A better benchmark

This month we take default analysis to a new level as DCisions scrutinises the performance of the five provider funds on the Ultimate Default Fund shortlist. Paul Farrow finds some interesting outcomes

The ultimate test of whether a defined contribution scheme is a success or not is the performance of its default fund. After all, it is well known that four in five workers opt for this fund, or more accurately, they show little interest in their company pension so, without doing anything, they are automatically placed in the default fund.

Despite efforts to the contrary, education and communication to engage workers to take responsibility for their pension is a slow burn. This has put the spotlight firmly on the quality of the default fund. Yet the quality of the default has long been questioned. Recently the Pensions Institute at Cass Business School warned that DC pension schemes are putting employees’ retirement prospects at risk unless and until they improve the quality of default funds.

“Despite efforts to the contrary, education and communication to engage workers to take responsibility for their pension is a slow burn”

In its report, Dealing with the Reluctant Investor, it found most traditional default funds did not match members’ needs in terms of asset allocation and risk profile.

This is perhaps, hardly surprising. Many default funds are still filled to the brim with equities and do little to protect members from the vagaries of stock market cycles and macro-economic issues.

But change is afoot. Providers are working hard to embrace new ideas and improve the governance of default funds. Many of these providers and their funds have been recognised in the Corporate Adviser Ultimate Default Fund Award.

“Beating a benchmark isn’t necessarily proof of a ’good’ return – it might have been the wrong benchmark”

The winner is drawn from a short-list of six after a readers’ vote. This year the winner was Scottish Life for its governed range – it is the third year running that it has scooped the gong, testament to the comfort advisers take from the governance it offers when recommending defaults to their clients.

This month we are taking the analysis of default funds to another level. Data experts DCisions, in partnership with Corporate Adviser, has put the funds on the Ultimate Default Fund shortlist under the microscope to see which funds are doing what they claim they do, in terms of risk, returns and actual value delivered to the member.

DCisions has devised a new way of looking at performance and volatility that we think can be developed into a benchmark of choice, a benchmark that will enable trustees, consultants, employers and members to have considerably more information than they do at present when they pick what they hope will be the ultimate default fund.

Performance results

For many savers the only thing that matters is the return. Forget about benchmarks, it is all about the upside. On the other hand, fund providers are often more concerned with just beating a benchmark, irrespective of whether the fund has fallen in value.

But Nigel Aston, business development director at DCisions, who oversaw the research, believes that there can be question marks over the stated benchmark of a fund.

As the total return charts show it has been a bumpy three years, for all but one of the funds. This is not surprising given the topsy-turvy markets amid the Eurozone crisis. Standard Life is an “outlier”, being considerably less volatile month on month, although it did “flat line” over one year. Given its structure, many people would expect to see a diversified growth fund at the top of the return tree given the turmoil witnessed since 2008.

Value for money

DCisions wanted to find a meaningful measure of what ’good’ means, given that DC performance is all about delivering decent outcomes for consumers.

“We wanted this analysis to be about people rather than products,” said Aston. “It is like testing a new drug. Pharmaceutical companies can do all the laboratory testing they like, but until people start taking the pills they don’t know if there will be any nasty side effects.”

“Many default funds are still filled to the brim with equities and do little to protect members from the vagaries of stock market cycles”

To this end DCisions looked at CuBIT, its market representative data base of more than a million UK long-term savers and derived a sample of comparable savers in the growth phase.

It then asked this straightforward question – how many of these real people would have been better off in each of the Ultimate Default Fund short-list.

To the credit, and perhaps relief of the nominees, and those that put them forward for that matter, the analysis proved that most DC members would have been better served in any of the ultimate short-listed funds.

The charts on page 25 show the percentage of our sample who would have achieved a better outcome if they had been in the various different funds looked at here.

Over three years 99 per cent of consumers would have had a better off in the Standard Life fund, based on a total return basis.

However, there were significant differences in value returned over shorter time spans, with one of the funds, Schroders, only giving an improved outcome to 24 per cent of people over one year (although it did far better over the longer time horizon, giving a better return to 80 per cent of people).

“The findings would seem to reflect the nature of absolute return strategies, in that they claim to give good reward over a market cycle, rather than promising positive growth every single year,” adds Aston.

Risk and return

Any professional investor will tell you that return is only half of the story. Aston suggests that the growth figures make interesting reading, but argues that it is not enough to judge or choose a fund sensibly. “You can’t just look at return – you have to look at volatility too.”

Arguably, the aim of many pension funds is pretty much the same – they all try to deliver a decent return by taking as low as risk as possible – or at least that is what they purport to do.

Yet a look at the charts shows that volatility is varied. Aston argues that looking at return only is like only looking at latitude and not longitude. “If you don’t use both you’ll get lost,” says Aston.

He adds: “Unfortunately, the risk descriptions given to investment products are largely meaningless to ordinary people. One person’s low risk might be another person’s high and funds are sometimes labelled differently, depending upon which platform they sit on.”

The ultimate default nominees were variously described as “moderately cautious” ,”balanced” and “below average risk”. But these vague risk scales mean little to engaged investors, let alone defaulters.

The charts on pages 26 and 27 look at risk-adjusted return – in other words how many return ’bangs’ do savers get for each of their risk ’bucks’. It’s a new measure of value. Funds that are below the line are taking excessive risk for the return delivered. Not a good place to be, says Aston.

DCisions analysed the funds against this “fund-ranker” methodology ranking the funds against their objective ’fair value’ benchmark at each level of risk.

One constraint with the research is that the shortlist contained only three funds that had a three-year track record. Of those three, DCisions calculated that Schroders and Scottish Widows would be in the medium high-risk group and Standard life in the medium low group. As the table shows the Schroder fund delivered a positive £7.50 above the benchmark, Scottish Widows £7.25 and Standard Life £18.18.

“Regardless of how they are described, this is what the funds have delivered. Such analysis is good for the market; asset managers can now be held to account.


View from the consultant

Andrew Cheseldine, principal, Lane Clark & Peacock LLP

The risk and return work is the most useful – the most obvious point made is that most people don’t have a clue what anyone else means when we discuss risk.

What is obvious when you talk to members and investors is that they don’t buy into the actuaries’ definition of risk (volatility).

I don’t know anyone other than mathematicians who think that the possibility an investment might grow 20 per cent in a year is a “risk”. Most members think “risk” is what actuaries etc would describe as “Value at Risk” or just the chance of losing money. Maybe we should put the assumptions in context by describing them in terms of:

  • Chances of winning the lottery (assuming you buy a ticket) – 1 in 14 million [Camelot]
  • Chances of losing more than 25 per cent of your fund in any one year if you are invested in an equity fund – 1 in 10 [LCP]
  • Chances of making a gain of more than 25 per cent of your fund in any one year if you are invested in an equity fund – 1 in 5 [LCP]
  • Chances of making a gain of any level in any one year if you are invested in an equity fund – two in three [LCP]

The key to making any investment decision is to understand what you are actually trying to achieve – what level of return, what are the risks of failure, what costs are incurred (charges) and how much faith do you need to have in the manager’s skills.