DCschemes have a “once in a lifetime” opportunity to improve member outcomes through smarter deployment of capital, which could also help transform the UK’s economy, while delivering on climate change promises.
This is the rather upbeat assessment of the potential for the sector by Redington’s head of DC and financial wellbeing Jonathan Parker.
Parker doesn’t mean to downplay the “significant challenges” facing the DC pensions sector, particularly when it comes to meeting a raft of new regulations around sustainability, stewardship and ESG-based investments.But he says the opportunities created by the transition to a lower carbon economy should not be overlooked. “This is a fundamental shift in the way the world economy is wired. Yes, there will be risks, but there are a lot of exciting opportunities too.
“To date, trustees and pension schemes have been very much focused on the risks presented by climate change, and the need to adapt investment strategies accordingly.
“But we should not lose sight of the fact there’s a lot of really exciting corporate activity and investment opportunities out there, and a number of asset managers actively seeking to make the most of
Named Best DC Investment Consultant at the Corporate Adviser Awards last October, Redington works with a range of clients, from large master trusts to smaller single-employer trusts. It has positioned itself as a trusted voice on ESG, being one of the first consultants to offer a ‘net zero advice’ proposition, and employing a number of ESG specialists, including Anastasia Guha, the firm’s global head of sustainable investment, who previously worked for a decade in engagement programmes for the UN’s Principles of Responsible Investment (PRI) [see box below].
Regardless of size of the client though, Parker says ESG is not only the main topic of conversation with clients, it is also the main driver for their investment decisions.
“We have seen a real shift over a relatively short period of time. In two to three years, ESG has moved to be front and centre, and the lens through which every kind of investment decision is viewed.”
This has largely been driven by regulatory change, which has forced larger schemes and master trusts to disclose information about how exposed their underlying investments are to different climate
change scenarios, under TCFD reporting requirements.
When it comes to managing ESG investment strategies, Parker says that over the last couple of years trustees have focused on the equity allocations of their portfolios, particularly of default funds, to ensure they are more integrated with their ESG beliefs. “We’ve seen a change, where schemes basically investeded most money in the biggest companies to an approach where they invest the most money in those companies that exhibit the most favourable ESG characteristics.
“This has been one of the key drivers when it comes to equity allocations. But we’re starting to see these conversations broaden out, to look at other asset classes. For example, we’re starting to have some early conversations about illiquid assets and productive finance, again primarily through an ESG lens.”
This focus on ESG-related investments dovetails with the government’s ‘levelling-up’ agenda, which has called for far more investment into ‘productive finance’, particularly from the DC sector, to help ‘green’ the UK economy and boost it post Covid.
Parker says that in many ways DC is at a crossroads in the UK. “Given the rapid growth in DC assets under management and the size of many schemes, they have now got to the point where they can take advantage of some of these more interesting investment opportunities.
“If you look at other large global DC markets, and how they invest their members’ assets, you see that they’ve taken more opportunity to use that money and to work in a way that obviously benefits members, in terms of returns, but also benefits the economy of the country in which they are in.
“We’ve seen this in the UK to a certain extent in the DB sector. Pension schemes have always been a massive supplier of very stable, long-term capital, and because of this have been able to take advantage of some really interesting investment opportunities that have the potential to deliver good long-term returns for members.”
However, many of these opportunities will be in more expensive asset classes, such as infrastructure or private equity. Parker says: “It would be a shame if DC savers were to miss out on some of these long-term opportunities because access to these asset classes costs a little bit more than trustees or pension providers have been used to paying.”
Getting DC schemes to invest in a far broader range of assets is one of the challenges facing the industry over the next few years. Parker says there is a “pure investment” case for the greater use of illiquids within DC defaults. “Over the medium to longer term we would expect a diversified portfolio with illiquid assets to deliver a higher return than equities with a little bit less risk.”
This case is further strengthened by pension scheme’s need to meet wider ESG goals — and investment opportunities created by the need to ‘green’ the economy in the UK, and beyond.
Political and regulatory change is helping DC schemes negotiate some of the hurdles to greater investment in illiquids, for example there have been various consultations on the DC default charge cap.
However, Parker says for significant progress to be made two things need to happen: the DC sector needs to be less focused on cutting costs to the bone, while the asset management industry needs to structure illiquid offerings so they are more suitable for DC schemes. Both are now starting to happen he says.
“We are starting to see more products structured in a way that makes it easier for DC schemes to invest in them. For example some asset managers have removed the performance fee element and they are also taking a good hard look at the absolute level of fees and trying to bring these down to a level where it’s easier to introduce them to a different application.
“We have also seen some trustees bite the bullet and be bold in introducing an allocation to these types of asset classes.Even if there is a marginal increase in fees this should hopefully lead to a much improved investment return over the medium to long-term and therefore better outcomes for members.”
But Parker says that these will be “challenging conversations” for many consultants to have with trustees, and trustees to have with members. “I have been working in the DC sector for about 20 years now, and for most of that time the narrative around DC has been about evidencing value, which invariably has focused on costs.
