Employers signing off the fund choices for their defined contribution pension schemes have been so keenly focussed on price that they are overlooking the potential value in well-run active management strategies, according to corporate advisers.
The abundance of passive funds used in DC schemes has previously been attributed to the 0.75 per cent charge cap rule which came into effect in April 2015 and was upheld by the UK government when reviewed again in 2017.
While experts acknowledge that the charge cap undoubtedly impacted how employee benefits consultants assess funds, they note that, today, off-the-shelf workplace pensions typically have charges far lower than the 0.75 per cent government requirement.
Advisers explain that employers have been seduced into offering comparatively safe options with little sophistication, because the funds offer the cheapest price. As a result, competition between investment houses has intensified, according to advisers, leading to a “race to the bottom,” to offer the cheapest possible funds.
“Ultimately, it is the employer that is signing them off,” says Hargreaves Lansdown senior pensions analyst Nathan Long. “If the employer is being offered pedestrian performance and no outperformance, but has the certainty of no relative underperformance or market shocks, it’s quite a compelling argument. Remember, they are not buying this for themselves, but for their workers, so their head is on the block if they make a mistake.”
Long’s view is echoed by employee benefit consultants, who say that employers are increasingly only focussed on the charge. “Many employers are happy to accept the product default,” says Mattioli Woods senior employee benefits consultant Anne Lawson. “There is almost a drive to bottom on the annual management charge.”
Long explains that, while active management might be more commonly used in the larger DC schemes, where employers cover the administration costs, it is far less common in the master trust or group workplace pension arrangements.
“If you are talking about an off the shelf workplace pension, the costs are nowhere near 0.75 per cent. They are typically at 0.5 per cent or below and it is not uncommon for those to come in at 0.4 per cent. The cost pressure isn’t the charge cap, it is the competition between providers.”
There are a host of reports that illustrate the dominance of passive allocations in DC schemes, across the asset classes, but particularly in equities.
In November, last year, City University’s Cass Business School and the Defined Contribution Investment Forum published its report on DC schemes entitled “Investment Strategy: A bird’s eye view.”
The survey of 20 schemes, each with more than 5,000 members, found that 85 per cent of defaults used passive equities as the “dominant asset class and investment approach” for members in the accumulation stage, with some schemes saying they invested all member contributions in passive equities in the early part of the accumulation stage.
However, the report also highlights the increasing importance of diversified growth funds to DC schemes and shows that around a third of DC schemes do offer an active equities component.
Hymans Robertson head of DC investment consultancy Mark Jaffray says that “very few” of Hymans’ DC clients choose to “go fully active.”
Jaffray says that this decision goes beyond just price, however, arguing that governance considerations and restrictions to accessing some funds are other hurdles that schemes need to overcome.
“The platforms that people operate on can make it quite expensive to access the active managers that they like. The ones that can be accessed are active equities, bonds, cash, property and diversified growth funds.
“But the ones that are really difficult to access are things like private equity, private debt, high yield debt, and absolute return bond funds – all of which you would want in a strategy, but may find unavailable on platforms, so they are ruled out.”
Jaffray acknowledges that “passive dominates defaults in DC schemes,” but says that this can partly be attributed to the decisions made when these plans were first established.
“If we think about the evolution of DC schemes, they started off with very few assets and needed to get something arranged quite quickly. That effort to get something up-and-running can make it easier to implement a passive strategy, just to get something in place.”
If Jaffray’s explanation is correct, then the market is likely to witness increased numbers of passive-heavy DC schemes as those automatically enrolled pensions from the smallest businesses, which had later staging dates, start to grow.
After all, the number of active members in defined contribution pension schemes is already rising at pace. The pension reforms which started to be introduced in January 2012 as a result of the Pensions Act 2008 have transformed the DC landscape.
The Office of National Statistics’ Occupational Pension Schemes Survey – conducted annually in September – shows the speed of growth in the UK, with active membership of DC schemes growing from 1 million members in 2008 to 6.4 million by 2016.
This figure is widely projected to grow sharply, beyond 9 million, in the next September report, when the 2017 figures are digested, due to more companies falling under the Pension Act auto enrolment rules.
Some in the industry believe that things may change once DC schemes get to a size where they can command better terms for active strategies.
Arc Pensions Law partner Anna Copestake explains: “Greater assets under management enable schemes to secure more favourable terms with providers and managers, leading to wider investment product opportunities – so growth may help.
“We see this with master trusts and larger schemes. With impending consolidation in the master trust market, due to the new authorisation regime, we may well see master trusts – as well as large schemes – continuing to break new ground.”
Despite the optimism of a more balanced approach to passive and active allocations, concerns around levels of engagement persist. With engagement levels remaining very low, advisers say that members lack the understanding of where their pension is invested, let alone whether it is done so actively or passively.
“Most of the default investment strategies are not bad. They have been well-constructed and designed to meet a specific need,” says Lawson. “But whether these individuals, who are in the default, fully understand what they are getting, I don’t know.”
Lawson says that many employers may be losing out on the additional value that can come from having higher-cost active allocations in a scheme, simply because they haven’t asked an adviser for assistance when making the initial arrangements.
“So many of these schemes are direct from providers and there isn’t an adviser engaged to give investment oversight. Where you have an adviser involved, that should be one of the discussions that they should be having.
“Yes, the AMC will have an impact on the value of the fund, but it is very small in relation to ensuring that the individual gets a better-than-standard investment return and ensuring that the member gets the right options at retirement. This is to do with financial education of the employer.”
Corporate advisers interviewed by CA were in universal agreement that greater education of both the employer and the employee would lead to better decision-making in workplace pension schemes. However, the tactics required to make this happen have yet to be identified and it may be some time before we see any radical shift from the current status quo.