Schroders, one of the UK’s leading Defined Benefit (DB) pension asset managers, with over £30 billion UK DB assets under management, is today announcing five key lessons learnt from DB and how they can be relatively seamlessly translated into Defined Contribution (DC).
The following five key lessons from Schroders DC Team look to address the future of pension design and to build the next generation of solutions for the DC market. A combination of all of these components can lead to an improved solution for pension scheme members. Some of these key lessons can be implemented simply and immediately, where others look more to the future and require a level of innovation.
5 Key Lessons
Lesson 1 - Governance Structures: DC Schemes have had significantly less assets than DB schemes and trustee groups have understandably focused on the ‘larger’ problem. As a result some groups have identified ‘easy’ solutions that require little governance such as passive lifecycle default options. There has been recognition amongst a number of schemes, advisors and the DWP that this is not a sustainable approach. The key findings are:
• Suitable governance structures are essential: For example, specialist committees should be established, consisting of trustees with suitable knowledge and experience of DC schemes.
• Members’ interests are important: Time needs to be taken to identify the most suitable investment solutions and products for members, rather than just the ‘easy’ ones.
• The default fund should be a ‘safe harbour’ for both members and scheme governors: In the UK, without the explicit involvement of the sponsor as in DB, DC governors remain severely reluctant to take decisions on behalf of members. This is probably the most material obstacle to progressing investment solutions in DC.
• Governance of growth assets and derisking assets are equally important: Governance is required across all stages of the flight path, including the pre-retirement phase, which has largely been neglected to date.
Lesson 2 - Diversification: Diversified solutions have been widely adopted in DB growth portfolios and their relevance and benefit for the growth phase of DC strategies is beginning to be recognised. Daily priced diversified growth funds with inflation plus targets, originally designed as DB solutions, can also offer an ideal solution for the DC market which is very simple to implement. The key findings are:
• Real returns: DC investors need strong growth (in excess of inflation) in order to achieve a decent standard of living in retirement.
• Stable growth: As DC schemes mature, greater attention should be paid to the type of risks members are taking at older ages; achieving growth through investment returns is important but the stability of those returns is also vital.
• Lifestyling isn’t enough: Lifestyling alone does not provide the level of risk reduction that members require in their 40s and early 50s, when losses can inflict considerable damage on retirement incomes.
• Improving outcomes: A DC investor can potentially reduce risk without significantly sacrificing expected returns by diversifying their assets.
Lesson 3 - Liability Modelling: In stark contrast to DB, where asset liability modelling is the cornerstone of investment strategy, the use of modelling in DC schemes has been limited to the implementation of simplistic lifecycle strategies. Modelling DC liabilities can be challenging, especially given the uncertainty around members’ retirement preferences, but DB risk modelling measures and techniques can help us better understand the risks that members are exposed to at different ages. The key findings are:
• Modelling DC liabilities can be challenging: Fiduciaries need to establish what are the most important liabilities (e.g. pot size, replacement ratio or otherwise)
• Value at Risk measurements traditionally used in DB can also be helpful in DC. For example: thinking about how many extra years a member may have to work if he suffers a one in 20 event can help determine whether the level of risk is acceptable
• Path dependency: The timing of gains and losses is key. Later years in DC matter more because the larger the pot size, the bigger the impact of good (and bad) investment returns.
Lesson 4 - Monitoring the Flight Path: DB pension funds in the UK are generally embracing the idea of a ‘flight path’ and we believe that this, although not yet widely discussed, could be directly relevant to DC plans, DC members could use DB flight path techniques to design a better lifecycle, helping them to stay on track towards a specified target retirement outcome. A personalised flight path is appealing for members who pay attention to their investments and want information to be able to take action. These members are in a minority, but it is possible to move towards individual flight paths by creating lifecycle funds for cohorts based on their circumstances. This should improve on the current model of one lifecycle for all members. The key findings are:
• Improving the default: Individual member flight paths may not be achievable for all schemes but we believe the current approach of one lifecycle for all members can be improved upon by creating lifecycle funds for cohorts of the membership based on their circumstances.
• Engaged management: A flight path should help members to stay on track towards their retirement goals but requires members or governors to take action when needed (e.g. by adjusting risk, contribution levels or retirement dates in line with projected targets)
• Sharing responsibility: Given the current general lack of member engagement and understanding, scheme governors would need to take control to ensure that members remain ‘on track’ towards their retirement goals.
• Targets, not guarantees: DC flight paths would need to be clearly articulated to members as not constituting a guarantee but could be communicated as a ‘personal defined ambition’.
Lesson 5 - Use of capital efficient liability management techniques: One of the innovations in DB is Liability Driven Investing and we believe that this approach can be adapted for use by DC pension schemes. A liability management approach in DC should result in a more capital efficient solution which allows members to invest in growth assets for longer and achieve annuity protection earlier, potentially improving retirement outcomes. Although many DC schemes are reasonably immature with few members nearing retirement, the age profile of UK DC plans (weighted by pot size) is increasing and we argue that members need improved solutions in the later stage of the lifecycle sooner rather than later. The key findings are:
• Growth for longer: Bonds used in the lifecycle phase for annuity matching can be replaced with synthetic assets using only a proportion of the capital. The freed up capital can then be invested in non-bond assets with a higher expected return, allowing more flexibility around retirement targets.
• Earlier annuity protection: As the capital requirement (and therefore return drag) is lower when using synthetic assets, there is the potential to achieve more annuity protection earlier in the lifecycle (e.g. there is not a ‘pound for pound’ exchange for coverage in comparison with matching through physical assets).
• Achievable: Synthetic assets can be embedded into lifecycle strategies and this will allow fiduciaries to overcome communication issues.
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