Annabel Tonry: How defaults should adapt to a slow growth future

Expectations of a slow growth future mean default funds will have to be creative if they are going to deliver says JP Morgan Asset Management client adviser, UK defined contribution Annabel Tonry

Annabel Tonry, JP MorganLack of member engagement and understanding around investment choices is hardly a new challenge for DC schemes, but the market regime shift now underway brings fresh urgency to the issue. We’re on the cusp of a major step change in the underlying drivers leading capital markets’ direction – a shift that underlines the need for investments that can help reassure members by mitigating some volatility without sacrificing the ability to still generate returns with diversification.

Research into behavioural economics over the last few years has shown us that most members are not actively managing their investment decisions for a myriad of reasons, be that a failure to translate financial information into rational decision making, an inability to relate short-term decision to long-term consequences, or most commonly, just plain inertia and indifference. With ingrained behaviours and the eternal challenge of retirement seemingly a distant future, there are limits to the power of education in making a meaningful difference. So the onus falls on the default fund, the path of least resistance for the vast majority.

Ensuring the default is fit for purpose takes on a new dimension as we are set to move to a reflationary environment for the first time since the financial crisis – and possibly a rising rate environment. It will ratchet up the importance of members having access to well-diversified multi-asset investment options that can smooth volatility and deliver returns.

The reality is that the investment journey for members is only going to get more difficult and less rewarding in the coming years. Research by JP Morgan Asset Management predicting likely market returns for major asset classes over the next 10 to 15 years shows a clear pattern – average annualised returns to be expected from a basic balanced portfolio that 60 per cent equities/40 per cent bonds. have fallen steadily since the financial crisis, down to just 5.5 per cent – from 8 per cent in 2009.

The discrepancy between returns in the past decade and expected returns in the next decade from major asset classes is sobering. Taking European bonds as one example of the trajectory, they averaged an annualised 6 per cent total return in the 30 years leading up to 2017. But projecting forward our expected returns for the next 20 years, assuming a slow growth scenario, annualised returns will average a meagre 0.5 per cent. The difference is less stark but similarly depressing when we look at European equities, which are expected to go from having generated 7.5 per cent for the last twenty years to generating less than 5 per cent in a slow growth future.

Why is the outlook so challenging? The fact is, accommodative central bank policy of recent years drove asset returns far in excess of underlying economic growth. In the last 50 years US stocks have, on average, outrun GDP growth by around three times during phases of economic expansion; in this post-financial crisis expansion, U.S. stock markets have outstripped the U.S. economy by almost eight times. An inescapable conclusion is that this extended period of policy largesse – designed to stabilise the global economy – resulted in asset returns being borrowed from the future, and now that future is here.

We find ourselves caught in an uncomfortable, but potentially enduring equilibrium: growth is unlikely to be strong enough to support a sharp rise in interest rates, yet at the same time the exuberance and excess that often mark the end stage of an economic cycle are palpably absent. Some may call this a “goldilocks” scenario; but if it is, then it’s a rather bleak read of the fairytale. Poor demographics and weak productivity combine to peg developed market real economic growth at just 1.5 per cent over the next decade. This translates to a significantly slower and shallower path of global interest rate increases, and lower terminal rates for both the cash rate and 10-year yields. In turn, any respite for capital owners from higher yields or better growth is likely to be a long time coming.

But it is not all doom and gloom. It simply means returns are going to require more creative thinking and more active diversification.

In such a landscape, there’s a clear need for DC members to have professionally managed, well-diversified investment solutions in order to have a fighting chance at accumulating enough to fund their retirement. Motivations that have fueled the popularity of diversified growth funds (DGFs) at the core of default options, as well as the growing use of target date funds, will only accelerate in a lower-for-longer regime.

The added benefit of such a multi-asset approach is that with a managed solution in place, DC schemes and trustees are freed up to focus on what is going to be even more critical going forward – getting members to save more.