“The charge cap, and the amount of money trustees are prepared to spend on investment, as distinct from the other costs associated with running a DC scheme has been quite low. So even if there is a good ESG case and a strong investment case for an asset class with higher fees this is going to result in some challenging conversations.”
Outside of the brave new world of ESG and illiquid assets, Parker says trustees of many schemes face other difficult conversations, particularly in relation to asset allocation.Higher inflation, higher interest rates and the expected slowing down of quantitative easing look set to change an investment landscape that has been largely benign to pension schemes, particularly those with high equity weightings.
Parker says: “We have been having these conversations for a while, before inflation and interest rates starting picking up.
“After the 2008 financial crisis, and big losses in equity markets, we saw a shifttowards more diversified DC defaults. There were very sound reasons for this, particularly for savers approaching retirement who don’t particularly like seeing 20, 30 or 40 per cent falls in the value of their funds.”
But as Parker points out, since then the industry has enjoyed a 12-year bull run in equities. “The more diversified approach that a number of schemes adopted during the period hasn’t delivered as strong returns as those going for higher equity weightings, particularly during the growth phase.
“Over the past three to four years we’ve started to see a shift away from diversified portfolios into a more equity-heavy approach. I think the inflation and interest rate considerations we are now starting to have conversations about may seek to drive that change a bit further.”
However, he says this trend may be tempered by wider geo-political events, which have caused more volatile markets. “Recent events may just give trustees cause to pause. Unexpected external events can cause precipitous drops in equity markets, which serve to underline why diversification was a good idea in the first place.”
There is the danger that it is those schemes that have lagged behind, performance-wise that are most likely to shift investment strategy, potentially at the wrong time. “If you seem some schemes getting returns of 1, 11 or 12 per cent a year, and you’ve been getting six or seven per cent then it is natural to look at whether you should change things. Even though we understand past performance is no guide to the future, it is still a factor when employers and their advisers are looking at switching to a master trust provider, or assessing their own scheme’s performance.
“DC trustees face a conundrum. Do those that have been more cautious now move at a time, when stock markets could become more volatile — and potentially give up the protection they offered members through diversification at a time when it could be needed?
“When we are having thee conversations with clients the important thing is to come back to the core investment principles on which their investment strategy is based. Diversification over the medium and long term is a real benefit for DC members and is the bedrock of many investment strategies.”
He points out that greater diversification for example into illiquids could help deliver a more optimum risk-return, rather than necessarily narrowing into a single asset class.
BOX Greening the pension consultancy:Anastasia Guha – global head of sustainable investment
Advisers may be used to reading about pension schemes declaring net zero commitments for assets under management. But what is a net zero proposition from an investment consultant? Anastasia Guha, Redington’s global head of sustainable investment explains.
“The first part of this pledge is that we will bring up net zero investments with clients. Over the next few years
will speak to all our clients to discuss how they can transition their portfolio. We don’t wait for them to ask us first.
“The second aspect is that regardless of funding requirements, expected return, investment strategy, liquidity needs or any other philosophical view you have on investment, we will find a portfolio in terms of strategic asset allocation that will work for you, and reduce your emissions, hopefully to net zero by 2050.”
Guha adds that the second bit of this pledge is clearly “the trickier part” because she sees there are currently a lot of hurdles to achieving net zero by 2050. “But what we are saying is that we will monitor this, keep on top of it and make adjustments where necessarily.”
Guha says that as a consultancy Redington considers itself a team of “progressive pragmatists”.
“What this means is to stop hand-wringing about asset classes where it is hard to make progress at present because there’s a lack of data when it comes to carbon emissions. Instead start doing something about the asset classes where there is this information, for example look to start decarbonising equity portfolios.”
Guha says there is real demand for greener pensions, and ESG-led investment solutions. “There is real demand out there, for the products themselves, and for help trying to understand this issue better.
“Schemes are asking for context around ESG issues, what it means for them and what their options are. This is the number one issue for schemes – there are very few who don’t have this at the top of their agenda.”
However she says the enormity of the task can lead to “analysis paralysis”. “It’s such a big topic, the defining problem of our lifetimes, and there often is incomplete data or information. This can lead to a sense of inertia from trustees, of not knowing where to start.”
She says advisers and consultants have a critical role to play here, helping provide this information and guidance. “This is where our expertise comes in. It’s our job to present the risks they face, explain the exposure they now have and look at the strategies they can take to make a more positive impact.”
She points out that climate change isn’t some issue that will affect us in future. It is happening now for 40 per cent of the world’s population according to a recent IPCC report. The same report pointed out that one of the key risks of climate change is instability, security issues and war, she says. “We can look at the current crisis in Russia and Ukraine.
“Investing in localised renewable energy sources, helps address climate change but it also addresses issues of energy security, and renewable energy, by its nature is deflationary, not inflationary.”
Regulation has played a major part in driving ESG up the pensions agenda. Guha says that the UK is leading the way when it comes to sustainable finance and net zero targets, with the government keen to attract as much ‘green finance’ as possible. “Trustees are becoming very sophisticated in their way of thinking about ESG. We are ahead of Europe and the US on many of these issues.”