Volatility looks here to stay yet few schemes are really using diversification to combat it says Paul Farrow
Pension scheme members probably don’t know whether they are coming or going. When their annual pensions statements landed on their doormats a year ago they would have been horrified to learn that the value of their fund had fallen sharply. This year, many will be surprised by their reversal in fortunes as the market recovery puts funds more or less back to where they were 12 months earlier.
That is volatility for you – but the recent financial crisis and the continued economic uncertainty looks set to make volatility an issue into the future. The question is how much emphasis should corporate schemes have on managing volatility, and what can happen if the issue is handled badly?
Many in the industry argue that a key part of the issue with volatility is managing members’ expectations.
“In my experience of presenting and meeting with members in the past they often have seemed to be under the illusion that the default option is “safe”; that someone is looking after their best interests and managing the volatility,” says Helen Dowsey at Aon.
“We know that this is not usually the case and members have had a nasty shock when their annual statement hits the doormat showing that their fund value has plummeted.”
The fear is that if members do not understand volatility – and they receive bad news that they will run for the hills.
Julian Webb, head of DC at Fidelity Investment Managers, says that if volatility is not managed and communicated properly, there is a danger that members will make irrational investment decisions, which can result in crystallisation of losses and ultimately a loss of confidence in DC pensions and disengagement.
In the past, pension scheme members often have seemed to be under the illusion that the default option is safe…
“This is the worse case scenario for employers as their investment in the pension scheme will lose value in the eyes of their employees. Our view is that diversification of investments delivered via multi-asset funds which have active asset allocation overlays and roll-down strategies is probably the future of DC investment defaults.”
Webb is not alone in his thoughts. Most fund managers agree that a multi-asset approach, or diversification is the answer to counter volatility. In the consultation for Pada’s report: Building personal accounts: designing an investment approach, most respondents agreed that diversification of assets reduced volatility.
For example, State Street Corporation suggested that: “At the asset class level, we similarly believe the scheme can benefit from improved diversification by adding liquid alternative investments. The addition of alternatives (assets) has the potential to reduce portfolio volatility through most market conditions, thereby significantly improving the certainty of return.”
JPMorgan meanwhile said: “Strategies that invest across equities, bonds and cash, as well as alternatives, can offer an improved risk-adjusted return (equity-like returns over the long term but with lower levels of volatility).”
A recent survey by Clear Path Analysis of DC schemes also suggested that diversification was top of schemes’ agendas. The survey says that the majority (88 per cent) of UK pension schemes state that picking a suitable diversified growth fund is still one of their top three areas of concern. Why? Because they could offer equity-like returns but with lower volatility and protect the downside risk for DC members.
John Lawson, head of pension policy at Standard Life, says that recent events has made it clear to him that most savers are not comfortable with that level of volatility. “Another issue with volatile investments is fairness between different age cohorts within the same scheme. This is particularly an issue when there is no lifestyling glide path, but applies to some degree regardless. For example, someone retiring in May 2008 would have enjoyed a fund 40 per cent greater than a similar fund for someone retiring in March 2009.
There is a gap in what fund managers are saying and what schemes are actually using
“Most schemes have lifestyle profiles to smooth volatility as retirement approaches but increasingly, schemes are using funds that smooth returns throughout the whole period of investment such as absolute return funds and other hedging strategies.”
Yet despite the industry suggesting that diversification is the answer, few in reality are adopting the strategies. Look at the numbers and it would appear that corporate schemes are simply paying lip service to the need for diversified strategies. Instead, pension funds are filled to the brim of equities, let alone having any exposure to basic assets such as bonds and cash. It is a fact that most members still invest in defaults and most defaults are still 100 per cent invested in equities in the accumulation phase.
PensionDCsions research into default strategies of large schemes shows that 82 per cent of members are in default schemes. Its figures for 62 of the UK’s largest schemes, accounting for 630,000 members and £10bn of assets show again that most members are in funds that are 100 per cent in equities at the accumulation stage.
Next month the DC analyst will publish its findings of its latest survey, which asked fund managers to reveal what their ideal default fund would be. The final findings have yet to be collated but most seem have a preference for diversified growth funds. “There is a gap in what fund managers are saying and what schemes are actually using,” says Nigel Aston, head of business development.
Certainly anecdotal evidence from some consultants suggests that trustees and sponsors are not being proactive in addressing the volatility debate. Mercer, the consultant, has been on a push to get schemes to look at general issues surrounding investment and governance – yet it is the one that been doing all the running.
“We have been taking the message to them, they haven’t been coming to us,” says Brian Henderson, principal and senior investment consultant at Mercer. But it seems the message is having the desired affect.
“Every scheme we have seen has changed their default – we have 1,000 schemes here and are going through them one by one. We have found it an easier message to convey with trust-based schemes because they meet more often and have a better understanding of our though-process.”
Even if there is a sea change to shift away from equities and diversify, it is a slow burn. The issue is more pressing for scheme members who have little choice but to take on more risk themselves as defined benefits schemes bite the dust. Unless that is, trustees and sponsors step in.
“The closure of defined benefit schemes is shifting the risk across and there is a feeling that employers and trustees need to up their game and be proactive in managing volatility,” says Webb.
Webb reckons that plan sponsors need to fully engage with their investment advisers.
