Defined contribution

Our coverage on the defined contribution industry in a world blighted by Covid-19.

July 2020

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Defined Contribution 2020 roundtable

The pensions savings market is changing. More and more defined benefit (DB) schemes are closed to new members, while the introduction of
auto enrolment has seen 10 million more UK workers, many of whom are under the age of 30, join a defined contribution (DC) scheme in the
past eight years.

This has seen the assets under management in the world’s six largest DC markets grow 8.4% in the past 10 years – double the rate of those entrusted to DB managers.

With the government and companies sharing a desire to stop being responsible for funding people throughout their retirement, DC, or a hybrid of it, has been pushed centre stage.

The government cannot afford to fund an ageing population’s retirement while a deficit in a final salary scheme can impact a company’s valuation and it is ultimately the shareholders, not members, who are responsible for closing the gap.

portfolio institutional has traditionally focused on the DB market, but with DC likely to become the future of the retirement savings industry, it is
going to be more of a fixture in our coverage.

The ways in which a final salary scheme differs from a DC plan goes beyond it guaranteeing savers certain payments in retirement versus the
size of a pension pot depending on the performance of the markets. There is the impact of the charge cap to consider as well as how consolidation in the industry is affecting outcomes for savers.

To discuss these issues, we hosted an online debate with people from across the DC market.

We also wanted to discover if rising unemployment and lower salaries resulting from the Covid pandemic could have a long-term impact on the
DC market
. The economic upheaval witnessed in the past three months may not just be an issue for those on the verge of retiring.

With the UK still in lockdown, we once again return to the internet to continue our series of group discussions on institutional investment. This month asset owners, investment managers, the regulator, consultants and a pensions policy specialist came together to talk about defined contribution. On the agenda was the long-term damage that the pandemic might be causing the industry, communicating with members and investing in illiquids.

Watch the video discussion here

Roundtable Discussion

portfolio institutional: What long-term damage will the Covid pandemic cause the pensions industry?

Keith Sully: It is too early to talk about long-term damage.

In the past 20 years we have lived through three once-in-a-lifetime events with the credit crunch, the dotcom bubble and now this. In all of those
you get people wanting to look after their cashflows. Cutting the amount they save is an obvious first step, but they are doing this at the
wrong time when markets are heading

Inertia helps people work their way through it by not looking at their plan, but some will look and then reduce contributions to increase their
take-home pay.

Philip Smith: Employers and savers have been remarkably resilient. There has not been a drop in contributions. There has been limited switching as well.

We were on the front foot with our messaging right from the get-go around the importance of taking a long-term view, not panicking and following the regulator’s guidance.

That seems to have worked, but it is early days and one of my concerns is how this plays out over the long term because we have not seen the
true economic impact yet.

PI: Are your clients concerned about long lasting damage, Julien?

Julien Halfon: There are different behaviours depending on how clients are invested. If they are invested in early stage liquid assets and credit spreads are rising while the market is falling, you have the question of what happens next.

People who are invested in illiquids have already learned some of the lessons of the past in that illiquids can avoid volatility in the
short term, which can in turn reduce the need for additional contributions.

PI: What conversations are you having with your clients, Julian?

Julian Lyne: An interesting development is what the implications are for markets from changes that are coming through, for example, in dividends. If we think about retirement, about drawdown, about defined contribution (DC) members nearing retirement, what does the investment-return environment look like? We have not seen how that plays out yet and the question is whether this becomes a long-term issue.

If you combine that with the economic effect globally and people losing their jobs, then wrap into that the potential implications of the market return environments, it is clear that the Covid situation could potentially have an impact into the medium and long term. I can wrap that up into the behavioural finance side. If people see their pension valuations fall sharply during this period, could that act as a disincentive to save? Those combinations can be quite challenging in terms of the economic environment and individual savings.

“There is interest in illiquid asset classes, but there is also a lack of understanding about them.”

