What should employers look for in a default investment strategy?

Most defined contribution pension (DC) schemes use the lifestyling method for their default investment funds, with asset allocations dependent on the employee’s retirement age, switching from growth-focused assets such as equities at young ages, to a greater allocation to low-risk assets such as bonds, as the member approaches retirement.

Ken Scott, head of investment solutions at Royal London, says: “Department for Work and Pensions (DWP) best practice suggests that lifestyling is a key consideration. This allows workers to be exposed to higher market risks when they are far from retirement and are willing to accept volatility for improved returns, while also mitigating the market risk from making a step-change in investment at the point of retirement.”

Recently, there has been increased focus on default strategies that attempt to drive returns in the accumulation phase by investing in private equity and early stage businesses. Stephen Budge, partner, DC investment consulting at LCP, says: “An improvement in return of 1% per annum over the course of a member’s working life is equivalent to an additional 2% contribution over the same period. Setting a long-term strategy incorporating the latest thinking in investment design is, therefore, incredibly important. Innovation currently means turning to investment opportunities which are more commonly used in other DC markets such as the US and Australia: private markets or illiquid assets. This is a key focus of the UK government and where we see greatest level of innovation across the industry.”

UK investment

Chancellor Jeremy Hunt believes the industry has missed a trick by not investing sufficiently in UK growth companies, both hindering returns and denying investment in the UK economy. He, therefore, announced plans in his Spring Budget for a reporting regime for pension schemes to disclose the level of their investment allocations to UK markets. The policy will stop short of stipulating how much schemes should invest in UK markets, but the Chancellor has said further action may be taken if there is not an improvement.

UK pension schemes invest relatively little in the domestic economy compared with other nations. For example, Australia’s pension funds invest around 38% in domestic markets, although the country constitutes only 1.3% in the Morgan Stanley Capital International (MSCI) World Index. In contrast, UK pension schemes invest just 3% at home although the UK has a weighting of 4.5% in the World Index, according to the Capital Markets Industry Taskforce in December 2023.

Arguably, governments can justify encouraging pension funds to invest domestically because pensions enjoy generous tax advantages. However, a pension scheme’s first responsibility is to its members, and recent poor returns from UK equities could put trustees in a difficult position. The Chancellor spoke of the need for greater investment in high-quality domestic growth stocks, but the UK lacks growth-style companies, such as technology firms, and instead is bloated with oil and gas companies, which would challenge socially responsible investing (SRI) strategies; and banks, which are inconsistent with Islamic beliefs. Many large UK companies are fairly global, so the index has a lower focus on the UK economy than often expected.

Joanna Sharples, chief investment officer, DC solutions at Aon, says: “We’re not sure how helpful this will be. It raises the question whether the Chancellor is seeking investment in UK economic activity or companies that are listed in the UK. This is an important point if we think about the number of multi-nationals listed here in the UK but which derive most of their revenue elsewhere.

“This development risks conflating how pension schemes provide value for members versus how they support the UK economy. Looking back over five years, investments in global equities have delivered for our younger master trust members particularly, with a return of 12.8% per annum to 31 December 2023. In contrast, if we’d allocated all our equities to the UK, those younger members would have seen a return of 6.6% per annum.”

Alison Leslie, head of DC investment at Hymans Robertson, adds: “The FCA [Financial Conduct Authority] will be concerned that this disclosure may lead to an expectation that more be invested in UK assets where potentially the investment case for doing so doesn’t stack up.”

She anticipates DC default strategies will continue to increase their exposure to illiquids via long-term asset funds (LTAFs). “Selecting the right manager will be crucial for this asset class, given the diversity of the underlying assets and the potential difficulties in divesting from underperforming illiquids funds,” she says.

The Universities Superannuation Scheme (USS) allocates some 20% of the default funds in its DC investment builder scheme to illiquid assets and private markets, with the aim of achieving better risk-adjusted returns for members and improved diversification. These assets include infrastructure, private equity, private debt, sustainable growth equity and special situations. The allocations in the default funds depend on where members are in their career lifecycles. During the accumulation phase, more capital is allocated to private equity for strong returns, and as people approach retirement, more is allocated to private credit and debt which offer attractive inflation linked cashflows.

Aleck Johnston, head of DC investment product at USS, says: “We first introduced private markets to DC in January 2020, and by 2023, they made up around 20% of our default growth fund. Even our ethical growth funds have 7% allocated to private markets, like renewables and natural capital.

“We believe that diversifying our DC investments in this way reduces investment risk and will hopefully improve long-term returns for our members’ retirement savings. Not only this, but private markets allow us to invest more in sustainable assets, like wind and solar power, that align to our ambition to be Net Zero for our investments by 2050.”

Employee demographics

In designing a scheme’s default funds, the first step is to research the characteristics of the membership, says Dan Mikulskis, chief investment officer at People’s Partnership. “Overall demographics, the level of contributions, behaviour at retirement, all need to be considered,” he explains.

For example, members intending to go into drawdown will benefit from staying invested in the market, whereas members planning to buy an annuity should gradually switch into a bond fund.

“A well-designed default will consider how to balance risk and reward, asset allocation, integration of responsible investment and costs to meet the scheme objectives,” says Mikulskis. “Scheme trustees need to ensure that once a strategy is in place the objectives, design and implementation are regularly reviewed. Changes in regulation, market conditions and member behaviour should all be reviewed as part of an annual value for money assessment.”