Alternative assets could give DC higher returns with no extra risk

The report ‘Could DC pension default investment strategies better meet the needs of members?’, sponsored by the Association of Investment Companies, argued that DC default funds could better serve the needs of particular members by expanding the range of asset classes in which they invest, putting more focus on both enhanced returns and reduced volatility.

Members who would benefit from an increased focus on returns include those working beyond the state pension age, savers who accumulate marginal amounts of savings, individuals with “patchy” work and contribution records, and those who have both defined benefit and DC savings.

The individuals who would reap the rewards from reduced volatility, meanwhile, include members who stop contributing before they reach the state pension age, those who purchase an annuity or use uncrystallised funds pension lump sums, and savers without supplementary savings.

Judicious investment into illiquids and alternatives could, in some cases, both enhance returns and reduce volatility, benefiting the whole membership. However, these strategies will require extra time and resources

Daniela Silcock, PPI

The PPI report sets out three policy options for achieving better member outcomes, the first of which would see default funds increasing allocation to alternatives to enhance returns, while also increasing diversification.

The second option would see schemes utilise existing member data to provide prompts about using non-default or self-select strategies, while the third option would involve gathering more data in order to make default strategies “more tailored”, as well as providing prompts about non-default strategies.

Alternatives enhance returns but carry costs

The report argued that many alternative asset classes offer both higher returns and increased diversification, potentially allowing default strategies to both enhance returns and reduce risk.

Previous PPI research suggested that, net of fees, a median earner contributing throughout their working life into a pension with 10-15 per cent of funds in illiquids would end up with pots between 2 and 3 per cent higher than individuals whose funds did not invest in illiquids at all.

However, it highlighted costs as one potential barrier to default funds broadening their range of asset classes, which, if incurred, may result in a loss for some members.

Higher returns might be sought in four asset classes in particular: private markets, real estate, other alternatives (such as infrastructure and commodities), and “selected parts” of the fixed income market.

“These assets are typically more volatile and/or less liquid than listed equities or listed fixed income (such as bonds and gilts), and generally cost more to invest in, while also requiring higher levels of due diligence and ongoing monitoring,” the report stated.

Other caveats include the fact that projection risk can be greater for alternative assets, not all schemes have equal access to these investment opportunities, poor timing “can be a drag on performance”, and “liquidity needs” can constrain exposure to alternatives.

“The role of fees and other investor costs is particularly important, and trustees and investment managers tend to place considerable weight on fees as a decision factor. Fees are an easy way to justify decisions and to divert potential criticism,” the report explained.

“This can lead to fees being dominant in decision-making, with less weight being placed on other factors that are more opaque or difficult to interpret, even where this does not lead to the best outcomes for scheme members.

“An overemphasis on cost, rather than value, may be a particular hindrance to the consideration of alternative asset classes.”

Data and prompts

At present, most default funds use data to incorporate ‘lifestyling’, whereby the nature of the investment strategy changes as members age. 

In aid of its second policy option, the PPI report suggested that this data could be used to provide greater customisation, “even without direct member engagement”.

It cited, as an example, members with a high account balance who “might be regarded as having more to gain from more customised investment approaches, be able to afford higher member charges, and bear more risk, so that group might receive targeted communications about their options”.

These approaches would still have to be “carefully designed”, as many of these members may still rely on their DC income, or otherwise have a low-risk appetite, it stated.

“Schemes or employers informing members about appropriate investment strategy could also be seen as giving advice, which is a regulated service. Therefore, some form of protection for the provider of the prompt would need to be built into the system.”

Where schemes are limited by the type of data employers gather on their employees, the third policy option may prove useful, and could be achieved by the gathering of additional data on things like income level, gender, ethnicity, ability, caring responsibilities, other savings and assets, and attitude to risk.

“Gathering additional data could make customising the default investment strategy simpler, as well as making it easier for schemes to identify members who may not be best served by remaining in the default investment strategy,” the report continued.

There would, however, be additional cost and privacy concerns to account for with such an approach, which would require “the investment and support of both the government and industry in order to ensure policies are clear and straightforward, and that cost and privacy concerns are dealt with in a way which does not pose a threat to members, employers or schemes,” it stated.

Daniela Silcock, head of policy research at the PPI, said: “The inherent nature of defaults makes it difficult to target variations at particular people, but there are potential strategies, for example, using existing data on members, such as pot size, to provide prompts about using non-default investment strategies or gathering more data on members in order to make DC default investment strategies more tailored or to provide prompts.

“In addition, judicious investment into illiquids and alternatives could, in some cases, both enhance returns and reduce volatility, benefiting the whole membership. However, these strategies will require extra time and resources.

“In seeking to implement them, it is important not to lose the benefits of default strategies — in particular, the low cost and simplicity of the safety net that they provide for those with low financial capability. As scheme managers look to provide a better service to a greater number of members, the benefits of defaults must be kept in mind.”

Guy Rainbird, public affairs director at the AIC, added: “This research from the PPI should reassure pension trustees that alternative assets can offer benefits to a wide range of savers, including those on lower incomes or who stop contributing early.

“It’s particularly helpful that the report modelled the impact of adding a range of assets to the mix, such as private equity, direct lending, infrastructure and property. All of these have different risk-return characteristics and different degrees of correlation with equities and bonds. All can offer benefits when building a portfolio for beneficiaries and there is no one-size-fits-all.”

He added that investment companies are “tried and tested” vehicles for investing in illiquid assets, providing “a closed-ended structure” that protects funds “against fire sales and suspensions”, while offering liquidity through their listing on the stock market.

“They have a track record that in some cases extends back beyond the global financial crisis,” Rainbird said.

“This does not apply to other proposed solutions for allowing pension funds to access alternatives, such as the Long-Term Asset Fund, which would rely on notice periods to resolve liquidity mismatches and could run into problems if those notice periods prove too short.”