As saving into defined contribution becomes the norm, it’s worth seeing is some of the strategies associated with defined benefit could be applied, says Maragaret Taylor
Membership of defined contribution schemes overtook that of defined benefit for the first time in 2015. The value of assets held in money-purchase schemes is expected to exceed what is held in final salary funds within the next four years.
Despite this, DC pensions still lag DB when it comes to the sophistication of their investment strategies. With the tipping point between the two types of scheme approaching, many pensions professionals are turning their attentions to DC.
“A lot of schemes are closing their DB business and DC has become a more important part, while investment consultants who have advised on DB are coming into the DC space, bringing some of their expertise,” says Jenny Holt, head of investment solutions at Standard Life.
On the DB side, diversification has been achieved by investing in what Mercer partner Brian Henderson describes as “more esoteric asset classes” such as private equity, hedge funds, infrastructure and derivatives, as well as the traditional mixture of equities and bonds.
“Research says that DB returns tend to be better and in really large schemes there’s a lot of money in private equity and that’s really made a difference,” says Henderson.
While DC schemes can gain access to some alternative-type investments via pooled funds, one of the problems with trying to mimic DB investment strategies is that these kinds of assets typically cost more to manage.
Last year the government imposed a 0.75% cap on the annual management fee pension providers can charge on their default funds. There is talk of it being further reduced to 0.5%, making it unlikely that any default strategy could consider alternatives.
“Those illiquid asset classes are more expensive,” says KPMG principal investment consultant Mark Powley. “DB can afford it because it can get it back in the long term, but to put those in as part of a default fund with the charge cap is a challenge.”
At the same time, the long-term nature of something like a private equity investment, which requires a fund to take a potential hit at the beginning only to make it up after a lengthy holding period, is a difficult sell in a scheme that is essentially made up of numerous individual portfolios.
“In DB it’s collective; in DC members might all be in the same fund but the entry and exit point won’t always tie in,” explains Powley.
“Your entry point might suit the J-curve because you’d get the back-end loading, but there is a timing issue.”
Related to the long-term nature of such assets is the fact that they are illiquid, something that doesn’t sit well with DC, which not only requires daily liquidity but demands daily prices on the assets it invests in, too.
“The need for daily liquidity and daily pricing is a fundamental difference between DB and DC,” says Holt at Standard Life. “With infrastructure, there are a lot of funds in that space but they aren’t daily priced so they’re not available to DC. If you had a really big DC default fund that could manage its liquidity you could do that, but our platform can’t support anything that doesn’t have a daily price. Customers will be retiring on a daily basis so you get into challenges with fair-value price if assets aren’t daily priced.”
However, Niall Alexander, director of DC solutions at consultants P-Solve, says this is a key area where lessons could be learned. A more relaxed attitude towards daily liquidity was likely to have a knock-on effect on the need for daily pricing, and therefore for investment options.
“If anyone is in a position to take on the disadvantages of illiquidity it’s DC schemes because people are putting in money and not taking it out for many years,” Alexander explains. “There’s the risk that everyone withdraws on the same day, but how likely is that in reality? People might also want to trade their funds every day, but the reality also is that not many people do that.”
The issue, then, is more around convincing trustees that their schemes could function without daily dealing, while also convincing pension providers that their platforms should support some element of illiquidity, such as weekly or monthly pricing.
The latter, says Alexander, may not be easy to do, not least because the types of illiquid investment in question are not generating significant returns.
“There’s a risk that people look at this and think this is cool and clever and niche, but with infrastructure a lot of insurers are looking at it but only getting gilts plus one or two per cent, so is it worth investing in?,” he asks.
“If you’ve only got 5-10% going in, then is there a business case for bothering to do it? Non-daily pricing can be useful, but you’ve got to be clever about what you do with it.”
Convincing trustees may be easier said than done, too, with figures from the Pensions Regulator suggesting that while around two-thirds of DB trustees are engaged with their scheme, only a third of DC trustees are.
With so many new members coming into occupational schemes as part of auto-enrolment, an estimated 80-85% of people are now members of their employer’s default fund. Many will have no knowledge of pensions or investments, so trustees need to up their game when it comes to governance.
“If you don’t understand how investments work and that it’s a personal responsibility to ensure you’re putting the right amount in – you might not get what you hoped for,” says Helen Ball, a partner and head of DC at law firm Sackers.
“In the past you were able to let other people get on with it for you. Now as a DC member you have to take more of an interest in your own finances.”
For Henderson, DC could learn from the way scheme funding is tackled in DB.
“In DC trustees don’t periodically look at the scheme to see if it’s over- or under-funded because it’s just a bunch of individuals, but the principle still applies,” he says.
“You can tell an individual if they’re on the right track or not and they could put more money in. That’s not done well in DC, but it’s important because if you double your pension savings you double your pension.”
And just as in DB if a scheme is underfunded its sponsoring employer will have a responsibility to add more cash, employers in the DC world must take some responsibility, too. The days of financing massive deficits may be coming to an end for some, but now that employers are paying for every employee to join their DC pension scheme, should they be providing them with paid-for financial advice?
As Powley at KPMG says: “Employers have a duty to raise their game. They can’t just look at DC as a cheap and cheerful way to manage their costs.”