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• Risk is an important factor to consider when designing an investment strategy for contract-based DC pension schemes.
• Employers should think carefully about how they will structure their contractbased DC scheme’s default fund because this is where the majority of members will end up.
• Diversified growth funds spread investment risk more evenly because they include a range of asset classes.
Case study: Many assets classes reduce fund risk for Towry
Towry focused on the diversification of asset classes when designing the investment strategy for its group personal pension (GPP) scheme. After switching its pension provider from Axa to Zurich in 2009, the financial advice firm was able to offer its own funds to scheme members. This means staff can access 85 funds offered on the Zurich platform and three independent funds, which are managed by Towry and are also available to its private clients.
Each of the Towry funds is made up of 18 asset classes to minimise the investor’s exposure to risk. These include equities, bonds, commercial property, precious metals and cash. Investments can also be made in emerging markets and overseas.
Richard Higginson, head of reward at Towry, says: “The key to having a large number of asset classes versus having five or six, which you get in a standard pension fund, is that you then can take the upside of classes performing well and spread your risk. If you have a fund 90% in UK equities and the UK stock market crashes, you lose huge amounts of your pension fund, whereas if you have a much smaller amount in UK equities and loads of money in other asset classes, you win on the good years in the UK equity market, but are not so exposed to the risk of a downturn.”
The firm has created a default fund from its three independent funds. It also offers a lifestyle fund, plus a cautious or growth option, a balanced fund and an alternative lifestyle fund using all three approaches.
Case study: First Group focuses on age
First Group has designed the investment strategy for its contract-based defined contribution (DC) pension schemes to take account of an employee’s age and appetite for risk.
The transport operator, which runs two contact-based DC plans in the UK, has devised a series of investment options based on these criteria and has created several age-based default funds. This means staff who do not decide about investment when they sign up to the scheme will end up in a default fund, designed specifically for their age group.
John Chilman, director of reward and benefits at First Group, says: “We have adopted many of the [strategies] that we adopted on the defined benefit (DB) side. They are diversified and not just looking at equities and bonds, but also have some global diversifications and diversified growth, so people get a decent reward for the risk they are taking.
“Some schemes just have a default fund. If an employee does not tick anything, they are going to be in this, whereas our scheme tries to force the employee – based upon age and attitude to risk – into a certain investment.”
On the other hand, if pension scheme members want to make their own choices, they can make selections from the 2,000 funds that are offered alongside the organisation’s contract-based DC pensions.
Employers need to tailor investment strategies in contract-based DC pensions so staff can optimise value, says Nicola Sullivan
To help members of contract-based defined contribution (DC) pension schemes achieve the best returns on their savings, employers must ensure they adopt an investment strategy that suits their appetite for risk.
To do this effectively, organisations must consider a number of factors, including what kinds of fund to offer members and at what stage in an employee’s career to introduce lifestyle funds. After the financial crisis, which dramatically diminished the value of pension funds, the risk associated with investment choice is likely to be at the
forefront of any strategy.
Diversified growth funds
Diversified growth funds, which aim to balance stock market risk, are currently proving popular for contract-based DC pension schemes. Such funds aim to balance stock market risk and typically include a wide spread of asset classes, such as equities, bonds, property and hedge funds.
Paul Francis, head of asset consulting at Alexander Forbes, says: “Diversified growth funds are split between the different assets in an attempt to add value and provide a smoother level of returns than you might get from the equity market. What you want from a diversified growth fund is for it to provide access to different drivers of return, basically different types of asset class that move in a different way.”
One of the best-known asset classes is the equity, which represents the value of an ownership interest in assets such as property or a shareholder’s equity in a business. Despite their volatile nature, equities, which can attract high returns, remain an obvious choice of asset class for contract-based pension schemes. This is especially true for pension scheme members who are a long way from retirement and have time to recoup any losses.
Paul Armitage, consultancy director at JLT Employee Benefits Solutions, says: “It will remain the asset of choice for the growth period.”
But recent turbulence in the financial markets has made people look twice at the kind of equity they are holding. Francis says: “Developed markets have become less attractive relative to developing markets and, longer term, there is a growth story to be had there. As these economies develop, their currency depreciates, which is probably why employees want to invest in equities now.
“There are also some people who have been looking at Latin American equities and emerging market debt.”
In the early 1990s, DC pensions invested in equities were typically split, with 70% held in UK equities and 30% in overseas equities.
Today, the proportions are likely to be the other way round, says Steve Rumbles, head of UK defined contribution at BlackRock.
“You are seeing an increase in emerging markets and, generally, a bigger exposure to overseas equity,” he explains.
Bonds are another attractive asset class. This is a debt investment in which an investor loans a certain amount of money to a company for a specified period of time at a certain interest rate. Government bonds are usually thought of as a safe option because a government can raise taxes to redeem the bond at maturity. A government bond is issued by a national government and is denominated in the country’s own currency.
Many governments issue inflation-linked bonds, which should protect investors against inflation risk.
Tim Drayson, economist for Legal and General Investment Management, says: “Should the economic recovery accelerate, forcing government bond yields higher, there is still room for the excess corporate bond yield to compress as risk premium reduces, dampening the overall impact. On the other hand, the large excess corporate bond yield provides a buffer against ongoing volatility.”
