Defined benefit investing has undergone much innovation over the past decade. These examples of best practice have seen schemes reduce their exposure to equities and seek out more overseas opportunities.
Managers are investing outside of their comfort zone – and the risks are being rewarded. Not surprisingly, the contract-based DC community is starting to notice.
“As well as more fixed income investments to match their maturing liability profile, DB schemes have also diversified particularly around alternative investing such as infrastructure, hedge funds. Smaller to medium sized plans have, in general, not hired so many specialist managers and have instead moved out of equities into diversified growth funds, where the manager invests into a range of asset classes and typically actively asset allocates between them – the overall aim is to provide equity like returns with materially less volatility,” said Peter Ball, Head of Investment Solutions, JLT Benefit Solutions.
“Other trends have been increased allocations to emerging markets both equities and debt. Many of these asset classes come with higher manager fees given their specialist nature, but defined benefit plans have embraced these asset classes in the quest for better returns after fees and a more diversified approach.”
It is this embrace of a multi-asset approach that Target Date Funds (TDFs) – considered by many to be the most advanced incarnation of managing risk in the approach to retirement in DC – has borrowed off DB schemes.
TDFs are diversified multi-asset funds that de-risk their portfolio on approach to retirement. According to the TDF Group, TDFs aim to offer more flexible risk-return management, and more consistent savings outcomes relative to traditional ‘lifestyling’.
Tim Banks, head of client relations UK DC at Alliance Bernstein, says that TDFs use some of the best investment techniques that are also employed in DB schemes.
“We believe that the use of dynamic asset allocation techniques is important to help manage volatility on a members behalf. This needs to be professionally managed on a daily basis. Other best practise ideas include asset class and fund manager diversification, the ability to source the best investment ideas irrespective from where they come from, and the alignment of the investment strategy to the eventual likely benefit to emerge. These can all be incorporated within flexible TDFs,” he says.
Not all DB investing asset allocation features should be replicated in DC schemes however, warns Will Allport, DC business development manager at PIMCO.
He says that while it is absolutely correct that there should be a significant crossover of tactical asset allocation ideas from DB plans, whether implemented via TDFs or otherwise, DC schemes may benefit from lower risk asset allocation.
“The ultimate investment challenge – that of generating sufficient retirement assets to provide a sustainable income to members from retirement point until death – remains consistent across both DB and DC,” he agrees.
“However, DB plans embed the feature of risk-sharing with the corporate sponsor and between age cohorts of the membership, which as they stand today, are not present within DC plans’ target date fund or lifestyle mechanisms. Excepting certain DB issues such as funded status, accounting disclosure requirements by the sponsoring employer, the implication is that DC plans may require a more conservative asset allocation approach, due to their inability to take advantage of risk pooling.”
Risk-pooling is when different pension funds pool their investments in order to reduce transaction costs and improve risk management and governance.
And although DC schemes currently are unable to take advantage of risk pooling, according to Paul Gilbody, head of DC consultant relations at BlackRock, there is talk of pooling risk in DC.
“This may help increase the likelihood of understanding potential returns, which is akin to the DB model,” he says .”But this feels as if it has a long way to run.”
Richard Parkin, head of proposition, DC & workplace savings at Fidelity, tips liability driven investment (LDI) as the next DB strategy to be dragged into the DC market.
“In reality, this is a slightly crude version of LDI where each DC investor sets their personal retirement goal and their progress against that goal is used to dynamically alter their fund mix to maximise the likelihood of them achieving that goal. For example, if a member had enjoyed strong growth against their retirement goal then they could “bank” their gains by switching in to lower risk investment funds. The other benefit of the approach is that, as for DB schemes, we can factor in contributions. So a period of underperformance against the target might point to the maintenance of a growth-oriented investment strategy but coupled with an increased contribution rate to get the member back on track,” he explains.
Unfortunately, in practice, these approaches are not easy to implement from an administrative point of view.
“They also need to be communicated clearly to members and will likely involve members in some decision making further increasing costs and complexity. Nonetheless, as the size and value of DC schemes grow, member understanding and familiarity with DC increases and technology improves we should see more activity in this area in the same way we have seen managed accounts grow in the US market,” he adds.
Mark Futcher, partner at Barnett Waddingham, also called for greater communication between DC savers and the pension providers.
“Most DB schemes have very good governance structures in place and there is much that DC schemes can learn from this. Monitoring investment performance is at least as important in a DC environment as it is for DB. Good member communication is essential in a DC plan as the risk and responsibility primarily sit with the individual and they must engage with the decision they have to take,” he says.
