18 June 2020
The financial market impact from the pandemic is providing a litmus test for DC investment strategies; the first real test in the auto-enrolment era and probably more importantly, the first post the freedom and choice reforms. This has made many schemes think about their approach and how they should evolve default design. The Pensions Regulator has also stepped up their focus during the pandemic by releasing guidance for trustees specifically targeting DC investment strategy considerations and engagement with members.
When markets fall the key concern for trustees, governance bodies and sponsors is how well protected members have been from the market shock. This is particularly important for those members close to retirement who do not have the luxury of time to benefit from additional contributions or investment growth. However, whilst downside protection is important it is key to look at how your strategy performs over the long-term too. There’s no point investing to protect on the downside if you get no participation in the upside!
Fortunately, in recent years there has been a real focus on DC investment strategy design and many schemes have made significant innovative strides when it comes to their DC default design. For example, incorporating illiquid assets to diversify the growth phase and integrating ESG principles throughout the default, both of which have typically benefited members in the recent downturn. However, there are still a significant number of DC defaults which didn’t exactly pass the test, especially in terms of the protection the investment strategy gave in the run-up to retirement. So what should you be focusing on? Here’s a few thoughts from strategies that have done well, and those that haven’t.
Diversify risks for younger members
Looking at younger members, those in the early to mid growth phases, while equities is typically seen as a low cost growth opportunity many DC schemes have therefore significant concentration risk to equity markets and within those markets. Schemes that have been able to add in some illiquid assets in the earlier phases have seen some positive results which has provided strong upside prior to the pandemic and many examples have protected on the downside too. Thinking about risks within equities, we do still see many schemes with overweight positions to the UK – in my view, a hangover from DB schemes using UK assets. The UK equity market is a more concentrated index compared to more global markets, for example there’s limited technology exposure and there's a predominance in the energy sector in the UK stock market so we've seen these areas have a significant impact on members' outcomes. With expectations of a Brexit headwind Schemes should be thinking about their equity allocations and consider diversification – reducing that UK overweight could be really beneficial.
There are other ways to improve your equity allocation too, for example looking at Environmental, Social and Governance (ESG) tilts. The performance and risk experienced by different ESG strategies has varied significantly over the first part of 2020. This has been due to a variety of factors from active managers’ stock picking ability in capturing the factors, to how much deviation passive implemented approaches have experienced versus a broad market benchmark – some control risk against standard market benchmarks so won’t have seen much benefit. However, in general, ESG strategies have performed well; largely through avoiding the recent oil issues but also typically due to higher concentration of quality stocks, which have done well recently. In my view, ESG is a key consideration for all assets and we could see an ESG tailwind as economies rebuild.
A longer smoother de-risking phase
The main problem with DC investment strategies as members approach retirement is they are often designed around a single retirement age and outcome, which can be very different from when your members actually access their pension savings. This often means that strategies run too much risk when people can access their pot, or too little risk if they stay in the scheme for longer. We’ve seen real variation in when people are taking their money, and what they are then doing with it. We have people accessing their pots at 55 and people that are staying invested until they are in their late 70s, but only a handful of members are pro-actively updating their target retirement age.
Consequently, schemes need to think about that de-risking period a lot more, to ensure members are appropriately invested as they are moving into their 50s, and more likely to access their money. With many members accessing their pots at 55, schemes with the worse outcomes for these people in the pandemic were those that are still fully invested in the growth assets at age 55. I believe it’s essential to increase diversification as members get older but how quickly a strategy should de-risk, and over what time frame depends on the assets being used in the initial growth and mid-growth phases with a longer de-risking phase required where schemes are moving out of pure equity for example.
For me, the most important thing we can learn from the recent markets is that pensions are a long term investment and we need to ensure our members are protected and supported. This is not just from an investment strategy perspective but supported so they don’t disinvest from the scheme or de-risk their assets at times of markets lows. The schemes that have done well are the ones that have been thinking about their investment strategy in a long-term way and are built with a long term communication strategy to support this. They have been prepared from a communication point of view and have already been talking to members about volatility in markets in the good times and trying to increase engagement with members so that when times like these come, it's just a reminder of those messages rather than starting an education campaign for members.
That said, given the significance of the market turmoil, now is a good opportunity to review your investment strategies, to test whether they are fit for purpose and to evolve them as needed.
For more thoughts on this subject, please listen to Professional Pensions' virtual roundtable which looks at how DC schemes are coping with the investment volatility caused by the Covid-19 pandemic and assess any actions they should consider now to protect members.