Julien Halfon, BNP Paribas Asset Management

PI: When we come out of this crisis, will higher unemployment, lower wages and perhaps slower career progression impact the size
of the DC market?

Daniela Silcock: It is worth remembering that auto enrolment has some clever policies built in. One of the interesting ones is re-enrolment.

People will stop contributing because they have lost their job or their earnings have fallen, but because they will be re-enrolled when they get a new job, and because we are seeing fairly remarkable levels of inertia, the level of savings will pick up again over the long term.

Let’s not forget that the 8% minimum contribution level might rise one day, so I feel fairly positive on the long-term policy of auto

Where this is going to affect people is if they have just retired or are close to it and do not have an annuity or a defined benefit (DB)
pension. This is where we are going to see the level of assets fall and potentially not rise again, particularly as people often react by
withdrawing money at a low point to put it somewhere else.

PI: How is NEST reacting to such unprecedented times?

Stephen O’Neill: It is business as usual from a policy and process point of view. The impact that we have witnessed over the past six
to eight weeks has been significant volatility in our portfolio, which means that a lot of the work we are doing is focused on
keeping everything rebalanced to appropriate target weights.

We are doing that against a backdrop of uncertainty around the contributions that are going to come from members.
NEST’s membership is continually exposed to the economic effects of Covid and the government’s income replacement policy
for furloughed workers has dampened that somewhat, but it is too early to see how that will shake out. So, we are slightly more cautious about illiquids than we might have been if we were having this conversation in February.

The number one priority is to make sure our members have the right balance of growth and defensive assets. As asset prices move
around widely, and we do not know what contributions are going to be coming in from one period to the next, that normally routine
challenge has become a bit more day-to-day and hands on.

Victoria Panormo: Some good might come out of this. Once employees are back to work, where they are in their pension contributions might not be top of their list. We could use this time to engage with members.

Contributions generally have been too low up until now. Auto enrolment has helped with that, but generally, with the exception
of low earners, people are not saving enough.

Now that they have had a dry run at what it is like to be retired, maybe we can get members to think about what they should be
saving versus what they are saving.

PI: How is the regulator reacting to the current environment?

Geoff Cheetham: With the position unfolding, we are trying to provide as much flexibility as possible in the way that we are implementing regulations and setting a proportionate approach recognising the challenges that employers have.

We are seeing a high level of resilience in terms of contributions, but we are in an early phase of this. Our position is to watch the
situation unfold and to keep flexible.

We will try to do as much as we can to provide guidance to help people navigate through it, whether that is an issue such as re-enrolment or the reporting processes that companies have to pursue.

We are trying to be pragmatic.

PI: Should we be cautious of investing in illiquid assets with the volatility we have seen or is this a good time to pick up a few

O’Neill: We are not cautious of illiquids because of relative value or a particular view as to whether or not they are worthwhile investments in the long term. Managing short-term liquidity and rebalancing in volatile markets is a temporary priority. Sticking large amounts of money into an illiquid portfolio makes that challenge more difficult.

That is a temporary situation, however, and within three to six months we will see markets return to a somewhat more manageable level of volatility. Then we will be back to business as usual when it comes to funding our infrastructure and private credit portfolios for the long term

“We are keen that trustees are alert to the risk of members cashing-in their chips at the wrong time.”

Geoff Cheetham, The Pensions Regulator

Smith: It is business as usual for us. We have dialled down our equity a little to allocate to short-term credit. We do not have large infrastructure or private equity allocations. Given our scale and size – we are around £1.7bn – that is something on our radar for the future, but right now we are managing in a traditional DC-type environment, just with a slightly lower equity allocation.

PI: Has the pandemic changed how you are putting your clients’ money to work?

Lyne: What the current environment has done is to reaffirm the importance of making sure our default investment strategies are
fit for purpose. It makes asset managers, asset owners and consultants remember the high level of apathy among the DC membership, and what the default strategies are looking to achieve. It ties into the importance of timescale, of where people are in their working life.

