Winds of change drive innovation
Asset managers' clients want more for less, as in other global industries. They want a new generation of products based on absolute returns and liability matching, backed by a value-for-money fee structure that clearly separates alpha and beta. They also want these requirements customised on the back of business stability that improves their replicability.
These are the key findings emerging from a new research study* from CREATE, a UK think-tank. Sponsored jointly by T Rowe Price and Citigroup, the study surveyed 300 asset managers and pension funds in 37 countries with combined assets of $3trn (€2.3trn).
However, the study also found that although defined benefit (DB) plan sponsors need new products, they are not yet prepared to buy them in their current form. They want to see a replicable track record before venturing into anything radically different. For them, migration to new products will be a matter of more haste, less speed. At the global level, this much is evident from the marked differences in what pension funds will demand and what asset managers think they will demand (see figure).
Out of a list of 20 products, the top five items identified by asset managers are liability driven investment (LDI), portable alpha, hedge funds, structured products and private equity. They are often labelled as ‘new' because of their overt focus on liability matching, or absolute returns, or diversification potential. In contrast, pension funds have only included private equity in their own top five list. There is a huge perceptions gap.
There are some country differences, however. The top five products identified by very large pension funds in the US and the Netherlands are roughly similar to those identified by asset managers around the world. Apart from disillusionment with mainstream asset classes, such pension funds generally have the in-house investment and governance expertise necessary for a more radical diversification, which their smaller peers cannot undertake.
For sure, pension funds everywhere have expressed interest in the new generation of products as identified by asset managers. But prudence will be their guiding motto in the face of continuing under-funding and mark-to-market valuations required by new accounting rules. Even in the Netherlands, for example, where many pension funds have had comfortable funding levels, new rules will dictate a far more cautious diversification from here on.
The underlying issue is one of confidence. In every region, pension funds' current stance towards new products falls under one of three labels:
q Believers, who understand the products, have the necessary capabilities to invest and are already doing so;
q Pragmatists, who are interested but have a ‘wait and see' attitude, pending a longer track record;
q Sceptics, who do not believe that genuinely new products can be produced so quickly after the last bear market. They see these products as old wines in new bottles. They are also suspicious about ‘hidden' charges.
The approximate percentage breakdown of the three categories is 25:50:25 respectively. At best, these products have not been stress-tested over a long enough period; at worst, they are viewed as yet more new fads.
New DB products will require further innovation before they become mainstream.
To their credit, asset managers are unsurprised: they recognise that they are boldly going where they have not been before. Even more than their clients, asset managers see further innovation as a key stepping stone to success. Interestingly, the top five products identified as requiring maximum innovation by asset managers and pension funds largely overlap.
The product features identified as requiring major improvements include:
q Risk-return ratio;
In addition, clients also expect service quality that anticipates and meets their unique needs. Customisation, backed by a value-for-money fee structure, will be an important aspect of innovation.
The study also found that defined contribution (DC) and retail markets are also ripe for further innovation. The retail market will be increasingly influenced by retirement-oriented products due to changing demographics and phasing out of DB plans in virtually all countries. In Europe and North America, demand growth will be greatest in four categories: target date retirement funds, investment advice products, involving tactical asset allocation, lifestyle funds, and managed accounts. In contrast, the interest in enhanced annuities is likely to be modest.
These newly emerging products seek to provide simplicity for the client and importantly a better outcome for their retirement by choosing static or dynamic risk profiles. Specifically, they offer one or more of the following:
q Allow clients to define their own risk profile;
q Facilitate a progressive switch from aggressive equities at the outset to conservative bonds over time;
q Wrap all investments into a single managed account.
However, everywhere, there are two concerns that DC plan sponsors and asset managers share.
The first concern relates to the small size of individual pots in the accumulation phase. As the switch from DB to DC plans gathers momentum in each region, the need to deliver decent returns and appropriate asset allocation will be paramount, as would be capital protection.
Currently, most DC products offer neither sensible tactical asset allocation nor capital protection. The problem is aggravated by the current seemingly low rates of contribution in many countries. For example, even in the US, where 401(k) plans have a long pedigree, the rates are deemed inadequate. Clients need to assess what constitutes an ‘adequate' portfolio for retirement; most clients significantly underestimate what is required. To compound the problem, many have experienced huge capital erosion due to the bear market.
The second concern relates to the range of benefits in the ‘decumulation' phase. In principle, DC plans are meant to build up assets to levels high enough to buy benefits similar to those now available under DB plans. Currently, such benefits are not bundled. Also, advice is not widely available on decumulation issues.
In the US, for example, the 401(k) ‘roll-over' market continues to grow geometrically at a time when the current generation of annuity-based products are deemed inadequate. The alternative for members is either to draw down their account balances or roll the balances in a retirement account. Neither addresses the risks when members outlive their assets.
More generally, across most OECD countries, life expectancy is increasing but disability-free life expectancy is not; promoting demand for health, welfare and retirement provision under one package. Asset managers are thus presented with a huge opportunity which they are just beginning to grasp.
The current generation of insurance products is deemed inadequate and uneconomic. Worldwide, there is growing demand for a more holistic approach.
Accordingly, the scope for further innovation has been identified by asset managers and DC plan sponsors alike. Both anticipate the emergence of a ‘cafeteria plan' that bundles a range of retirement products into a unified whole, where the total cost is less than the sum of individual parts. Such a plan effectively involves buying options on a range of future benefits.
Assembly will, therefore, emerge as a major activity in the value chain, enhancing the scope for alliances between asset managers and the best-of-breed external producers.
For fund managers, it is no longer possible to confuse product innovation with product proliferation. Clients have wised up on copycats. Although markets have recovered, clients are not confident that their fund managers can meet the new needs without further innovation. On their part, fund managers recognise that in the absolute returns world, innovation is not the first or the last option: it's the only option.
As one pension fund put it: "Without innovation, LDI risks facing the same epitaph as medieval medical procedures: ‘the operation was successful, but the patient died.'"
Professor Amin Rajan is the CEO of CREATE, a research consultancy in the UK.
*‘Tomorrow's Products for Tomorrow's Clients' is available from email@example.com
Case study .…
ur trustees are showing more interest in LDI and specialist mandates, while demanding a value-for-money fee structure. They are less averse to talking to investment banks on new products. Those with fully funded schemes are more open to looking at LDI solutions. Those with large deficits are looking at absolute returns strategies to plug the hole.
Most pension funds are still very domestic-oriented. Their covenants restrict them from going into asset classes for which they have neither the governance nor the investment expertise. Besides, having lost a ton of money in what was the longest bull market in living memory, they are understandably cautious. Many of the new investment ideas - portable alpha, LDI, global tactical asset allocation - are perceived as unproven at best, and fads, at worst. Many trustees perceive them as old wine in new bottles. They want to see some tangible results before they commit their money.
They find it hard to believe that so many new strategies have suddenly appeared from nowhere, as a direct response to the bear market. They want to see some evidence of success over a five-year period before looking at them seriously. They have been fooled in the past. So they are understandably
As trustees, no wonder we agonise about every good idea in case it's a bad idea. Take the example of credit derivatives. On the upside, they provide an insurance against defaults. On the downside, they are not only opaque but they also encourage moral hazard and excessive risk. So, what does one do?
Despite a booming equity market, our black hole has worsened in the last three years. The sponsors will only stump up extra cash if the retirement age is raised, benefits reduced and performance improved. The strength of our covenant with plan sponsors has definitely deteriorated.
A UK Pension Fund