In a webinar held in April, PP’s expert panel discussed how DC investment strategies have delivered through the Covid-19 pandemic
The panel
Andrew Brown, institutional business director at Columbia Threadneedle Investments
Brown leads the DC business at Columbia Threadneedle and has responsibility for DC clients, business development and the firm's investment proposition
Mark Pemberthy, head of DC and wealth at Buck
Pemberthy has over 25 years of experience in DC pensions and employee benefits, helping employers and trustees deliver better DC outcomes and meet the financial needs of multi-generational workforces
Sophia Singleton, partner and head of DC at XPS Pensions Group
Singleton leads the DC business at XPS, helping clients deliver high-quality DC services to members, either through their own scheme or through XPS's mastertrust, the National Pension Trust
Dean Wetton, founder at Dean Wetton Advisory
Wetton founded DWA in 2009 and has wide experience of advising DC and DB pension clients on a range of investment issues. He was previously an investment consultant at firms including PSolve and Hewitt Associates
The discussion
Jonathan Stapleton: How well have defined contribution (DC) investment strategies delivered through the pandemic and to what extent has there been significant volatility?
Sophia Singleton: Generally, DC strategies have weathered the storm really well, primarily because the markets bounced back so quickly.
Covid itself didn't highlight major shortcomings in DC strategies but it did open the debate on the use of property and it's fair to say many trustees hadn't appreciated how liquidity risks could play out in reality. They now understand those implications much better, which puts some schemes off property investments, but some use that understanding to look at other illiquid opportunities such as private markets. We're starting to see schemes consider other ways of getting exposure, whether it be through real estate investment trusts, alternative liquid options or through infrastructure as a diversifier.
Mark Pemberthy: In many ways, DC schemes and asset owners probably avoided a significant impact of the pandemic because of the recovery in markets. It could be argued a lot of that was driven by quantitative easing and the artificially low interest rates we've had. That really has masked a lot of the underlying economic impact of the pandemic.
Investment strategies have held up, but I think in terms of trustees and members being able to visualise the risks inherent within different investment strategies, it's really brought that into sharp focus.
The biggest impact was on people who were moving money during the period of the second and third quarters of 2020 and crystallising losses. Mechanical life-styling strategies which moved large amounts of money from equities to bonds during that period when the markets were depressed. Members who were accessing money early - people retiring earlier than their target dates or people already in drawdown with high equity ratings who were wanting to take money from their pension funds and doing that at a time when the markets were low - were the ones most impacted by this.
Jonathan Stapleton: From the asset managers' perspective, do you think DC investment strategies delivered after that initial dip?
Andrew Brown: The experience of individual members would have been different depending on where they were on the glide path. Clearly, members who were far off retirement would have been more exposed to riskier assets and they would have experienced more volatility, particularly in those schemes that have very high exposure to equity markets.
It's not necessarily a case of looking at the past year, however, but perhaps looking back over the last two decades which have been somewhat a historical freak and it is important that we future-proof DC pension investments. If we look at the US stock market crash of 1929, the market did not recover in nominal terms until 1948. Members should be more exposed to multiple, low-correlated risky assets. It's the basics of diversification. Currently, we probably don't see that addressed in many DC schemes, particularly during the accumulation stage.
When we look at equities, we've got to remind ourselves what they are. Equities are the most junior and riskiest part of a firm's capital structure and as such can have high levels of uncertainty that manifest in bouts of volatility over a market cycle along with periodic large drawdowns. I'm not convinced (engaged) members want this degree of volatility. Members deserve or should expect smoother returns and a reduced disparity of expected outcomes at retirement.
Jonathan Stapleton: How do you think the sort of ESG members are expecting from their schemes changed during Covid?
Mark Pemberthy: One of the themes that is very relevant when discussing illiquid assets or ESG is to reflect that a vast majority of DC assets are invested in passive instruments. There's really a bigger onus on large scheme trustees and master trust providers to start to take the initiative around those issues on behalf of the members and on behalf of sponsors within the constraints of low-cost passive investing.
Jonathan Stapleton: Are DC schemes generally doing enough on ESG?
Dean Wetton: My impression is that ambition is well ahead of execution, both at the trustee level and the manager level. But some of the drive is coming from the conflation of the recovery in growth stocks. That's where a lot of ESG perception is as well.
Growth and large cap stocks were protective for people in the Covid crash and the following recovery, so we've got a conflation of those normal market things that we've looked at for years and years, and ESG. When we're thinking about risk in particular, we need to unpick those and be very clear about if we're going into ESG.
Andrew Brown: There is now a general acceptance that mitigating the E, S and G risks should deliver sustainable returns for members over the longer term. Either way, research tells us that this is something members care about, particularly younger members.
That said, there is no one-size-fits-all approach to integrating ESG factors within an investment process. I do wonder though how it is possible to meaningfully engage with an index approach including potentially thousands of companies. I see the research intensity of our responsible investment analysts and the levels of engagement with individual companies and wonder if that's possible within a very large index-based fund.
Another point is stock lending. For passive providers, stock lending boosts revenues and returns but also transfers the right to vote to the borrower. From a governance perspective, that doesn't sit well with me.
Finally, it is important to realise that ESG is not confined to equities; it also sits with property and bonds. And when you think about investing in bonds, it is lending money to a corporate or a government and they're going to deploy that capital. We should want to know exactly how that capital is going to be employed and whether it meets a certain criteria or set of beliefs..
Jonathan Stapleton: How do you suggest an investor embarks on an ESG journey from the DC perspective?
Sophia Singleton: DC trustees should not be afraid to move from what they've got in place at the moment and to look at funds that might have more of a focus on ESG elements, whether it be a ‘tilt' because you're investing passively, or something else.
Also, don't just focus on the E, look at the S as well and look for funds that deal with them in a more robust way.