In an appropriate lifestyle default strategy, where you have the benefits of long-term investing, any market volatility or drawdown
creates opportunities. It is when people are in the wrong strategies with short time periods that the risk of being in the wrong asset classes comes to bear. In long-term strategies there are opportunities if you can suffer, if I can use that word, volatility. We are not through this, it will continue to unfold in the coming months, but there are opportunities for people with the right timescale.

PI: Is the volatility that we are seeing a long-term investor’s friend?

Halfon: There are opportunities in illiquids. On the liquid side investment-grade spreads have shot up by less than 100 basis points, so you can turn to safe, high-quality illiquids that offer very good yields. But we do not know if there is going to be a second wave of Coronavirus, which could make things worse.

When it comes to liquid assets, the VIX shot up to around 80% but fell quite fast. It is less the case in DC than in DB, but if you have protected equity investments, through futures or options, then volatility is probably your friend. You potentially rode a nice wave.

If not, you had a bad ride and are probably 20% down with volatility still negatively affecting you. So, it depends on how you have
constructed your investments.

PI: Are DC schemes communicating more with their members during this pandemic?

Sully: Our third-party administrator has had a minor uptick in contact with our membership, but nothing significant.
Communication is always a difficult balance from an employer and trustee governance perspective. You do not want it to act as a disincentive and have unintended consequences by talking about risk. What we have done is stick to our normal communication timeline. We have issued our annual statement and annual newsletter at the same times as we normally do.

We also utilise an internal employee forum, which has three member representatives. We use them as a sounding board. They are
clued up enough to know that this is low down on the list of things
to lose sleep over.

They are happy for us to communicate in the way that we do and to say the usual things about pound cost averaging and assets that
they might want to invest in at a particular life stage, but not specifically addressing particular economic events.

” Members making their own investment decisions tends to result in selling low and buying high, which is not an investment strategy I have heard many IFAs advocate.”

Victoria Panormo, Hymans Robertson

PI: Is it business as usual for your clients, Victoria, or are they putting out special bulletins for their members?

Panormo: Schemes are adding wording to websites and call centre scripts, but we are not seeing schemes mailing letters to members
about the impact of Covid.

It is too early to tell what the impact will be and so when communicating with members you must proceed with caution in case you
awaken the beast.

Members making their own investment decisions tends to result in selling low and buying high, which is not an investment strategy I have heard many IFAs advocate.

In terms of communication, member segmentation is key. Those approaching retirement will have different concerns to a 20-yearold who has just joined the scheme and can withstand volatility.

PI: Is the regulator happy that it’s business as usual in terms of DC schemes communicating with their members?

Cheetham: Business as usual is important to give members reassurance that everyone is in control and the providers of the
schemes are comfortable and confident with what they have.

There are two areas that we are worried about. One is members making hasty decisions when they see the extent of the drawdown
on their pots. We are keen that trustees are alert to the risk of members cashing-in their chips at the wrong time.

The other area that we are alert to is that this is the environment where scammers start to emerge, offering to return a member’s
funds to where they were before the Covid drawdown through a fantastic investment idea.

Unfortunately, we see a lot of this, so are keen to see members being advised not do anything hasty and to review everything carefully. They need to be directed to areas of support, such as the Pensions Advisory Service and Pensions Wise to avoid making hasty decisions.

PI: Is the Pensions Policy Institute happy with the level of support that schemes are giving their members?

Silcock: Since freedom and choice was introduced, we have seen a major uptick in scams. With Covid there has been another uptick, even trying to get people who are under 55 years of age to take their pensions out early. This is a serious issue.

The problem is that the instinct people have when seeing a crisis like this is to take their money out and put it somewhere that they
think is safe, which is exactly the wrong thing to do. Any decision made in haste is going to be risky and dangerous.

We are working against behavioural economics and the scammers, who unfortunately are good at addressing peoples’ concerns. The regulator and government are working hard to stop them, but the scammers are working hard as well.

We need to keep up the effort because over the long term we would like as little damage to trust in pensions as possible.

