Active fund management can be expensive, and schemes are looking for more creative ways to boost returns, says Charlotte Moore
The raft of changes the government has recently made to defined contribution pensions is radically re-shaping investment strategies.
The imposition of a 0.75% fee cap on pensions provided for scheme members who have been auto-enrolled has forced investment consultants and managers to look again at the design of default funds.
Before the imposition of the charge cap, the use of multi-asset funds in default funds had become increasingly popular. The industry acknowledged that the reliance of many legacy DC schemes on passive equities to provide investment returns would not suit newly auto-enrolled members – they could too easily be spooked by equity market volatility.
More diversified multi-asset funds help to smooth out investment performance while still promising to provide equity-like returns. But these funds were not cheap – most fell outside of the 0.75% charge cap.
Many fund managers, however, have already adjusted their fees for their multi-asset funds so that they now fall within the charge cap, says Ryan Taylor, senior DC investment consultant at Aon Hewitt.
“Large schemes can afford to carry on using the more expensive funds they have used in the past”
Some schemes, however, did not have to make too radical an adjustment. Taylor says: “For large schemes that either buy funds directly or unbundled funds, it’s easy to get below the charge cap because the additional platform and administration fees are minimal, as most of these costs are borne directly by the company or the trustees.”
For these, Taylor thinks little will change. “Large schemes can afford to carry on using the more expensive diversified growth, absolute return, global equity and actively managed funds they have used in the past,” he says.
But some believe large schemes will face additional cost pressures as a result of the government’s decision to end the requirement for pensioners to buy an annuity. This change has implications for the types of investment strategies schemes will be able to employ throughout the life of the default fund.
Robert Holford, senior consultant at Spence Johnson, says: “Many of the large schemes have been able to effectively subsidise more expensive accumulation investment strategies with much cheaper pre-retirement strategies – it’s relatively cheap to hold cash and bonds to match annuity pricing.”
But it will no longer be possible to switch to such cheap assets, especially if scheme members want to invest in drawdown products at retirement.
Facing the cost challenge
Holford says: “It will make much more sense to hold on to growth assets as people approach retirement, but these are more expensive, which will erode large schemes’ ability to cross-subsidise the more expensive accumulation strategies.”
While these changes in the at-retirement market will make it much harder for larger schemes to continue to afford the more expensive multi-asset strategies, other schemes face even greater challenges.
“Many of the large schemes have been able to effectively subsidise more expensive accumulation investment strategies”
Those that rely on a more traditional life company model where funds are bundled with administration and platform charges will experience even greater pressure on margins. Taylor says: “The margin for investment fees is significantly lower for these funds as admin and platform charges eat up as much as 40 to 50 basis points.”
Such low margins severely limit the range of investment options. Steve Delo, chief executive of PAN Governance, says: “The foreseeable future is moving towards to mainstream passive investment. The charge cap means there is simply no margin to put in more expensive structures.”
He adds: “Even though diversified growth funds are ideally structured for DC investment, they are effectively ruled out of the equation.”
To try to comply with this much lower margin, many investment managers are now offering an active asset allocation but using a passive implementation.
Amanda Burdge, principal investment consultant at Quantum Advisory, says: “Investment managers are trying to be as sophisticated as possible by using smarter approaches rather than just using index tracking funds.”
For example, multi-asset managers will look at different baskets of stocks that can be turned into an exchange-traded fund or looking at different indices they can track. Burdge says: “Many of the multi-asset managers have already used these techniques to access asset classes, so they already have the existing expertise in-house.”
Other fund managers have gone a step further to save additional costs by making their strategies much less dynamic.
Burdge says: “These managers still offer a diversified strategy but it is static with asset allocation only reviewed periodically – for example, once a year.”
But even with these steps, it’s still not easy to comply with the charge cap. Delo says: “The managers still have to be paid for active allocation and that requires investment talent, which is a relatively costly exercise.”
It is not only the charge cap, however, that has changed the investment landscape of DC pensions – the abolition of the requirement to buy an annuity at retirement also poses significant challenges to how a default fund should now be designed.
DC members now have three possible options available to them at retirement. They can take their pension pot as cash, use it to provide a drawdown income or buy an annuity.
This makes continuing to offer a default fund to, or even after, retirement much more complex as three different scenarios now need to be factored in.
Schemes are debating how to accommodate these choices. While it’s possible to build three different funds using different investment strategies to meet all three options, it can be argued that it would be better to have one default solution.
Dan Smith, director of DC business development at Fidelity Worldwide Investment, says: “The problem with offering three solutions is that the investor needs to make a choice five to 10 years before they retire, but that’s unrealistic.”
When Fidelity contacts scheme members about their options on retirement, a third of members do nothing, another third take their money elsewhere and a third take an annuity.
“There will be a role for a dynamic drawdown solution”
“If there’s currently a third of people who do nothing on retirement, the proportion that will know what they want to do five to 10 years before retirement will be very small,” says Smith.
It makes much more sense to offer them a fund that blends all three options.
Smith explains: “This would also allow scheme members to allocate a portion of their pots to each option allowing them to take some cash, use an annuity to purchase a minimum income and invest the rest to be used when it is needed.”
While it is pretty straightforward to find the right investment strategies to match either the cash or annuity portion of pension pot, the right solution for drawdown is less obvious.
Annabel Duncan, UK DC client adviser at J.P. Morgan Asset Management, says: “There will be a role for a dynamic drawdown solution which is a simple product that allows scheme members to access these funds as and when they want.”
A diversified income strategy could work well to help to provide some level of capital protection while also allowing scheme members to draw down funds.
But the real challenge facing those who design DC schemes is not finding innovative investment solutions – the industry is more than capable of meeting the intellectual challenge – it is doing so while still meeting the 0.75% charge cap.
Delo says: “It looks increasingly like there just won’t be sufficient margin in the DC market to pay for much, if any, form of active management.”