“They need to build DC plans, which provide broad investment diversification and management of asset allocation during the employees working life to reduce risk as people approach retirement,” he says. “Traditional default funds have focused on passive global equity default funds which have given plan members full exposure to the volatility of the stock market.”
Most schemes have lifestyle profiles to smooth volatility as retirement approaches but increasingly, schemes are using funds that smooth returnsthroughout the whole period of investment such as absolute return funds and other hedging strategies
Dowsey notes that the recent heightened period of volatility has resulted in a few corporate schemes reviewing their investment strategies. But she adds: “Many trustees and scheme sponsors could do more to help their members.”
But issues such as volatility will not be addressed unless there are formal governance policies in place. The likes of Aegon and Scottish Widows have revamped their GPP ranges so they take a more hands-on approach to asset allocation while Scottish Life has created a lot of noise with the launch of its Governed Range. The NAPF got in on the act with the launch of its Quality Mark. But despite these initiatives, many schemes are not doing enough to help members.
In Mercer’s 2009 Global DC Survey, 47 per cent of the 354 companies polled in the UK didn’t have any formal DC governance policies in place for their DC plans.
Nigel Aston at PensionDCsions is concerned that members are being let down and are being thrown “a hospital pass” from companies closing final salary schemes. “Employers may feel that they have divested themselves of onerous DB uncertainties, but there has not necessarily been a corresponding acceptance of these unknowns by the membership. The sponsor has unwittingly executed a ’hospital pass’. The unfortunate member may be about to be heavily tackled by the weighty forwards of volatility: volatile capital markets; volatile interest rates; and volatile longevity expectations.”
Aston adds: “Measuring return without the corresponding risk undertaken is like trying to navigate using only latitude and not longitude. You’ll get lost. You can only compare performance objectively by looking at risk-adjusted return.”
Aston points to DWP research that suggests six out of 10 pension savers are in some way risk-averse, yet his company’s research suggests a very similar proportion of DC members are almost entirely invested in equities in the growth phase. In other words, they are not in risk-averse strategies.
“There appears to be a mismatch,” says Aston. “The last three-years have been a wake-up call. Schemes and their advisers are diligently looking for solutions and many anticipate becoming more diversified. However, things move slowly.”
What members’ make of the volatility debate, is another matter altogether, which is why Nest’s quest to analyse members’ behaviour in light of the recent downturn and volatility should be intriguing.
It is currently analysing existing data because it “wants to know whether falls in the value of pension pots are linked to members changing their contribution patterns, or switching from their chosen scheme or fund”. Unfortunately we will have to wait until “later in the year” for the results. In the meantime, most scheme members will have to hope that the stock market remains stable at best – after all, that is where the lion share of their pension savings is going to remain for the foreseeable future.
Check list for dc governance committees and trustees of dc schemes
Mercer has created a 10-point MOT of factors for trustees and governance committees of DC schemes to review in light of the recent volatility in the market
What are your strategic objectives?
Objective setting in advance of strategic analysis is perhaps one of the more challenging aspects of DC scheme design. Co-operation between scheme sponsors, trustees and the governance committee is vital in setting clear objectives, strategies and success measures.
What can sponsors and trustees learn from profiling their members?
Members do not always act as expected. Member profiling can help identify particular patterns of behaviour to then improve the scheme by setting specific objectives, defining strategies or tailoring member communication to complement member behaviour.
Are contribution strategies (the scheme’s and members’) sufficient to achieve benefit adequacy? What is benefit adequacy?
While investment returns tend to have the largest focus, the main source of fund growth in the early years is the contribution level.
Is your current investment strategy fit for purpose?
Sponsors and trustees need to ensure that
they fully understand the implications of their scheme’s investment strategy for different groups of members, particularly where the workforce is diverse.
Can one size really fit all?
While ’lifestyling’ has generally achieved its objectives, it can be improved. Ideally, it would be much better for schemes to offer more appropriate member-focused default strategies that are better aligned with the profile of the membership.
Are members keeping their options up to date, reviewing funds and changing managers in a timely fashion?
Funds can become out-of-date leaving members invested in poorly performing funds. Offering structured choice can help encourage members to choose their own funds based on their own circumstances.
Have sponsors and trustees considered some of the newer approaches to fund choices that are now friendlier for members and better at managing risk?
There is now an increasing array of investments being introduced to the DC market that could be used as part of a balanced range for members to self select from, or to add diversification to growth elements of default/lifestyle funds.
How insightful is the current monitoring of the scheme’s investment options?
Current monitoring often simply focuses on reviewing the past performance of funds, which doesn’t provide a good indication of future performance. More active monitoring of the potential prospects of underlying funds and markets, and reviewing what members are actually investing, would be improvements.
How effective is your communication in engaging your members?
The biggest obstacle to members obtaining the most from their DC pension arrangements is often a lack of understanding of the scheme’s benefits and operation, rather than a lack of interest. Making DC pensions accessible and engaging through good communication reduces the potential risk to the reputation of both the trustees and the sponsoring company.
Does the governance structure support the trustees in achieving their objectives?
Sponsors and trustees need to respond increasingly to specific issues relating to DC – for example, investment options, modelling and metrics. Good governance of DC adds demonstrable value to members: an effective governance structure provides the framework for designing and implementing an effective strategy aligned to achieving objectives and making decisions, as well as obtaining advice and input, and working with the sponsor, providers and adviser.