It is a well-worn fact that the vast majority of workers do not select the fund they want to underpin their pension pot. At the last count, back in 2008, the NAPF reckoned 82 per cent of employees were opting for the default. Default funds have frequently been viewed as the nemesis of defined contribution (DC) schemes, criticised not least because they have been inflexible and have in, all many cases, let many workers down.
Yet it is up to consultants, trustees, employee benefit consultants and IFAs to select the default funds. But how do they pick them in the first place? What makes one fund a better solution than another?
The DC arena is still in its youth and consultants admit that the default landscape has been shaped by the defined benefit (DB) schemes pension schemes they are replacing.
“If you go back to the 1990s when DC developed, many defaults were a mirror of the funds used by DB schemes and so you had one or two active balanced managed funds – that was just the way it was,” says Antony Barker at JLT Benefit Solutions. “The first DC schemes had a strategic equity bias often because it simply mirrored the asset allocation (and investment management) of the DB scheme it replaced,” he adds.
Barker has little doubt that the brand of an insurer or fund manager has played its part in being selected as a default fund in the past – this is why he argues that L&G have ’hoovered up’ much of the passive market.
“The fund can be viewed as a ’quasi insurance’ policy because of the association with L&G. Passive funds have come in because there is less regret risk – all clients needed to know was whether it was cheap and whether it tracked well. And brand plays a large part – it is why L&G dominates.”
Many consultants admit that there has been a case of ’you scratch my back and I’ll scratch yours’, when it comes to a fund being on a platform or panel, and that if a manager had a reputation it was difficult not to select the group’s fund.
“In the past it was a case of who you knew – ’oh we have to have so and so fund manager on the panel’, irrespective of any due diligence done on the funds,” says Brian Henderson at Mercer.
Having a good working relationship also plays its part in the selection process. Once a provider has its feet under the table and is on a panel, it will take a while for the proposition to be dislodged – a relationship will also mean that a consultant or platform will be more receptive to new ideas.
Steve Bowles, head of DC at Schroders, says: “You have to get on with the day-to-day field consultants to win business. If we have a new fund we will go to them and it helps if we have a relationship already as they likely to be more receptive to new ideas.”
This is an issue that Vanguard, the US giant and DC leader, is battling against as it enters the UK. It has the onerous task of knocking the two passive giants, BGI and L&G off their perch. It is having plenty of “encouraging” talks with consultants and platforms regarding its offering.
Yet although it has led the way in target date funds in the US, and is one of the biggest passive fund managers in the world, it is not going be coming up as a default fund any time soon. It says that the decision to include its funds on fee-based platforms cannot be made overnight. “You are looking at a 12 month process,” says a spokesman for Vanguard.
Yet product providers argue that the default selection process is moving forward and that it is no longer about balanced managed funds, or passive strategies either. They say that multi-asset or diversified growth funds are in demand from consultants, and trust-based schemes in particular are looking for a different take on default strategies.
Julian Webb, head of DC at Fidelity, says: “The market has evolved and the constraints of passive have been shown up over the past few years and trustees, consultants and IFAs are looking at alternatives. There is a move towards multi-asset as passive funds have too high an equity content. The key is diversification and lower volatility.”
The move by Volkswagen – it has just placed half of its £70m default fund with an absolute return manager – appears to back up this argument. Half of the VW default fund will be run by Standard Life Investment’s Global Absolute Return Strategies (GARS) fund and the other half by Fidelity in global equities.
Roy Platten, pension manager at VW, says: “We did not want any member to miss out on any upturn in the equity market, but equally we wanted to make sure that they were not at any great risk from any further downturn in the markets.”
But despite the claim, employee benefit consultants appear to see it differently.
Robin Hames at Bluefin says: “My suspicion is that they (fund managers) are exaggerating the strides they are making. There might be a lot of talking about diversified growth but I’m not convinced there is that much business being written. Cost is such a sensitive issue that it has to be quite a compelling proposition to accept a higher-charging default fund.”
Hames says that his firm’s selection process depends on “the depth the client wants to go”, although they will never opt for a 100 per cent equity fund and will always recommend an aged-based risk vehicle such as lifestyle.
“For starters we do not look at a single asset class – it has to be multi-asset but how the assets are split will be down to the needs of the client.”
Bluefin undertakes online employee surveys to assess their attitudes to risk and loss aversion. “We are likely to then opt for a passive fund – Bluefin’s default fund of choice is BGI Consensus because of its consistency of performance to its mandate and cost – unless we are directed by our clients to go for an active fund, which is rare. The decision by an employee to opt for a default fund is a decision not to make a decision, they are disengaged and we do not feel that active management suitable for such a person.”
