By Raj Shah, FIA, Senior investment consultant and DC investment leader, Hymans Robertson
In the not so recent past, DB investment strategy would, to some extent, drive DC investment strategy, and the challenges they faced were often perceived to be similar (e.g. controlling short-term volatility). For example, many Diversified Growth Funds (DGFs) were designed for DB schemes to reduce funding level volatility, and provide sufficient growth at the same time. DGFs have now widely been adopted by DC schemes, with some DC defaults solely invested in DGFs.
However, we are now seeing a divergence in the investment challenges that DB and DC schemes are facing. Firstly, due to the nature of DB schemes, the focus is now concentrated on defensive assets and assets which generate cashflows. As DB schemes mature, the shift towards investing in defensive assets will increase. On the contrary, DC schemes are searching for growth assets; assets which will produce high long-term returns, especially for young Britons where the savings period is at least 40 years (60 years if drawing down assets after retirement). Although some DGFs have been marketed as providing equity-like returns for two-thirds equity volatility, for example, most DGFs have lagged the equity market for the past 5 years (I appreciate that we are in a prolonged bull market but many DGFs have failed to even meet a performance target of cash+4% p.a.).
The search for high long-term returns naturally starts with equities (passive equities to be more specific) when it comes to DC. But look at the universe of asset classes and you’d find multiple asset classes and styles of investing which could potentially generate higher returns over the long term than passive equities – active management, private equity, long/short equity funds, just to name a few. These are readily available in DB-land at reasonable cost. So what’s stopping DC schemes from achieving higher long-term returns?
Implementation options
The main difference between DB and DC scheme structures is that DC schemes have relatively little flexibility in the way that they can invest. DB Schemes have 3 main ways of investing (as illustrated below) directly through a particular fund structure with the level of overall flexibility reducing from left to right. In contrast to DB schemes, DC schemes usually invest via a life assurance platform and are constrained by the regulations governing these funds. Generally speaking, DC schemes do not have any real segregated options available, which means there are restrictions in the way that a scheme can invest. DB schemes have varying flexibility depending on the fund structure and vehicle.
Role of active management
Although there may be a role for active management in DC, it has been largely constrained by the 0.75% charge cap. For example, there are good arguments for investing actively in emerging market equities and smaller companies but investment charges within DC platforms for these types of funds could easily be north of 1.5%.
On the flipside, active management increases governance requirements and could also increase churn rate of managers (most actively managed funds do not consistently outperform) where managers are replaced continually. Therefore, there is an argument for investing solely in passively managed funds, but in a smarter way. For example, many of our clients are considering factor-based investments which now can be accessed at similar cost to traditional passive funds (tracking market indices).
Pricing
There is a fairly good level of fee transparency within DB, which means trustees have good visibility of what they’re being charged for. On the contrary, pricing within DC is often opaque. Some platforms do not distinguish between administration charges and investment charges (often citing they are unable to provide this due to the NDA’s / confidentiality agreements that are in place with their suppliers). This makes it harder to gauge whether the investment charges are competitive or not.
Additionally, the 0.75% charge cap constrains investment in high long-term returning assets such as private equity (liquidity is a secondary issue and there are ways to get around this).
Looking to the future
The challenges for DC schemes in accessing assets common-place in DB-land are not in any way insurmountable. We are starting to see providers stepping up to make available funds for asset classes that would have once been out of the question for DC schemes e.g. private equity. Also some of the larger schemes in the UK are actively seeking ways to access other asset classes for the benefit of DC members (e.g. private debt).
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