Playing catch up?
Developing sophistication in DC investment
04 Sep 2018 - Estimated reading time: 5 minutes
Since the government’s announcement of the pension freedoms in 2014, the speed of evolution of the Defined Contribution (DC) investment market has increased markedly. Against this backdrop, we were keen to gauge DC trustees’ perception of the level of ‘sophistication’ of DC scheme investment strategies compared to Defined Benefit (DB) schemes.
Click to expand
The results of our trustee poll* show that over half of (58%) of trustees feel that DC investment strategies are at the same level as DB or more sophisticated, while the remaining 42% feel that they are less sophisticated.
We can make some guesses as to why such a large portion, two out of five trustees, said DC investments as less sophisticated than DB compared to the 14% who think they are more sophisticated.
Firstly, many DB schemes invest in unlisted assets such as infrastructure, real estate and private equity. Due to the illiquid nature of these investments, it’s difficult to get exposure to these assets in DC due to the daily dealing requirement. Some DC friendly products have been launched that enable DC schemes to get exposure to unlisted assets but these are costly – costing members anywhere between 1-2% p.a. in charges. Coupled with the 0.75% charge cap on DC defaults, it becomes extremely difficult to allocate a meaningful amount to these products.
Secondly, even some listed asset classes are difficult to access in DC. For example, global small cap equity and overseas corporate bonds are difficult to access on a standalone basis.
In addition, we sometimes forget that administration charges are also part of the charge cap. DC scheme administration charges can range from 0.1%-0.25% which limits the cost budget on DC investments.
Finally, most platforms charge a platform fee which would range anywhere between 0.03-0.08% depending on the size of the DC scheme. This is an obstacle for smaller schemes who would find it extremely difficult to implement sophisticated solutions. It’s no surprise then that more than half of the trustees who were among the 42%, and managed schemes with AUM of less than £100m, stated that DC investments will take more than 10 years to be as sophisticated as DB, or never catch up at all (see chart below).
Focusing on the 42% of trustees who believe that DC investment strategies are less sophisticated, we were interested to find out how long they think it will take for them to catch up with DB strategies.
Click to expand
Overall 40% of the Trustees that said that DC is less sophisticated now indicated that DC would never catch up to DB, and 10% said it would take longer than 10 years. The other 50% believe investment strategies will catch up with DB within the next 10 years.
It is not surprising to see that Trustees managing DC schemes with assets greater than £100m were more optimistic than those Trustees managing DC schemes with assets of £50-100m. This is understandable as smaller schemes generally do not get the benefits of scale and more sophisticated strategies are usually more expensive.
Is there light at the end of the tunnel?
Since the introduction of the pension freedoms in 2015, charges have generally fallen, and access to many alternative asset classes has become easier, as opposed to gaining exposure via DGFs. High yield bonds, emerging market debt and UK small cap equity funds, to name a few, are now readily available on most DC platforms. Therefore, we can construct investment strategies using a wider range of asset classes that will improve member outcomes. There is also some innovation in the market focused on DC. For example, the recent launches of climate aware equity funds are aimed at DC schemes since members have very long investment time horizons.
We’re now seeing asset managers developing multi-asset credit, absolute return bonds and global direct property funds, to name a few, for the DC market. Price and contribution to risk-adjusted return will still be the major factors to consider when implementing these funds, but it is refreshing to see that product development in DC is gaining traction. Here’s to the next 10 years!