Jonathan Parker at Zurich agrees with Hames that you cannot keep cost out of the equation when it comes to selecting a default fund. “With a contract-based scheme our oversight committee looks at the default requirements, but price is often an issue and so the vast majority of requirements are for passive strategies. We find BGI’s range more restrictive than L&G’s.”
But despite the protestations of consultants, there is evidence that a change in default selection by some is afoot. The past few years of market performance have brought the limitations of passive investment to the fore and there has been a move to diversified portfolios into a multitude of assets – beyond the limitations of just equities and bonds.
That is precisely why Lane Clark & Peacock made a conscience decision two years ago to change the way they viewed and selected default funds. Today, the key factor for the firm when deciding which default fund to pick, the platform it uses, is the quality of the diversified growth fund on board.
Chris Clough at LCP says: “In the beginning everyone had BGI and L&G – the investment didn’t make any difference. The key was added value such as administration, communication and internet modelling. Now for the first time we look at what diversified growth funds are on the platform – everything falls behind that.
“We create a default fund made up of a diversified growth fund and a passive global equity fund. But the key for us is the selection of the diversified growth fund. There are now lots of different but similar funds out there, all with slightly different remits. The eventual mix of the default fund will be down to the equity element of the diversified fund.”
LCP’s favoured diversified funds are those offered by Standard Life and BlackRock.
There is little doubt that in-house research, both quantitative and qualitative is the name of the game in default selection, more so than ever. Consultants tend to have their own in-house research to design default options by identifying and setting out a number of objectives and the strategy the fund has to meet.
Henderson says: “We need to work out what the objective of the member is in the first place, whether it is a trust-based or a contract-based scheme. If the scheme is moving from a DB arrangement that has been paying two-thirds salary then we will try to create a default fund that is capable of delivering a similar return.”
Mercer believes that the decent fund providers will recognise that members’ pots will be small at the outset and so it is important to preserve as much capital as you can. “It is a fast way to lose members in the early years if they start to lose money,” adds Henderson.
Jesal Mistry, consultant at Aon says: “Once we have this list of requirements that meet the objectives we are able to narrow down the fund universe. Final fund selection comes after a number of analysis points, which are considered by our research teams and our internal DC investment committee.”
Aon’s research in common with its peers includes analysis of organisational stability, selection process, methodology and personnel. “We take a forward-looking view as much as possible when selecting a fund as this is what really matters to our clients.”
The question of whether past performance plays a core part in fund selection is a mute point. Many reckon it does not play a part. Others are not so sure. Some reckon that investment makes up only 25 per cent of the decision – costs, member communications, servicing and internet modelling can all make a difference.
“A contract-based scheme is more likely to opt for an insurance backed proposition because it can offer an overall package including decent administration, rather than a pure investment proposition,” says Barker.
“Besides it would be a very brave trustee to pick a manager that has underperformed for the previous five years because its style has not been in vogue but it is set for a turn around. The best performance of the previous five years is a lot easier to present to clients and trustees.”
Mistry admits that performance does play a part in default selection – it has to, he says, because pension investors must have a long-term view. “This means that new products or funds generally need to show a reasonable track record to gain the trust of investment consultants for use in a pension scheme. We take a strong steer from our research team in this area and rely on them to provide views on whether they believe a fund or manager to be appropriate.”
Consultants are not the only ones that have honed their investment research skills. Fund platforms have upped their games and where in the past they would take any fund manager on board now they are becoming more selective.
Many platforms, from Aegon to Fidelity have their own investment committees to review funds on their platforms. Scottish Life has been publicly banging the drum about inferior default funds for a while and it has enlisted the help of Barrie & Hibbert for its own Managed Strategies range.
Bowles says: “Platforms used to be open doors – everyone welcome, but they have started to be pickier on which funds they have on the platform and which they don’t.”
The default market continues to evolve and investment research is underpinning many of the default selections. Trustee-based schemes will be in a position to make the most of this development. They have greater flexibility in reviewing performance and selecting managers.
But cost still appears to be the overriding issue for many DC schemes, especially those that are contract-based. It is of no surprise that cost will be one of the biggest influences, as the forthcoming National Employee Savings Trust (Nest) default is putting costs high up the agenda. If cost, and the desire to avoid making the wrong decision do prevail, all the due diligence in the world will be for no avail. Instead we will simply see the big two passive managers continue to dominate the default landscape for years to come.