Mark Pemberthy: If we look at this in terms of practical aspects for trustees, at the moment, rather than go into that kind of detail around specific investments, they're actually in a position where they have to be taking a step back and really thinking about their objectives in relation to the investment strategy and the roles the E, the S and the G will have in it.
In recent years trustees have had an obligation to consider what their members' views might be on those, and most trustees have really struggled to do that in a coherent way. We're now moving very quickly into an environment where trustees have to articulate within their statement of investment principles what their intentions are in relation to financial and non-financial risks, specifically at the moment focused on the impact of climate, but we've already seen the consultation on social aspects.
The governance piece is equally, if not more, important. Just last year we saw Wirecard implode in Germany. It made up 2% of the DAX index so a lot of DC funds with trackers exposed to European markets would have had an impact from that.
The first step for trustees is to take that step back and ask to what extent they want to factor these issues into their investment strategy on behalf of their members and then ask how they are going to go about doing that. I don't expect many schemes to rush into an accelerated approach to, for example, achieve net-zero investment; I think it will be a much more measured implementation.
Jonathan Stapleton: How can trustees future-proof defaults? Are there particular cohorts of members for whom more work is needed on DC investment strategy?
Sophia Singleton: For me, the group of people and the space where I think this future-proofing is most important is in the run-up to retirement. At whatever stage that might be, for example 15 years to retirement, we need to make sure that whatever we have in place at that point really protects members from inflation and market volatility in the right way, while still trying to deliver the return our members need.
We also need to look beyond that and into retirement. There's a huge amount of work to do as an industry to look at post-retirement investment strategies and how they can deliver longer term into the future.
As part of the government's Plan for Growth published alongside the budget in March, it reiterated it wanted to remove disincentives for institutional investors, particularly DC schemes, to investing in a broader range of assets. There seems to be an orthodoxy about liquidity in DC schemes, but DC pots are long-term investments and, for most of the investment period, it is not obvious why liquidity is required. How will the panel challenge this orthodoxy?
Mark Pemberthy: There's a real paradox with DC. Clearly, we recognise that, for the majority of members, DC is a really long-term investment holding and so, from a theoretical view, the investment strategy should absolutely reflect that.
The challenge is that we are increasingly dealing with DC almost as a retail product. The expectations around transparency and visibility to members are benchmarked against things like internet banking experiences. People want online valuations daily; if they're transferring money in or out of their scheme, they want it to be transacted in days, not months. They expect to be able to switch funds almost instantly if they want to do that.
On the one hand, we're saying we should be able to take a long-term collective view around DC member assets. On the other, most schemes will be looking at their own digital experience, how transparent they are to members, and how can they improve that engagement and interaction with their assets.
Successful solutions will need to resolve these conflicts.
Andrew Brown: The DC market or investment decision-makers have a fascination with liquidity, though with long-time horizon and positive cashflows, DC schemes are well placed to take advantage of illiquid asset opportunities. However, they miss out on the associated illiquidity risk premia that populate the asset portfolios and returns of most defined beneit schemes. It really doesn't make sense that they are not able to benefit from that illiquidity premium. With their diverse return drivers, long-term cash flows that are often linked to inflation, and returns that are often less sensitive than equity or credit returns to the macroeconomic environment, illiquid assets, such as real estate and social and economic infrastructure equity and debt, typically offer a markedly different risk-return profile and pattern of returns to that of public equity and credit markets.
Jonathan Stapleton: What are the panel's key takeaways and concluding remarks following our discussion?
Sophia Singleton: DC strategies haven't done too badly in the last year. Looking forward, diversification of returns is key, so finding ways to bring in new asset classes will be crucial. That does mean we need some lower-cost, lower-governance solutions in some of these asset classes, so there is work to be done in this area.
The one thing that worries me around what's happened over the last year is I have seen a little bit of a change in member behaviour. We had three times the number of investment switches from members over 2020. That was from a small base but still it just shows the responsibility that sits with us in getting the member support right - these members were switching all over the place, there was no real pattern to it. Whether they have done the right or wrong thing, who knows? The challenge is for us to develop our communications and member support, as well as the investment solutions that sits behind them.
Mark Pemberthy: The last 12 to 18 months have brought into sharp focus what objectives or strategies trustees and sponsors have in place and whether their current scheme design or strategy is delivering against them - whether that's in terms of their investment or their communication and engagement. Is the underlying investment strategy delivering what they are hoping it will? Are members behaving and interacting with the scheme in the way they would want them to, particularly given the extreme circumstances they've gone through? If they are not, then what should they be doing about that?
Is the underlying money delivering what they are hoping it will? Are members behaving and interacting with the scheme in the way they would want them to, particularly given the extreme circumstances they've had? If they are not, then what should they be doing about that?
Dean Wetton: For me, it's all about scheme fiduciaries being really clear about their objectives. What do we believe? What are our objectives that come out of that? How do we work to that, whether it's inclusion of ESG or illiquids? And then careful consideration of the risks and your risk tolerance to things that could go wrong should be an integral part of that. It worries me that, at the moment, we've got a little bit of market euphoria and risk tolerance is a bit too high.
Andrew Brown: Investment requires more governance resource and it needs a greater share of the member-borne charge. The low-cost mindset may not necessarily lead to good value in the long term. That is my main concern for DC members today.
Providers should be assessed and scored on the net risk-adjusted returns they achieve for members. Surely that is the key criteria for business to be won or lost. Auto-enrolment has been hugely successful in terms of coverage, though a significant and prolonged market drawdown could be damaging and we should look to avoid that being the catalyst for any meaningful change.
This webinar was held on 14 April in association with Columbia Threadneedle Investments. To view the webinar in full, visit: bit.ly/2Q9OfeA