“We are slightly more cautious about illiquids than we might
have been if we were having this conversation in February.”

Stephen O’Neill, NEST

PI: Is the fee cap a help or a hindrance when it comes to generating returns?

Halfon: Depending on what you are investing in, the fee cap is not that low. For illiquids, it is sometimes complex to manage, but we
have done it in several cases, so for us it has not been that much of a problem.

For liquids, it is high enough to allow sophisticated strategies to be implemented.

The fee cap is good for maintaining transparency, but it is not enough to protect DC members from scams. Something cheap is
not always good.

As far as we are concerned, the fee cap is not a problem because it is high enough. It should reflect what you expect of the

It could also potentially protect DC members if they are forced to look in more detail at what the investment is really about. In periods of stress – the tech bubble, 2008 and Bernie Madoff – if you base your reasoning on one dimension – the fee level – you are oblivious to the investment’s real problems.

Lyne: The biggest challenge DC has is getting people to save, so anything that can give savers reassurance that they are not going
to get ripped off is important. The fee cap is trying to make the industry deliver value for money.

In the US, however, it has probably gone too far. They don’t have a fee cap as such, but their biggest threat is litigation. Plans are being sued by their membership because they have a fund at five basis points while the one down the road is paying three basis points.

The fee cap gives schemes a sense of delivering value for money. Low cost does not necessarily equal the best outcome for members. It is that balance between value for money and understanding when you have a long time left until your retirement, and when you can go for passive fund options and low fees.

As you get nearer, try to use that fee budget sensibly to deliver the right outcome to members at the right time.

As a concept, we are supportive of the fee cap.

O’Neill: NEST, and most of our peers, stay below the fee cap. 75 basis points is more than enough for any default strategy to deliver a sophisticated and diversified investment solution.

The challenges that arise are in the private equity space where the practice is to have performance fees. The point is, notwithstanding
the level of fees in the private equity or infrastructure equity spaces, it is the structure of annual management charge plus carried interest that does not fit into the calculus of the charge cap that poses a challenge.

Having this structured pay-off to the manager is challenging within the charge cap formula. For that reason, we look for managers who can accommodate a total expense ratio, but that narrows the field somewhat because a lot of private equity funds are over-subscribed and are not necessarily minded to overhaul their business model to accommodate the DC market just yet.

PI: Has the charge cap delivered value for money, Philip?

Smith: It has. The fee cap has never been an issue for us. We are well within it and it has not hindered our ability to deliver good
default solutions for our members.

I do have a little concern around the broader DC market and the race to the bottom on fees, which might hinder some investment
innovation if the consulting community’s practice is always focused on the lowest possible fee. It has been a subject for debate for a long time, but I don’t sense any trend yet that there might be a move away from a price-driven selection process towards looking at the overall quality of the investment solution.

PI: Has this been an issue for you, Keith?

Sully: The cap provides assurance to the membership and is not a hinderance to us in constructing an appropriate lifestyle default

PI: Has the fee cap generated value for money as the authorities intended?

Cheetham: Phil made an interesting point about being wary of a price-driven market. There are parts of the DC market that are
much smaller than those represented here today. It might be more difficult for smaller schemes to get innovation into their investment strategies than it is for larger schemes.

The reality is that we want to provide transparency. It is important that people who are defaulted into schemes have the transparency and the reassurance of value. We think that it has achieved that. No doubt questions will be raised on what the right number for the charge cap is. I am sure that will be revisited from time to time. We are keen to encourage innovation. Performance fees and carried interest will potentially challenge the fee cap in default arrangements, so we need to be wary of that.

When we reviewed the market, we were not critiquing the quality of investment strategies, but there is a view that cost is driving a lot
of design, rather than investment innovation. That is something we probably need to look at not only from a regulatory perspective but also from a market perspective.

It is about value for money, not cost. We want to avoid the situation in the US where people are arguing over one or two basis points.
That does not sound a healthy place to be.

