Five years ago, 100 per cent shares was a common strategy for the growth phase of a default fund. Are we finally falling out of love with equities? Emma Wall investigates
For a quarter of a century equities served investors well. From the mid-Seventies until the tech bubble burst any pension scheme linked to equities would have enjoyed an unbroken run of gains for their members.
But the tide has turned. It seems portfolio managers no longer trust equities to deliver – even for the least risk averse members.
The new workplace pension scheme National Employment Savings Trust (Nest) will invest younger members’ money in a mix of equities, cash and bonds – despite the fact that with their long term investment horizon they are the seemingly perfect candidate for a pure equity play.
Instead, Nest’s investment strategy will see younger employees invest their initial contributions in low-risk assets such as gilts.
Mark Fawcett, Nest’s chief investment officer, says: “We have undertaken a lot of research on potential members – and we know that the majority of the target audience is more risk averse than those older people currently able to save for a pension. Although older people say they don’t like to suffer loss, they seem to be able to live with it better and so don’t tend to act on falling fund values. On the other hand, younger people are more likely to act. They may say, ‘I’m not going to contribute any more.’”
The law of compound interest – described by Albert Einstein as the eighth wonder of the world – decrees that gains not accrued at this early stage cannot ever be caught up at a later date.
But Mr Fawcett says that it did not matter if you put your money into low-risk assets during the first five or 10 years of investing, the outcome was very similar over the long term to someone who piled into riskier assets such as shares. “The pot is so small in the early years and whether you invest 100 per cent in equities or 100 per cent in bonds it won’t make too much difference (around 5 per cent) over 45 years,” he says. “The middle years of investing – our growth stage – will be the most important. All we are trying to do is introduce risk gradually to members, so the initial portfolio will be half in gilts and cash and half in equities. It is not ‘no risk’, just lower risk.”
Nest may be a special case, but this caution is not just restricted to the state-sponsored scheme’s investment strategy.
The 2012 DCisions Report revealed that the traditional heavy allocation to equity in the growth phase of defined contribution (DC) pension funds showed a marked reduction over the last six years. This reduction has been similar across domestic and international equities.
In December 2006 the average asset allocation for DC schemes in the growth phase was 51 per cent exposed to UK equities and 43 per cent exposed to international equities. Fast forward to December 2011, and the average growth stage scheme is just 43 per cent exposed to UK equities and 35 per cent international equities.
Kritika Ashok of DCisions says: “Our data also shows that asset managers are increasingly recommending diversification as an asset allocation strategy. Asset managers recommend a 54 per cent allocation to equities versus what is actually being consumed, which is around 78 per cent.”
Of the blended funds that Fidelity run on behalf of DC clients, which contain more than one asset class, the average allocation to equities is now just 56 per cent. Aviva’s Diversified Strategy Fund, which has been specifically designed for pension schemes, describes itself as an alternative to conventional equity portfolios and has just 33 per cent in equities.
Equities are decidedly out of favour. Statistics from the Investment Management Association over the past year routinely reveal that bond sales trump equities.
But if you compare the yields available from each asset – equities are a clear winner.
A five-year gilt is now offering around 2 per cent – compared with 6 per cent five years ago. Compare that to a Vodafone share, currently yielding nearly 8 per cent and even with share price fluctuation, reinvested dividends seem to offer a greater chance of growing a pension pot.
Chris McNickle, global head of institutional business at Fidelity, says: “Low interest rates and bond yields are encouraging a search for yield that forces investors to look beyond government bonds towards assets with more attractive risk-reward characteristics.”
Given the current minimal income from bonds, many see them as a bubble about to pop, whereas equity income is able to grow.
“Inevitably, if investors with a longer term time horizon are not exposed to riskier assets at times when investments such as shares are performing well, they will miss out on potential gains,” says David Calfo, Head of Group DC Pensions Strategy at The Bank of New York Mellon.
But historical evidence is not sufficient to persuade nervous portfolio managers.
“Heightened levels of market volatility in recent years have shifted the investment focus of defined contribution DC scheme trustees and plan sponsors from maximising portfolio returns to reducing portfolio volatility for members,” says Julian Webb, head of DC & workplace savings at Fidelity.
“This shift in focus of DC trustees is most telling in the default fund space, where trustees have replaced large proportions of equity market exposure with diversified growth funds, fixed income and real estate investment. DC schemes achieve this change in investment strategy principally two ways; firstly through investment in a single diversified growth fund or alternatively through a blended fund structure that enables trustees to mix funds from different asset classes within a single fund wrapper.”
To add to this, the Department of Work and Pensions issued guidance for default funds, encouraging pension providers to build a fund that meets investors’ needs. The fund must be regularly reviewed to ensure that investors are happy.
