The rise of passive (index-tracking) investment options in defined contribution (DC) plans throughout Europe has important implications that will alter the fundamental roles that employers, employees and asset managers play in providing and funding retirement benefits for workers. What follows is an analysis of non-cash balance DC and hybrid DC/DB (defined benefit) arrangements, where employees are given discretion regarding contribution levels and/or investment choices.
The trend towards DC plans in Europe has been well documented. Factors triggering recent growth in DC plans will likely sustain future increases in their growth and popularity, while the rate of DC growth throughout Europe is, of course, a function of each country’s regulatory, economic and political situation. The key factors behind the trend are outlined in the box below.
Perhaps the most important issues associated with the rise of non-cash balance DC plans are those regarding the shift of investment decision-
making responsibility from employers to employees. Many employees have never been faced with the task of
making important investment decisions. Plan sponsors and providers will therefore need to provide a high level of investment education and guidance.
It should be noted that many major service providers are offering important tools that give employees the comfort and confidence of a solid individual pension arrangement.
Investment performance will increasingly be in the spotlight for all to scrutinise, having obvious implications for plan sponsors and the decisions they make about asset managers.
In addition, we’re likely to see a flood of new investment products designed to help employees make asset-allocation decisions, such as ‘life-style’ funds, fund-of-funds and passively managed investments.
As employers seek out employee-focused solutions, they will increasingly view indexed investments, or tracker funds, as their natural fit. Dr Paul van den Heuvel, director of investment management at OPTAS Pensioenen, maintains that: “Passive management has been chosen for all equity investments at OPTAS Pensioenen to pass on lower costs to members. Index trackers offer the best long-term pension investments. Selecting the active manager that will outperform over the long term is very difficult, if not impossible.” Index investments offer characteristics well suited to the DC environment.
As a result, the investment managers providing these passive vehicles may find themselves evolving to remain competitive in the DC environment – providing ongoing product and service improvements and innovation as well as developing employee education and communication tools.
Indexed investments remove a degree of uncertainty from the investment decision-making process at both the plan-sponsor and employee levels. The link to an existing and recognised benchmark ensures clarity of investment objective. Passively managed funds are also easy to track and to explain to employees since investment performance is tied to the index that the fund tracks.
Asset manager-related risk can be simplified with passive investments. Plan sponsors typically consider the negative impact of changing an investment manager due to poor performance. The likelihood that an index fund will need to be removed from a fund line-up is low relative to actively managed funds, allowing the plan sponsor to avoid the pain and embarrassment associated with an asset manager change.
Passive investments reduce the risk of changes in investment objectives, portfolio managers and poor performance. As plan sponsors monitor their DC investment line-up, they will recognise the low maintenance associated with the passive investments. Performance reporting to members and trustees is simplified, as the performance will correlate to an existing benchmark that is monitored regularly in the news.
The low fees associated with passive index investments make them well-suited to the DC pension environment, where investment performance is judged over a longer period. Passively managed investments have no hidden fees, which facilitates clear employee-friendly communication and comparisons against other investment options.
Passive investments deliver competitive investment performance across a range of asset classes, providing flexibility and diversification to investors developing a well-balanced, risk-diversified portfolio.
Index investments also allow plan sponsors to offer employees a variety of approaches to asset allocation, appealing to both the novice and the more experienced investor.
For the novice investor, plan sponsors may choose to offer ‘life-cycle’ funds – pre-mixed, professionally managed and well-diversified portfolios that suit groups of employees with different risk profiles.
For the moderately experienced investor, plan sponsors may offer a balanced line-up of all index funds. The easy-to-understand nature of index investments simplifies the asset-allocation decision for employees. For the more experienced investor, a ‘core–satellite’ approach simplifies the decision-making process while allowing employees to create their own portfolio.
This approach, gaining acceptance in the European pension market, uses a combination of passive investments as core options and active investments as satellite options. Employees would use core options to build the base of their portfolio and satellite options for exploring additional return.
The further utilisation of indexed investments in European DC plans will also have profound implications for asset managers.
As employees increasingly require retirement planning and investment education, plan sponsors will look to their providers for greater assistance. Effective employee education and communication services are likely to be differentiating factors among providers, particularly in the bundled, full-service arena where the asset manager also provides administrative and recordkeeping services. Those providers who don’t offer these capabilities will be at a distinct disadvantage in the growing European DC market.
As plan sponsors demand greater transparency and more information to choose investment options for their DC plans, providers will need to respond with clear disclosure of key data, such as their indexing processes.
Greater transparency in the marketplace will also lead to greater pressure on asset managers to keep total costs low. This is especially the case with passively managed investments, where fees and expenses are often the only differentiator among similarly benchmarked index vehicles. It follows, then, that low-cost asset managers will have the long term advantage.
Finally, providers will begin to
capitalise on the demand for new investment products and services that further help employees make investment decisions. Some products already surfacing include life-cycle funds and ‘funds-of-funds’.
Although it is not yet clear how and if personalised advice will expand across Europe, investors will continue to drive providers to offer asset-allocation and investment selection-advice services.
Frank Satterthwaite is managing director at Vanguard Europe in Brussels