After Brexit, where now for default strategy?


Defaults with unhedged equity exposure have outshone dynamic asset allocation peers since Brexit. But David Rowley sees little consensus on where defaults go from here

A media headline that says ‘Your pension is at threat’ will always attract more attention than one saying ‘DC savers get 10 per cent Brexit boost’. So ever since the outcome of the EU referendum, employees will have felt growing concern about the percentage of their salary put aside for their retirement.

Indeed, never letting the full facts get in the way of a good headline means the mainstream media has largely focused on the Brexit threat to DB plans, annuities and the state pension, rather than to DC.

So, while the UK workforce may describe its DC plan as a pension, as far as national media headlines are concerned, ‘pension’ is first and foremost a defined benefit.

In a BBC online report on the impact of Brexit the day after the referendum, the pensions section contained only gloomy forecasts for the state pension and annuities. Even the FT stoked fears with its round-up the day after the referendum containing the worrying sub-head ‘Market volatility could shrink the value of retirement funds’.

The reality is that a sharp fall in the value of the pound has seen the value of overseas assets in DC default funds jump in value. With around three-quarters of the FTSE 100’s earnings based overseas, the fall in the pound has translated directly into an inc­rease in the index. While falling gilt yields mean the lower income an individual can buy with their pot is largely offsetting any fund gains, for most DC investors looking at their fund values the news looks rosy for the moment.

A fund such as the Legal & General Master Trust, which holds a relatively small portion of UK equities, rose by 11.35 per cent between the opening of markets on 24 June and the close of markets on 8 August. Over the same timeframe, Aviva’s DiversifiedAssets fund, which is used for SME auto-enrolment, grew by 10.1 per cent and a pure global equity fund, Fundsmith Equity, did even better, growing by 16.88 per cent.

But Brexit has hit returns of leading dynamic asset allocation funds, which eschew traditional 70 per cent equity, 30 per cent bond allocations for more market-sensitive moves. Over the same 45-day timeframe, the Standard Life Investments GARS fund rose by only 0.46 per cent and the Newton Real Return fund by 5.4 per cent.

Morningstar UK director of manager research Jonathan Miller reveals some of the performance figures since the Brexit vote that have confounded experts. In July the FTSE 100 had its best ever month compared to the FTSE 250 since the latter’s launch in 1992. Meanwhile, UK 50-year gilts have increased in value by 32 per cent since the referendum and by 54 per cent since the start of the year.

Miller says: “The craziness of rising bond prices is carrying on for longer than people have anticipated. On paper, the valuations for gilts and treasuries do not look attractive at all on a 10- to 20-year view and those investing on a dynamic view will have had less exposure. The ones that have stayed more fixed have reaped the rewards of falling yields.”

Hedging bets

In such a crazy environment, the level of currency hedge on overseas assets has become a bigger key in default fund performance than in asset allocation. So the L&G Master Trust and the Aviva Diversified Assets funds, which are both only 50 per cent hedged, did better than the Now: Pensions default, which is 100 per cent hedged and returned only 6.5 per cent between 24 June and 8 August.

Legal & General Investment Management head of DC Emma Douglas explains the rationale of a 50 per cent currency hedge.  “Most members are going to be taking their benefits in sterling so you need some kind of hedge for foreign-held assets. A 100 per cent hedge does not give you that protection when the UK economy hits a rock. It tends to be that sterling gets hurt as well,” she says.

While it may appear a good time to reverse the hedge, L&G is holding firm.

“Are we changing our view and saying that sterling is going to recover sharply?” says Douglas. “Not particularly. We think the 50 per cent hedge is the right thing going forward. It could change, but at the moment we are comfortable with that.”

Now: Pensions is disappointed not to have gained as much as L&G but it is also holding firm to its strategy. Now: Pensions director of investment and product development Rob Booth believes the fund would need a strong conviction on currency markets to take anything less than a 100 per cent hedge. He says Now: Pensions’ principal bet is on long-term outcomes from a mix of the diversified assets it holds and not on the fortunes of currency markets.

“We are not keen on the uncertainty that currency can bring,” he says.

“Our job is to create an environment for long-term growth and to reduce as much as possible the potential for nasty surprises, which means having a big eye on volatility on that growth path.”

IN FOCUS: No consensus on asset allocation

The 25-30 per cent fall in fund values witnessed by savers in all-equity DC defaults in 2008 heralded a near-consensus move to diversification, particularly by DGF and DAA funds. But there is no consensus on defaults post Brexit.

LCP partner Laura Myers envisages more volatility and shocks and thinks employers and employees concerned at the impact of this may look to cut the level of risk they are running.

“People will stand back and make sure they are comfortable with the level of risk their default fund is taking. I don’t think there will be any rush to change strategies, but if you have a high level of equities then some may look to diversify.”

While such diversification may pacify nervous DC investors, there are some who believe the trend away from volatile growth assets has gone too far and a greater reliance on member inertia is called for.

Hargreaves Lansdown senior analyst Laith Khalaf says: “There has been too much reckless prudence among default fund selectors. There has been a real focus on reducing risk, which is all very well but you are also reducing your returns by taking that approach.”

He cites funds he has seen that have reduced equity holdings to 50 per cent, and in some cases lower, since the global financial crisis. This, he says, runs counter to the longer time horizons opened for savers to stay invested beyond retirement age with the new pension freedoms.

Khalaf thinks an over-complication and over-thinking of default fund strategies by consultants is partly to blame. He favours a simpler strategy of 60-80 per cent equities and 20-40 per cent in defensive assets.

“This is as good a bet as any,” he says. “Asset allocation is a fairly risky business and even the best practitioners get it wrong sometimes, but the pensions industry is making a big deal about their asset allocation skills. A lot of these funds are very new and they do not have easy-to-point-to benchmarks. It remains to be proven that they can do a good job.”

The sit-and-wait approach, or what may be termed an anti-intellectual approach in the midst of investment markets that confound the instincts of the smartest active investors, is gaining popularity. Douglas says the L&G Master Trust’s passively managed asset allocation will always be reviewed but is not designed to be tactical.

“It is a low-cost fund; there is not lots of trading,” she says. “You could say ‘What a boring fund’, but boring has done very well. Not all asset allocation views and tactical moves are the right ones.”

Part of the trend to lower-risk defaults comes from consultations with employers concerned at the sophistication of their employees and their ability to deal with volatility.

Khalaf says: “Default funds are never going to be wholly app-ropriate for all those people, particularly now when we have got pension freedom. Prior to that, you could put them in a default and lifestyle them to retirement; now you have got no idea what they are going to do post retirement, so you do not have an ending point from which to work backwards for investment strategy.”

There is a counter-argument that, with the low-growth, low interest-rate environment, equities are unlikely to repeat the bull runs of the 1980s or mid-2000s any time soon. To this end, several default funds are seeking new asset classes. Now: Pensions, with access to the world-leading investment team of the national Danish workers fund, ATP, is following this approach, while L&G would like to hold a greater range of unlisted property assets to better suit the needs of retirees adopting income drawdown.