That is not to say that Futcher believes DB schemes to be faultless. He called for DC schemes to learn from the mistakes of DB.
“The difficulty in measuring performance of target date funds for example should not be solved by peer-group benchmarking,” he warns. “This will simply lead to the herd mentality demonstrated by CAPS balanced funds in the DB sphere.”
Part of the challenge facing DC schemes is not concerned with investment structure. Despite the fact that DC has overtaken DB as the primary choice for future pension schemes, DB – and in particular final salary pension schemes – are still the more notorious retirement savings vehicle. This is in part blamed by the falling number of pension savers.
The number of “active” pension savers in the UK fell from 12.2 million at the peak in 1967 to 8.2 million in 2011, according to the Office for National Statistics. Currently four million people save into “defined contribution” (DC) pension schemes, where savers’ money is invested and the final pot is dependent on returns after charges.
Mark Futcher, partner at Barnett Waddingham says this is inevitably set to change with the roll-out of the Government’s auto enrolment scheme. Auto-enrolment, where employees are automatically included but have to ask to opt-out, began in October for companies with 120,000 or more workers, with smaller firms gradually being enrolled over six years.
“Although DC has long overtaken DB as the primary vehicle for future pension provision in the UK, it has not yet claimed its full share of care and attention. This is likely to start to change with auto-enrolment under way and as the proportion of people reaching retirement with DC pensions alone begins to rise,” he says.
“Down the line we expect to see greater development of LDI-style offerings for DC investors. The traditional approach of switching to government bonds on the approach to retirement to protect against changes in annuity prices is already being challenged. We expect that funds offering more sophisticated methods of matching annuity prices will become more common.”
Gilbody says that work is being done to close the gap between the attraction of DB and DC schemes: “Fundamentally, the huge attraction of DB is twofold – clarity of income level in retirement and limited risk for the individual. Neither of these aspects are naturally part of the DC approach. That said providers are working on taking ‘risk of the table’ by a different approach to lifestyling and offering more sophisticated but user friendly modelling tools.”
In order to retain these new clients, DC plans need to improve their ability to navigate challenging market environments, such as an inflationary era or periods of extreme capital markets turbulence, says Allport. He calls for more effective diversification, inflation hedging, downside protection and the ability to successfully navigate changing interest rate environments.
“Due to the current market practice of maintaining daily liquidity in DC plans, target date funds or lifestyle mechanisms will be restricted from having tactical allocations to illiquid asset classes such as private equity, infrastructure, distressed credit opportunities, which as defined benefits schemes know and embrace, can be highly additive to returns in long-term savings,” he says. “Providing daily liquidity to DC members is potentially damaging to their long-term outcomes, when in fact the need for such frequent liquidity is questionable for anyone below the age at which pension benefits can be taken. Modifying this requirement would allow DC schemes to further benefit from ideas already being embraced by their DB counterparts.”
Ball agrees. “One thing we would like to see DC plans learn from DB is the use of more alternative investing. However, the DC market in the UK is focused on daily dealing and this therefore makes it very challenging to invest in funds that have infrequent dealing or are closed-ended. If DB plans are deemed long-term investors and hence can invest to obtain the ‘illiquidity premium’ from such asset classes, then DC investors must also be so. It would be good to see this become a reality at some point in the UK DC but there would have to be a major shift in how DC operates today for this to happen.”
Allport also praises DBs focus on alpha in a muted growth environment, and said that DC schemes should recognise the importance of manager skill in achieving the total returns necessary to deliver good retirement outcomes.
As well as calling for further diversification of the assets and investments available to DC managers, critics lament their one-size-fits-all approach, although Parkin recognises the challenges in dealing with the irregularities of the timing of retirement and people’s exact income needs. He admits providing guarantees of any sort in DC immediately complicates administration and can reduce portability.
Banks believes there is no reason why the DC default investment strategy should be inferior to a DB strategy and many of the good techniques from DB investment are already built into Alliance Bernstein’s flexible TDF range.
“DC schemes should however avoid making overly precise assumptions, such as when members will retire, and how they will take their benefits,” he says. “In a world of individual outcomes the investment strategy needs to be robust to a range of possibilities and kept under constant review. In this regard TDFs are in sharp contrast to traditional strategies that have been typically employed in the past such as lifestyle strategies.”n