regulators have threatened to reduce the cap further if they feel members are not receiving value for money. But it will be decades before it is clear whether they have or not, and the choices they make as they enter retirement will have implications. 

The regulators could define value for money, but few would welcome it. “The only upside of prescription would be if the regulator offers a safe harbour recognition,” says Douglas. “That would be positive.” Safe harbour provisions allow employers and providers to offer limited advice without the risk of breaching fiduciary duty.

Stephen Budge, principal for UK DC at Mercer, doubts whether safe harbour would offer much additional protection for members but thinks an existing benchmark is more likely than a prescriptive approach from the regulators. 

“Nest may become the yardstick all others will be measured against,” says Budge, “ as it will be easier for them to compare performance with each other and against NEST as a benchmark.”

Cheseldine says the regulators will fall short of prescription. “They may encourage providers to err towards target-date funds away from lifestyle,” he says. This is because the managers remain in control the investments under target-date funds, he says, whereas lifestyle requires assets to be moved, which is where administration errors occur. 

Although, the regulators are seeking more stringent powers to manage master trusts, Cheseldine believes attitudes are shifting towards what may be considered a good set of asset classes. Some providers are looking at ways to incorporate illiquid assets. 

Safe harbouring may allow providers to become more flexible in their asset mix. “After all,” Cheseldine adds, “with-profits is starting to look really good for someone taking a lump sum at retirement, whereas stable value funds are likely to go wrong from an administration and investment point of view.”