Comparing default strategies: moving to a 360° perspective

Henry Cobbe, Managing Director, BirthStar shares his top 13 pension issues for 2013

Henry Cobbe, BirthStar

Many outsiders consider the pensions industry to be opaque. And they have some grounds. While fee transparency is one hot issue, what about performance?

Why is there no analysis in the DC market for how pension savings strategies, rather than component funds, have performed? How can consumers and intermediaries actually compare savings journeys on a like-for-like basis?

Historically, the reason for this gap is because pensions combine an investment function to deliver an accumulation strategy, with an administrative ‘lifestyling’ function to deliver a de-risking strategy. As the de-risking starting point varies for each individual, and the de- risking slope varies for each plan, be it 3 or 15 years, every savings journeys is unique but inconsistent. This makes comparisons between entire strategies impossible.

There are two important reasons why this has to be addressed urgently. Firstly, lifestyling, although administrative in nature, is typically the single largest asset allocation change that will impact savings outcomes, hence its impact needs to be assessed. Secondly, without consistent comparisons against peer groups and benchmarks, there is no transparency as to which strategies are working in the real world, and which aren’t, be that in relative or absolute terms, or on a risk-adjusted basis.

The expected growth in the Defined Contribution market, and the expectation that the majority of auto-enrolled savers will use a default fund, means that regulatory guidance is focusing increasingly on the design and governance of the default, be it trust- or contract-based. And rightly so. Regulators are encouraging advisers to review their clients’ default funds regularly (at least every three years), so advisers urgently need the tools with which to do this.

Our proposal is to take both a forward-looking and a backward-looking approach, for a 360° perspective. There are plenty of tools and methodologies to assess asset allocation strategies on a forward- looking basis. Some are simplistic (statutory projection rates), others are complex (mean variance optimisation and Monte Carlo simulations). But all are problematic, in that they typically assume that markets behave normally, and rely on long-run assumptions that vary from model to model. Hence projections are never cross- comparable, let alone certain. But they remain essential for a coherent strategy design and appraisal.

One of the missing pieces in the transparency jigsaw is the ability to compare consistently the performance of strategies in the past. We are shortly launching our TD-XTM Target Date Analytics service with an inaugural Default Strategy Review. We have crunched the numbers for some popular default strategies transposed onto a target date format to compare their performance to discrete maturities. This is because we believe that all pensions are, in a way, target date funds, but whereas lifestyle takes an administrative approach to de- risking, purpose built TDFs take an investment approach. Analysing the actual performance of both will therefore help inform the debate as to the relative merits of each.

We present our findings as performance “frontiers” in a format consistent with Modern Portfolio Theory, which is typically the basis for asset allocation design. Unlike theory about how strategies should behave, our historic frontiers are based on how strategies have actually behaved in real-world non-normal market conditions such as the 2008 Global Financial Crisis, and the current historic lows in UK gilt yields. In terms of assessing manager responses to market conditions, and assessing actual consumer outcomes, the distinction is critical.

While neither a forward-looking, nor a backward-looking approach is independently perfect, the combination of both gives advisers much more information than is available today. Indeed as advisers, your role has never been more important: to help your clients make evidenced-based decisions in their and their employees’ best interests regarding the on going selection, monitoring, review and, if necessary, replacement of a default strategy.

We hope this and future analyses will help inform these discussions, and will help put Corporate Advisers at the head and heart of their client relationships, in an increasingly unbundled DC world.