March Cover Story- Defined Contribution: A brave new world


28 Feb 2022

Defined contribution is the future of the UK’s pension industry. But will a lack of diversity in investment portfolios leave savers poorer in their twilight years? Mona Dohle finds out.


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Defined contribution is the future of the UK’s pension industry. But will a lack of diversity in investment portfolios leave savers poorer in their twilight years? Mona Dohle finds out.

Since the introduction of automatic enrolment 10 years ago, the defined contribution (DC) market has grown rapidly. Today it manages the assets of more than 20 million members, or two-thirds of the UK workforce, according to The Pensions Regulator (TPR).

Although far behind the £1.6trn managed by defined benefit (DB) schemes, the market is expected to continue closing this gap. The Financial Conduct Authority (FCA) predicts that during the next decade assets managed by DC schemes could be worth more than £1trn. And master trusts are at the heart of
this growing market with 84% of UK employers selecting multi-employer trusts for their pension provision.

But because most workers are being enrolled automatically, many might not know that they are responsible for their own retirement savings. This is highlighted through more than 90% of such savers being invested in a default fund, where the investment decisions are made without their knowledge.

Moreover, with automatic contributions being set low, most will have insufficient retirement savings. This means that most DC investments tend to be skewed towards growth assets. Combined with a strong focus on managing costs and having daily liquidity, passively managed index funds in developed market stocks appear to be the weapon of choice for stakeholder pension investors.

So far, this will have stood them in good stead. The introduction of automatic enrolment coincided with almost a decade long bull market for growth stocks and as a result, many DC default funds have booked double-digit returns, on par with the average hedge fund performance.

But the global economy is facing dramatic changes. For the first time in more than a decade, inflation is on the rise and central banks are signalling that they will lift interest rates, with potentially severe repercussions for growth stocks.

portfolio institutional has mapped the rapidly changing landscape of the biggest master trust providers and quizzed them how they plan to adapt their investment strategy to these new macro-economic challenges.

A nation of master trusts

Since the introduction of auto enrolment in 2012, the DC market has evolved rapidly. A decade into the enrolment process, master trusts are rapidly emerging as the dominant form of workplace pension provision.

Since the introduction of TPR approval process for master trusts in 2019, 36 providers have emerged, collectively managing more than £87bn in assets for more than 20.7 million members, meaning that the majority of workplace pension scheme members are now enrolled with a master trust.

For Maria Nazarova-Doyle, head of pension investments at Scottish Widows, the handful of master trusts that will evolve as the dominant players will define the future of DC investing.

“We are becoming a nation of master trusts, a bit like Australia with their superannuation funds. That is what the landscape is going to look like in just a few short years,” she adds.

“Instead of a landscape with lots and lots of corporates all setting up their own pension scheme, they are now giving it all up and moving to master trusts because it is too costly.

“And the government is pushing that consolidation because they would rather have several large professionally-run master trusts with all the resources, economies of scale and professional boards,” she adds.

“We are becoming a nation of master trusts, a bit like Australia with their Superannuation funds. That is what the landscape is going to look like in just a few short years.”

Maria Nazarova-Doyle, Scottish Widows

For Steve Charlton, managing director of DC at SEI, scale is a factor in the growth in assets managed by master trusts. “Master trusts will become the biggest providers in the DC market,” he adds. “A lot of smaller providers will look at themselves and realise that they are simply not able to provide the best value for money within the structures they have.”

Wild west

When the government introduced auto enrolment, it introduced a charge cap that limited the amount of DC providers can charge members. This in turn has shaped the focus on providing cost-effective investment strategies.

But the main reason for the attempts to keep costs low is not the charge cap, but competition, argues Daniela Silcock, head of policy research at the Pensions Policy Institute (PPI). “The charge cap plays a role, but it is more in terms of having led to the creation of an environment where everyone is competing on cost.

“The majority of master trusts charge members between 0.3% and 0.5% of assets under management. So, they do not reach the charge cap, but the idea is that you would not be competitive if you charged it,” she adds.

“The government has become aware of the environment that they helped create and are trying to move away from that by getting schemes to look more at overall returns and diversification, rather than just focussing on costs,” she predicts.

With a market that is still in flux, the race to become one of the remaining master trust providers is fierce, Nazarova-Doyle says. “The market is highly competitive, like nothing I have ever seen. It is a bit of a wild west out there.

“Everybody is trying to gather assets and it is a once in a lifetime business opportunity because once an employer chooses a master trust, the secondary movement will be much slower,” she adds.

