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DC pension schemes look after more than 26 million members in the UK. In contrast, just 16 million remain in DB schemes - and only 10% of such plans are open to new accruals. DC pension assets in the UK grew by 30% in 2021 alone. This market is not new but still young compared to DB pensions – and this is a great time for managers to start a dialogue with the industry and build products fit for purpose. But how prepared are managers to serve this market?
Default accumulation funds face performance issues
As higher inflation set in during 2022, the PLSA estimates that the retirement cost of living in has increased by 20%. This means that DC members now need more savings to secure their retirement, but the government has stopped short of legislating for higher minimum auto-enrolment contributions – which admittedly could be tricky if the cost of living crisis has diminished disposable income.
If contributions cannot be increased to improve outcomes, what role should the default fund, its investment return and volatility protection play in DC accumulation? The DC accumulation journey is broadly based on the expectation of inertia – in other words, members are auto-enrolled and their assets invested into the default fund, where ideally they should stay until retirement. In this sense, having a well-designed and diversified DC default fund is crucial.
However, when we revisited data from a research project for Newton Investment Management in 2020, we found that DC schemes and master trusts have had a long-standing issue with both the inability of multi-asset funds – the most popular ‘flavour’ of default funds – to meet return targets as well as capture the upside in an up market. An additional problem that unfortunately compounds over the long run is high investment fees.
What is particularly interesting is the role volatility plays when comparing the investment performance of growth funds offered by major DC providers. According to research by Hymans Robertson, three-year annualised returns vary from just over 10% to as much as 20%, while the volatility for the same period is between 7% and 15%.
So far, DC schemes have mainly looked at costs and net-of-fee returns when measuring the value for money they deliver to their members. However, new disclosure requirements currently under consultation may include net investment returns, as well as two risk-adjusted metrics – maximum drawdown and annualised standard deviation of returns.
A focus on the risk taken to deliver the returns of DC growth funds is welcome, given that, unsurprisingly, this volatility can affect member outcomes – and Hymans Robertson estimate the annual pension these arrangements can deliver may vary from more than £25,000 under a good scenario to less than £10,000 in a bad scenario, which each have a 25% probability. This shows that retirement outcomes in DC schemes are not secure or predictable enough.
Despite the material impact of investment volatility, very few DC schemes and master trusts hedge any risks, based on our research on this topic over the past three years – and the main reason for this is the belief that diversification suffices, closely followed by the costs involved.
The outcomes for deferred members can be even riskier due to higher fees, as some employers only cover investment costs for active employees. By definition, deferred members are more likely to have small pots, as they would have left the employer and be no longer contributing to their pots. Yet often, all the instructions they are given is to wait to review their options a few months prior to retirement.
Retirement outcomes are far from adequate or predictable
Pensions Minister Laura Trott announced that plans for pension reform focus on three pillars: fairness, adequacy and predictability. However, given the current focus on accumulation in DC product design, retirement outcomes are far from predictable. Furthermore, only collective defined contribution (CDC) schemes currently can span both accumulation and decumulation – and only one such scheme exists.
However, mallowstreet research conducted for Milliman in 2022 revealed that DC trustees view retirement pathways as a broad set of individual journeys – which makes designing solutions difficult. This research was the culmination of three years of data collection in the DC industry, which also showed that few DC members are on a de-risking path because, generally speaking, members of DC schemes are younger and the schemes less mature and more growth-oriented.
Additionally, most DC trustees expect their members to take cash in retirement, be it as their 25% tax-free pension commencement lump sum, an uncrystallised lump sum, or drawdown.
Unless DC products are designed to span accumulation and decumulation, and DC pots follow members as they move jobs, they will remain small and fragmented, and viewed as a mid-term investment targeting cash. This is why it should not be a surprise that DC schemes invest predominantly in liquid assets.
So what is the value-add of illiquid assets?
Data from our research on DC retirement solutions last year showed that illiquid assets can play a role in a potential default decumulation fund, which would be the vehicle for those choosing to go into drawdown but remain invested, or delay accessing their DC pension pot until later in retirement. Over three-quarters favoured private equity as an asset class in retirement, and 68% said private debt would fit well too.
But in reality, DC allocations to private markets are still small. Based on our research for Partners Group a couple of years ago, two-thirds of DC schemes had no investments in illiquid assets, nor did they plan to make such allocations in the near future.
The top issue identified was the high investment costs associated with private market investments. Such assets could be hard to fit into the cost budget of DC default funds, which cannot exceed the 75bps charge cap – and this includes all costs to run it, not just investments.
Some managers are quick to note that, given the small allocation to such assets, the costs should be acceptable for DC schemes. Others point out that recent reforms now allow DC schemes to exclude performance fees from the charge cap.
However, mallowstreet data from the Trustee Report 2021 reveals that the issue is not in the cost of illiquid assets itself – it is more about the value-add of such assets compared to the additional cost and complexity they introduce. In fact, two-thirds of UK DC schemes do not expect illiquid assets to have any impact on the risk/return profile of their default funds.
Hymans Robertson believe there is potential for up to £250bn of DC assets to be committed to private equity investments by the end of this decade, i.e. over the course of the next seven or eight years. This is based on a 10% allocation up to 10 years prior to retirement.
However, this suggests DC assets in the magnitude of £2.5T, up from their current estimated total of £220bn. It is not clear how this growth of more than 1,000% over eight years can be attained, given that DC assets have only increased by 413% since 2012.
Where next for DC pensions?
Even if it does not grow 1,000% over the next eight years, the DC industry remains hugely cashflow positive and growth orientated. Asset managers which have not yet started thinking about their role in this market may find themselves late to the party – and with no one to dance with. mallowstreet is planning extensive multi-year research on DC pensions, so contact us if you are looking to grow your reputation and capabilities in this market.