Statistics from the 2012 DCisions Report shows that five years ago 63 per cent of DC schemes used passive trackers and 9 per cent utilised multi-asset funds; last December this had changed to 48 per cent and 14 per cent respectively.
The incidence of multi-asset and target date funds is rising, primarily at the expense of passive trackers, with 32 per cent of schemes surveyed directly employing these solutions.
“Given the rapid and sharp twists and turns of the markets in recent years, the great increase in popularity of so-called diversified growth funds comes as little surprise,” says Mr Calfo.
“In these kinds of funds, a professional fund manager is responsible for investing in different kinds of assets, such as company shares, bonds, and commodities like gold, as market conditions change. Diversified growth funds are, unsurprisingly, proving very popular in DC pension schemes.”
With Nest – and others – taking a cautious approach and choosing to diversify away from equities during the “growth stage”, it remains to be seen whether other schemes will follow suit.
John Lawson, head of pensions policy at Standard Life, says he does not agree with Nest’s strategy to invest young pension savers in cash, but he does not think that a 100 per cent equity position was appropriate either.
“We are not in copycat mode – cash is not the right asset for growing a pension pot, even if your savers are risk averse. But investing it all in a FTSE tracker is not the answer either,” he says.
“A lot of the industry, and many economists, would tell you that equities will give you your best returns. The arguments for equities have not gone away – but there are other more important factors to consider.”
Lawson says that when the global recession first hit, he saw less money going into pensions – not because people could not afford to save, but because they could not stomach the volatility.
“We have looked at our population of investors and designed a diversified approach that meets their needs and attitudes towards risk,” he says.
Critics of Nest’s approach have argued that putting growth stage pension savers in to cash is actually more risky than equities.
“It seems odd to think that the desire to avoid negative publicity has triumphed over the need for scheme members’ investments to generate an acceptable retirement income,” says Calfo.
“The fact that the level of many Nest members’ exposure to riskier assets is increased after a couple of years is surely an acknowledgement of the need for members to be exposed to assets with the potential to generate good long-term returns, regardless of how much the value of the ‘pot’ goes up and down in the shorter term. The overall result of a consistently over cautious approach to investment could be inadequate pension pots that leave the nation hardly any nearer to solving the very pensions crisis that Nest was set up to help deal with.”
Defending the mixed-asset approach, Brian Henderson, investment consultant at Mercer and a member of Mercer’s DC leadership team, says that equities are not being pushed out of the picture altogether.
“We blend equity investment with a diversified fund, so you do still capture any upside in equity markets. The funds are not entirely replacing equity holdings, but to smooth volatility. If you take a pure equity portfolio and a diversified strategy and ran them together it would produce the same return over the long term,” he says.
If the returns are the same – and the aim of a diversified portfolio is “equity-like” returns – there is some argument for just retaining a pure equity strategy until members near retirement and consistency is required to secure the target annuity income.
Mr Henderson says that investing members in diversified funds offered portfolio managers more control.
“Over 30 years, if you use a diversified portfolio instead of just equities, the portfolio becomes more efficient towards the end of the term,” he says. “As a member hits the ‘flight path’ – when you start a life-styling a portfolio ready for retirement – it is a much harder task to move 100 per cent equities to a cautious stance. You have to have a much longer period to wind it down. But if you are already exposed to lower-risk assets through diversified funds it is easier to manage.”
This means that you can more easily meet target annuity rates and guarantee members a better retirement income.
Ashok says that while the industry was well aware that higher risk typically generated higher returns, diversified portfolios offered a cushion and can take away much of the downside.
Even Henderson admits that in a five-year equity bull run, a mixed portfolio has little chance of matching equity returns. However, taking a longer term view he insists that a diversified fund is here to stay.
“In the future we will see a menu of these funds; a whole range, offering a different blend of assets. Members will be able to choose the fund they feel meets their needs,” he says.
“I do not think we will ever see a return to pure equity pension portfolios. The system has evolved onto other things. Equities will always play a key part in the portfolios, but jumping back into pure equities when there is so much uncertainty around would be foolish.”
Ashok agrees that diversified funds ware the natural evolution of pension investment strategy.
“Notwithstanding the recent economic events and financial crises which have contributed to the downside that equities have been facing, our data shows the industry trending towards diversification slowly but surely,” she says.
Webb says the recent economic crisis is too painful a lesson to forget in a hurry.
“DC trustees, plan sponsors and members have learnt many lessons through the recent economic and market turmoil. Investment strategies have evolved accordingly during this period and we no see reason that this trend will cease.”
If the trend is here to stay then corporate advisers, DC trustees and portfolio managers need to wise up to a larger pool of funds.
Henderson admitted that those selecting default funds face a trickier job, but that it is for the good of pension savers.
“Choosing a diversified approach does make it more challenging than opting for simple passive equity funds, but you are selling control over risk. It buys members more certainty, and if you ask members what they want these day, certainty is top of the list.”