“Everyone competing on costs is affecting the way buyers are behaving in consultancies. It is now a thing to say to your client: ‘This is the cheapest, therefore it’s alright.’ There is no differentiation and people seem to only be buying on price, it is almost seen as a commodity,” she says.

Ranking: 17 biggest UK Master Trusts by AUM

Source: portfolio institutional

One example of this consolidation is SEI, which bought the Atlas Master Trust last year to create a master trust managing £2.1bn in assets. “It is perhaps a bit unusual that a smaller master trust acquires a bigger one, but we have always been clear that we want to grow organically and through acquisitions,” Charlton says. “The master trust market will continue to consolidate and we want to be one of the survivors.”

The focus on costs and the initially smaller scale of the funds has affected investment strategies, argues Nazarova-Doyle. “What that does to investment strategies on the master trust side is that everybody is trying to do their best to keep a cheap investment strategy because otherwise they will be uncompetitive, not be able to win assets and then not be able to exist in the years to come.

“My expectation is that this is a phase” she adds. “Once that market has consolidated, we are going to go from a fee focus to a quality focus and that is when master trusts will start to feel more relaxed about fees because they will be competing on quality and results.

“It is not necessarily a question of scale, but also a question of competition in the market and cost focus,” she says. “Once that settles, then they will be able to do more exciting stuff, which also helps with unlocking cheaper fees because the bigger you are, the better the deals you get.”

Heavy on stocks

The workplace pension market’s liquidity rules, cost pressures and the average demographic of its members have favoured investments in developed market equities. portfolio institutional has surveyed the asset allocation of default funds in the 10 largest UK master trusts to provide a snapshot of their current investment strategy.

The default funds in question were for members who are 20 years away from retirement, reflecting a reasonably high focus on growth. Of the funds surveyed, eight out of 10 had more than half of their portfolio invested in developed market equities.

Nest, the biggest master trust provider managing more than £20bn in assets, has 50.5% of its 2040 Retirement Fund invested in the asset class, including a tilt towards climate aware companies. As a result, the six largest US tech stocks account for 13.7% of the equity portfolio.

Similarly, The People’s Pension, which manages £17bn in assets, is alongside LGIM as the UK’s second largest master trust and has 58% of its default fund invested in developed market stocks, with US tech giants featuring heavily.

Lifesight, Willis Towers Watson’s £13bn master trust, has 70% of its default portfolio in equities, which includes exposure to emerging market stocks.

Standard Life, Aegon and Fidelity, the other big players in the market, are 64%, 80% and 75%, respectively, invested in developed nation stocks.

The £17bn LGIM Master Trust, stands out by having only around 40% of its 2040 default fund invested in equities, with a higher allocation to direct property, real estate investment trusts (REITs) and inflation-linked bonds. Similarly, Mercer’s Master Trust has just north of 40% of its assets in equities, with a higher exposure to emerging markets, high-yield debt and listed property.

If private markets want to sell assets, they should be adjusting their pricing structure so that it works in a way DC pricing works.

Daniela Silcock, PPI

But overall, DC master trusts tend to be heavily concentrated in developed markets and because of the market cap weighting of US indices, there is a heavy focus on tech.

There is something to be said for this strategy. By the end of 2021, Nest’s 2040 Fund returned 14.3% and more than 9% since its launch, outperforming the benchmark by more than 4%. No doubt if it had stayed clear of tech stocks, it would have underperformed. The People’s Pension’s 85% shares fund has also performed a respectable 14% during the past year, beating its benchmark.

Across the board, DC master trust default funds have achieved a relatively strong performance, given the investment constraints they are facing.

A brave new world

Yet the investment environment is changing, and DC members will have to react. With US inflation at 7.5% and the cost of goods and services in the UK climbing to 5.5%, multiple central bank rate hikes are on the cards. In return, developed market equity indices have dropped.

The S&P500 has fallen 6.7% in the year-to-date and the Dow Jones by some 4.5%. Data from option trades suggest that the S&P500 could fall by between 16% and 21% by April, Bloomberg reports.

Investors are not yet in agreement on the long-term outlook for developed market stocks, but most admit that the double-digit returns earned over the past decade may be a trend that is ending. So, what does this mean for the asset allocation of DC default funds? Are they able to diversify, given the investment challenges they are facing?

Marc Bautista, senior director, investments at Willis Towers Watson argues that inflation might not be as much of a long-term factor as feared, but uncertainty has increased. “Our base case is that inflation will remain high this year then fall back to more normal levels,” he adds.

“We are looking deeply at a range of factors that are causing that inflation and considering which are transitory and which are persistent. Then we look at how we expect those factors to play out in the medium term.