“What the current environment has done is to reaffirm the
importance of making sure our default investment strategies
are fit for purpose.”

Julian Lyne, Newton Investment Management

PI: Are master trusts serving members from an investment perspective or are they too focused on fees and administration?

Lyne: Master trusts have an opportunity to take advantage of their scale, but some of the smaller ones are perhaps struggling to
deliver that innovation and pricing power. We see the master trust as an opportunity for bringing the best to DC, be that in governance, investment innovation or pricing. It is not for everyone, but, as a DC solution, master trusts have a chance of delivering a good
outcome for members.

We are still relatively early in the master trust world, but we are
positive on master trusts.

Smith: As a master trust that has scale in the UK and having worked with them in the previous life, most master trusts are pretty-well governed. Our trustees are rigorous in how they govern the scheme and think thoughtfully and carefully about the investment solutions and service they deliver for members. That is a common thread across the market.

Master trusts are the future of the UK’s retirement market. They will drive innovation and are generally a force for good.

Panormo: As more and more money pours into master trusts following authorisation, performance monitoring and comparison of strategies is becoming more of a differentiator between master trusts. So, whilst there is probably a bit of headroom in the fees charged,
a lot of master trusts’ charges for their growth funds are between 25 and 35 basis points, which is well below the 75 cap.

What we are seeing now is more innovation in terms bringing responsible investment into the policy, using target date funds and
maybe thinking about liquids as well. Innovation in investment will start to stand out as one of their USPs.

Halfon: It is difficult to imagine small schemes of £15m to £20m accessing the best asset classes and most sophisticated strategies. Master trusts bring innovation and bargaining power, so small schemes can access illiquid debt, for example. With the fee cap, it would be more difficult to do
this by yourself because you have less assets to invest.

Master trusts can also have a governance function for the small schemes to avoid scams and to
protect against administrative mistakes, which are a plague in the DC world.

Master trusts are the driving force behind the sophistication of the UK’s DC market.

PI: Is your scheme planning to join a master trust, Keith?

Sully: We are single-employer trust. Our UK plan is £80m to £100m and has about 1,500 members, 50-50 active-deferred, or thereabouts. So we are a mid-sized DC scheme.

The thing about master trusts is the progression of the market. There were a lot of them to start with and they are now dwindling down to a
more sensible number and using their size in a better way.

Putting this into context, Intercontinental Hotels’ operating model is largely franchised, so we do not have the employee base that you
might think. We have a small, generally corporate-based, young, high earning workforce in the UK.

The scheme that we have set up meets that demographic and do not think that the large one-size-fits-all master trust is where we want to head. We do not see the rationale to make the jump yet.

PI: Is there much interest from DC members in alternative assets?

O’Neill: Inertia amongst NEST’s members is extraordinarily high, so the degree to which we engage on investment matters is limited. When we do, it is at a high level and is usually a reaction to an annual benefit statement or, occasionally, a piece of news, such as The Guardian’s campaign to reduce exposure to fossil fuels. That is the extent of the granular interest that most of our members
take in their pension pot.

There is no interest from our membership in alternative or illiquid assets. That is just an extension of the lack of interest they have in
the way their pensions are invested more generally.

PI: Is allowing DC schemes to invest in illiquid assets a good move, Geoff?

Cheetham: The regulator is open minded about it. We are keen to see innovation.

In DC, on average more than 90% of assets are in default funds, so this seems like an asset allocation which can add to diversification. It could potentially provide other characteristics and qualities
that are positive.

Ultimately, it is a trustee decision and they have to worry about value for money and suitability. They must consider the non-regulatory issues that create challenges from the operational and practical perspectives of investing in alternatives.

From a regulatory perspective, we are open minded and are positive about any developments in that space.

PI: Are you seeing much interest from DC schemes in illiquid assets, Julien?

Halfon: There is interest, but there is also a lack of information on the ins and outs of illiquids. NEST is different in that it has invested time and resources to understand these markets.

