Missing benchmark: Default fund performance vacuum

Stockmarket-Performance-Business-700x450.jpgDefault funds hold the assets of millions of Britons, many of whom have never even signed a pension contract. But where, asks Michelle McGagh, are the stats that show how well these funds have performed?

The lack of proper benchmarking in the default fund market is making it almost impossible for advisers to compare returns and ensure they are providing value for members without going through lengthy research processes.

The advent of auto-enrolment means the amount of money flowing into defined contribution workplace pensions is expected to reach £15bn a year by 2020, with as many as 9 million new employees slated to start saving for the first time.

But with an estimated 90 per cent of the money saved into workplace pensions placed into the default fund, the ability to compare schemes’ performance remains elusive.

Identifying cohorts

The main problem lies in the fact that most default funds are either lifestyle funds or target-date funds. Scheme providers argue that it is not possible to provide returns for specific cohorts, each of which will have an individual start date and retirement year – typically within a three- to five-year window.

FTSE director, business development Jennie Austin says: “One of the key issues is that cohorts are entering and leaving the fund at different times.

“We know independently how each fund is performing but calculating the default fund can be more difficult.”

Providers offering default funds must consider carefully the make-up of their members
in order to deliver the best outcome, but typically without the engagement of members, which makes it imperative that comparisons are enabled.

Elston Consulting managing director Henry Cobbe says: “Although there is no engagement from the member, [the provider] has to put their interest first.

“Schemes have to think carefully about the demographic of their members. They can look at age profile and average income profile and then make an assessment around that. They need to do demographic analysis… to determine what replacement rate they should be targeting. For company schemes, that demographic could vary greatly depending on the workforce.”

Cobbe says the Nest default scheme has “set the way in terms of best practice” when it comes to constructing default funds.

But he adds that, despite the analysis that goes into developing default funds, greater transparency is needed. He has worked with the FTSE Group to develop benchmarks against which default funds can be measured.

An index compares the performance of a two-asset port-folio that moves away from growth assets to income, mimicking lifestyle and TDFs, and measures specific cohorts grouped by
expected retirement date.

The default fund can be set against three index groups made up of equity allocations of 100
per cent, 80 per cent and 60 per cent: the FTSE UK DC 100% Standard Benchmark, FTSE UK DC 80% Standard Benchmark and FTSE UK DC 60% Standard Benchmark.

Cobbe argues TDFs and lifestyle funds are a help, not a hindrance, for the new benchmark.

“What we did with the FTSE to solve the cohort problem [in comparing default funds] was to set a benchmark that was broken down by cohorts, and target-date funds help with that valuation because they are broken down with cohorts,” he says.

“It is not okay to use the FTSE 100 as a benchmark [for all cohorts] – that may be good for younger savers [who are targeting growth] but not all…. Those in retirement need a different benchmark. If you break members into cohorts, you can see the risk-adjusted returns for each cohort.”

Austin says the “simple, baseline benchmark” will be able to be customised in future “to allow users to compare the experience of a specific fund”.

She adds: “The initial index series was always designed to be a plain vanilla starting point,
allowing users to measure whether they were getting a good member outcome.

“At present, the simple customised benchmark represents steady moves along the glidepath from a risk starting point to an un-risked retirement point. Depending on the saver’s cohort, starting risk levels of 100, 80 or 60 per cent equity allocation can be selected to match against the retirement date of the saver.”

She adds that, previously, “investors could look only at how individual funds had performed but there was nothing to act as a comparison”.

Performance differences

JLT Employee Benefits’ analysis of the performance of default funds found the top 10 funds ranged from 3.5 per cent to 9.5 per cent over the past three
years. Those who had been enrolled into the lowest-performing fund could end up with a pension worth hundreds of thousands of pounds less than those of savers in the best-performing funds if such differences in performance were to persist over their lifetime.

While the consultancy was able to access the performance data from providers for the anonymous research, advisers and interested members of the public would find it difficult to do the same analysis.

JLT Employee Benefits head of DC consulting Maria Nazarova-Doyle says providers measure the return and can tell members what their fund is worth but “it isn’t easy to obtain data” on the specific return of the fund.

She adds that it is “very difficult” to benchmark and compare default funds, and that advisers “may struggle” to make such in-depth comparisons because of restrictions on their research capacity.

Nazarova-Doyle describes default funds as “opaque investments” because of the inability
to compare returns but says it would be easy to benchmark them based on how well they “manage volatility and risk”.

She says: “The most important part of a target-date fund is the growth stage. From age 20 to
age 55 they are in a high-growth strategy and benchmarked on whether they make money, and in the pre-retirement stage it is on how the fund is de-risked.” She adds that the use of passive funds in a default fund makes it even easier to develop a benchmark.

“You could benchmark the funds against, for example, CPI plus 4 per cent in the growth phase, but at retirement that could drop to CPI plus 1 per cent. You benchmark the group and
see if it manages to deliver that for every cohort.”


Barnett Waddingham head of DC Mark Futcher says it is not just returns that need to be
comparable but also volatility, and he agrees that comparisons should be done at various stages as the member ages.

“You can generally break down a default fund as a growth element, a shaping element and an access point, and you could benchmark these three points,” he says.

In order to make any comparisons understandable for members, a traffic-light system, similar to that used for with-profits funds, could be overlaid on to the comparison, he says.

“We have got to get away from micro-managing the investments on a day-to-day basis and say what the aim of the default fund is – a positive return above inflation over a certain timeframe. “If we had something like a traffic-light system, we could say the default fund is either hitting its target, sort of hitting it or not hitting it. We could make it easier for people to understand.”

Cobbe says there is no single answer to the difficulty of comparing default funds but he believes the industry needs to work harder to find a solution. “Providers say it cannot be done but that is not an adequate response,” he says.

“It is not right that pension schemes and large providers are not being transparent about
investment performance.”

Massive DC market will drive greater transparency

The move towards transparency is being moved forward not just by industry initiatives but also by regulation.

Elston Consulting’s Henry Cobbe says new legislation means “trustees will have a legal obligation to show value for money” for members.

“I do not see how you can do that without a comparison of performance of scheme providers… and against a benchmark that references the asset allocation plan of that investment,” he says.

According to Barnett Waddingham’s Mark Futcher, default funds will be “high on the agenda” for the regulator’s Independent Project Board, which assesses DC pensions, and independent governance committees of the scheme will have a “very clear remit” when it comes to default fund member communications.

JLT Employee Benefits’ Maria Nazarova-Doyle says it is not just the regulator that will force schemes to provide a greater breadth of information and ensure ease of comparison when it comes to default fund returns.

“We have never had such a massive DC market before and an extra £15bn is going to go in [to DC schemes] every year, which is a huge amount of money,” she says.

“Before, there was no real interest [in default funds], but this market is becoming very professional and there is a lot of scrutiny.

“More of us will be in retirement with DC pots and they will have to be more transparent. Member pressure and the sheer amount of people in DC will mean things will have to become more transparent.”

FTSE’s Jennie Austin says the more solutions that are available to help with comparisons, the better it will be for everyone. “Anything that shows value for money in pensions is a positive.

“The market is taking a step in the right direction. Any provider ought to be able to show the track of their default fund offering against a plain vanilla benchmark.”