A hedge fund is a portfolio of investments, which are professionally managed and typically aimed at wealthy investors. Hedge funds rely on the skill of the fund’s investment manager to become a strong investment choice.
Francis says: “I really think what [the investor] is trying to access [with hedge funds] is manager skill. If you buy into an equity portfolio, what you are typically doing is getting a lot of market exposure. “With hedge funds, what you are typically looking to do is get most of the return from the manager’s skill, not the asset class, because it is about how good they are at adding value.”
Some schemes also offer a range of green, ethical or socially responsible funds, whereby a fund manager will invest only in companies that have responsible business practices. Advocates of these types of fund argue that
companies with ‘ethics’ perform more strongly because they are run in a more effective way.
Francis explains: “If you are a fund manager who is running money ethically, it does effectively cut you out of some sectors of the market. In a period where the likes of, say, tobacco and alcohol are really strong performers, then [the pension fund] is unlikely to have exposure to that.”
Rumbles adds:“On our platform, we have three ethical funds and a sharia fund. In total, we have £10 million worth of UK client DC funds under management and yet [BlackRock’s] ethical [investment funds] collectively have less than quarter of a million pounds in them.”
A sharia-compliant fund abides by the principles of Islam, which prohibit investments that guarantee returns or investment in companies that are contrary to its beliefs, such as those that produce alcohol. In January, the national employment savings trust (Nest) began advertising for a sharia-compliant fund manager. The fund will not include any asset classes banned under sharia law, such as conventional bonds.
Other investment options include cash, currency, property, infrastructure and commodities. But it can be difficult for DC pension funds to invest in property and commodities (gold, tin and copper). “Some of these products [commodities] do not trade on a daily basis – they might trade once a quarter,” says BlackRock’s Rumbles. “Obviously, if an employer has got people who want to switch pensions, leave or retire, or transfer in or transfer out pretty regularly, then [commodities] do not lend themselves to that sort of set-up.”
Meanwhile, schemes that invest in property could be subjected to higher fees than other investment types. David McCourt, senior policy adviser at the National Association of Pension Funds, says: “Whereas you can get relatively low charges for most standard asset classes – bonds, shares, including corporate and index-linked bonds – property can be a little bit of a rogue element and the fees will be substantially higher. It depends what the employer can negotiate with the platform provider. If it has got a lot of clout, it can sometimes drive the fees right down.”
Employees with access to a group self-invested personal pension (Sipp) may find they have greater flexibility and control over where their pension fund is invested. A Sipp offers a wider range of pension investment options than other contract-based schemes.
Investment choices offered through a Sipp typically include equities, gilts, unit trusts, open-ended investment companies (shared investments or funds that allow the investor to pool their money with thousands of other investors and invest in world stock markets), hedge funds, investment trusts, real estate investment trusts, traded endowment policies, commercial property and land.
When looking at their scheme’s investment strategy, employers should pay careful attention to its default fund. According to Rumbles, because such a high proportion (more than 90%) of employees end up in the default fund, employers must make sure it is fit for purpose. Typically, a default fund would include a lifestyling element, which moves funds out of equities to minimise volatility in the run-up to retirement.
Steve Bowles, head of DC at Schroders, says: “If I am looking to put in place a default fund, then I would be looking to incorporate some higher-performing global equity funds in the early years. I would then look to manage the risk as members approach retirement, perhaps by switching into some sort of multi-asset fund at that stage.”
The fund choice for any lifestyle element also needs to be considered carefully. Rumbles says: “When I started out in DC pensions in 1993, the typical lifestyle structure would be a balanced fund switching into long bonds or cash and with a switch over 10 years into bonds and cash.”
“[Today] we have seen a number of different usages. Some people are almost creating a blended fund at the start of a lifestyle matrix with a combination of equities and diversified growth.
“Some people are putting diversified growth in almost as a fourth stage within lifestyle. This means the member saves in equities in the early years and, probably in about 25 years, starts moving into diversified growth when the employee is starting to build up a pot where an investment correction would actually be quite difficult to recover from.”
Carefully tailoring investment strategies is therefore vital to ensure employees can optimise the value of their pension pot.
The Nest investment strategy
• The investment approach taken by the national employment savings trust (Nest), the government-backed pension scheme due to be introduced in 2012, could influence the future design of investment strategies for contract-based DC pensions.
• Paul Armitage, consultancy director at JLT Employee Benefits Consultants, says the final strategy adopted by Nest will create a gold standard for investment choices for cautious and unengaged members.
• Nest’s investment strategy has not yet been finalised, but is likely to focus on a low-risk approach. This could become an important consideration when designing default funds and investment ranges for workplace DC pension schemes.
• Nest’s investment strategy will be lower risk than most standard DC default funds in contract or trust-based schemes.
• Steve Bowles, head of DC at Schroders, says that unlike existing DC schemes where the commonly held wisdom is to invest in equities in the early years because there is enough time before retirement to ride the ups and downs, with Nest, a fairly low-risk strategy might be adopted to slowly grow membership and build their confidence before adding a little bit of risk later on.
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