In some ways, the defined contribution space has hardly changed in the last two decades. Most of the conversations we have today are the same ones heard 20 years ago – how we communicate with members; the need to be helpful without giving specific advice; fund choices; how many funds is the right number; and, of course, the real challenge for DC – the appropriate level of contribution.
Despite this familiarity, the DC environment is constantly evolving. Master trust structures seem to be the future, and the need to deliver genuine flexibility at the point of retirement is now dawning on providers and members alike. Meanwhile, the impact of the fee cap on default funds, as well as the improved transparency on costs, is actually delivering genuine benefits to members. But while the structures and the services around DC evolve, one consistent question remains; should DC members be offered active or passive fund choices?
The answer of course, is a simple yes to both. The reality is that both investment styles have important roles to play at different times. The two can work side by side in either a lifestyle or a target-dated fund. For example, low-fee passive equities, would play a key role when members have long time horizons, and are less worried about market volatility. Passive funds are often used to give exposure to core markets that are deemed ‘efficient’, and thus trickier for active managers to consistently outperform. Active funds could play a role in the long-term growth stage too of course, but because of their relative ‘expense’ versus passive options, they tend to be used to target higher returns from less efficient markets such as small caps or emerging markets. Alternatively, more aggressive active strategies such as concentrated global opportunities funds may be utilised in the search for higher returns above passive equity market exposure.
As members approach the point where they want to access their DC pension pots, be that via a move into a drawdown arrangement or simply to de-risk, active funds should come into their own. As an individual’s investment timeframe decreases, their attitude to risk changes and their tolerance to market drawdown reduces.
Absolute return funds, which come in many shapes and sizes, should appeal here. Historically,
these may have been hedge funds or hedge funds of funds. In the DC world liquidity requirements and the focus on fees has led to multi-asset funds with an absolute return focus becoming the normal route to delivering an absolute return option for DC members. These funds have tended to have LIBOR + 3 to 6 per cent performance targets. The rationale was simple; members with less than 10 years, for example, might lack the ability to recoup any losses of a sharp market drop and thus reducing their income in retirement.
It’s hard to argue with the logic that if one can deliver an asymmetric return, it will go a long way to helping members in retirement. Despite a long period of equity market growth, volatility has returned in 2018. Being on the wrong side of it could prove costly for a DC member nearing retirement or drawdown.
The range of absolute return funds in DC is growing, and fixed income options are increasing too. This may be due to the ageing demographic of DC members leading them to de-risk or seek more flexible options as they near retirement. Those unsure of whether to adopt a drawdown option or take an annuity may seek a ‘keeping your options open fund’ or one positioned for future interest rate rises. Whatever the reason, absolute return funds remain on the rise.
In DC land, a low fund price does not necessarily mean better value; it’s all about the ‘right’ and appropriate risk metric, which is why having a combination of active and passive funds could provide the solution. Both play important, but different roles in a DC member’s investment strategy. Passive offer cheap and efficient market exposure, but as a DC member nears retirement, be that either stopping work completely, or reducing working hours over time, the need for reduced downside risk and volatility grows. Indeed, having an absolute return focus at any drawdown stage might make sense as the timescale for potential recovery post market volatility reduces.
As DC members’ requirements evolve over time, the need to access the widest possible toolkit of investment options available to them grows. In our view, active investing can play an increasingly integral role in providing the right solution as members approach retirement.