NEST is the exception not the rule. The DC market in general has to make efforts to understand these asset classes better. It is also the role of asset managers to communicate with master trusts on this issue.

We have been talking to master trusts and realised that we need to supply more information on what illiquids do.

In the current environment there is an opportunity to show the resilience of some illiquid asset classes to market shocks, simply due to them not having the same link to market volatility as liquid equities or corporate and government bonds do.

So there is interest in illiquid asset classes, but there is also a lack of understanding about them. This is potentially a challenge for
the next few years.

Lyne: I would be surprised if members are banging the table demanding alternatives. It is all about the default options and delivering the best risk/reward that you can for members.

Most of our funds are liquid but we try to generate returns by using alternatives in those structures. It is all part of delivering the right risk-adjusted returns. Anything that can do that has to belooked at, but you need to be careful with illiquids.

Property is sometimes described as an alternative these days, rightly or wrongly, but you need to be mindful that you could have a mismatch between the liquidity you are offering unit holders and the liquidity of the underlying asset class. This is why the use of scale and default funds is important in enabling certain schemes to consider the use of alternatives and illiquid assets.

“It is too early to talk about long-term damage.”

Keith Sully, InterContinental Hotels

PI: Are you interested in illiquid assets, Keith?

Sully: The closest we have is a property fund of funds. The two or three holds that have been placed on that fund, which could potentially spook members that they may not get their money out when they want to retire, is a concern for us.

Member interest in that fund is low. In fact, it is one of our lowest with only a handful of people invested in the property fund. Where they potentially have a place is in master trusts, which have the scale to deal with it.

Panormo: The gating that we have seen on some property funds shows that operational issues for DC schemes are a key

It might be that the asset class suits the demographic at that point in the glide path, but if your platform provider does not allow access to these funds, or if it is part of a blend and that small part is suspended, operational issues will be key.

If we finally get members to engage with pensions and they cannot retire when they want to, it will damage the reputation of the pensions industry further.

We have seen some property funds still being priced by some of their providers, which has helped in this regard, but it highlights
how key these operational issues are for DC providers.

O’Neill: Just a quick observation on the property side. By and large, the property funds that have had to gate have done so because
their products straddle the retail and institutional spaces, I believe.

A purely institutional property fund, assuming it does not see enormous out-flows, would not be obliged to gate if they could value the portfolio reasonably accurately. Part of the many issues around DC is that it caters to retail and institutional spaces at the same time and therefore is caught by a stricter set of regulations.

Smith: One of the other things worth noting in terms of having illiquids within the DC environment, is that the industry’s infrastructure is not set up to support illiquids.

NEST is the exception because it has a custodian-led model for the way it delivers its assets to members, but most of the industry is dependent on life platforms and life wrappers. They and illiquids don’t sit to comfortably together at the moment, so I would expect, particularly in the master trust space as assets grow, that there will have to be a rethink around how illiquids are put into investment funds and delivered to members.

“Master trusts are the future of the UK’s retirement market. They will drive innovation and are generally a force for good.”

Philip Smith, TPT Retirement Solutions

Silcock: A lot of this is about scale. The infrastructure is not there, but we are expecting quite a lot of what is a relatively young DC
market. A lot of schemes have only just started growing as a result of automatic enrolment.

When you see the schemes that are looking into illiquids or have sophisticated ESG strategies, they are large schemes who can
afford to invest in illiquids and maintain cashflow while staying under the charge cap.

I suspect that in the long term, when they grow, schemes will find it a lot easier to invest in illiquids. It is the smaller schemes who
are struggling. So access to illiquids will be through long-term growth, consolidation or pooling.

In Australia, where the market is much more developed because auto enrolment has been around for years, they are not having any
trouble investing in illiquids or engaging with complex investment strategies. So we are quite hard on ourselves because we are expecting a sophisticated and fully-developed market that is actually quite new.

Scale is going to be one of the major issues going forward that is going to unlock some of the opportunities for DC schemes.

Roundtable articles



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