“We also recognise that there is a range of potential outcomes around that outlook,” Bautista adds. “For the first time in many years, there is genuinely a feasible possibility of high inflation and disinflation.” The team has attempted to diversify the portfolio by investing in a combination of alternatives, higher yielding fixed income strategies, property and infrastructure.

He is sceptical that listed property and REITs offer sufficient diversification from equity indices. “We didn’t just want to invest in pure passive REITs or infrastructure securities because the correlation with equities is too high,” Bautista says.

“We didn’t think they were truly diversifying. So, instead, we worked with a special infrastructure and property manager and asked them to construct something akin to an index which covers a subset of the infrastructure and property universe respectively.”

Nest, as the biggest player in the market, has been at the forefront of master trusts branching out into more illiquid assets.

It aims to invest some 5% of its portfolio in infrastructure by the end of the decade and has also issued a tender for a private equity strategy. Its 2040 Fund includes 3.3% of the portfolio in listed property, 4.5% in hybrid property and 1.8% in infrastructure.

For Bautista, it is important investors remain flexible to adjust their strategies if the market changes. “We keep refreshing our look at those indicators and try to construct portfolios that are relatively robust to whatever happens,” he adds. “Our allocations to sectors such as fallen angels, global high yield and even emerging market debt do not have a high duration.

“So, if anything happens, they will be hit but not hugely because of how much we have allocated to these funds and because of their duration. It’s a tricky act, but we are looking to be nimble.”

Nazarova-Doyle also acknowledges the need for greater diversification. “We used to have only equities in our portfolio, mostly developed market, with some emerging nation and some bonds. “About a year ago, it became clear that we caught the end of a bull market and our forecasts were starting to change so we have diversified the funds,” she adds.

“We added emerging market debt, REITs and put some hedging in as well. We have hedged 50% of our developed market equity exposure. So, we have started to think about managing for the future and trying to find different sources of return and trying to manage volatility.

“The two big trends for us now are ESG syndication and integration, adding a climate tilt to our equity allocation, and introducing ESG exclusions into our bond funds, that is one area where we are definitely planning to do more all the time,” she adds.

For smaller schemes, the cost and liquidity requirements remain a constraint, says David Cooper, head of pensions development at Creative, a £700m master trust that invests on behalf of some 217,000 members.

The master trust uses Scottish Widows and Mobius as investment providers but trustees are regularly reviewing the investment outlook. He acknowledges that the trustee is aware of the changing macro-economic outlook but describes the charge cap and liquidity rules as “restrictive.”

Even Bautista still sees challenges in accessing illiquids. “We would like to put more into illiquid long-term investments because our scheme members are long-term investors,” he adds.

“But at the moment there are massive practical constraints in terms of costs and the need for daily pricing and liquidity. We try to work innovatively to access illiquid assets, in our property strategies, for example.”

Picking up the mantle

The government and regulators are looking to address these challenges, in part by easing cost restrictions for DC schemes as well as by launching the Long Term Asset Fund (LTAF), which is aimed at encouraging more institutional investment into infrastructure. By offering a platform to pool smaller investments, allowing for a longer redemption period and stronger liquidity management, the government hopes to facilitate more investments in illiquid assets.

The PPI’s Daniela Silcock welcomes the initiative, but stresses that cost still remains an obstacle. “Another factor is the different pricing structure in private market assets,” she adds. “If the private market wants to sell assets, they should be adjusting their pricing structure so that it works in a way DC scheme pricing works.”

Bautista also believes the solution has to go both ways. “It’s got to be a mixture of the regulator and the asset management community coming up with solutions,” he says. “The charge cap is a bit of an impediment but I don’t think it is the main impediment right now. There are practical challenges with the need for daily pricing and liquidity as well as the commercial pressures. Right now, there seems to be a focus on cost, rather than value.”

For Nazarova-Doyle, adding illiquidity premia to DC portfolios will be a key challenge going forward. “There is a lot of movement, a lot of working groups like the productive finance working group which is working on figuring out how to put illiquids into a DC default strategy.”

The demographics of the DC membership should make the industry best suited to become a long-term liquidity provider. “A person who joined at the age of 18 could stay invested in the portfolio until 15 years before retirement. And we have the money, £48bn of it, but there are still lots of barriers,” Nazarova-Doyle says.

“So, we try to work with the industry and internally as well to figure out how to make it happen, because DB is dying and DC is becoming the new DB,” she adds. “As DB funds start de-risking into gilts and stop being the source of money to private markets, then DC will just pick up the mantle.”


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