DC plan design has evolved to incentivise younger people to get into the savings habit and remain invested, even through difficult market conditions. Nick Fitzpatrick looks at innovations in the UK.
Should bonds be the primary asset class for defined contribution (DC) pension savers in their 20s and 30s? Nest, a multi-employer DC scheme set up by the UK government to facilitate auto-enrolment, puts much of its younger members’ savings into lower-risk assets like bonds and money markets. Are other, more commercial, plan providers copying it?
Making bonds or other lower-growth investments a starter asset class for younger savers contradicts received investment wisdom, which posits that these members – with so much time on their side – can ignore equity volatility for decades in the expectation that this early risk, and losses, will eventually pay off by retirement.
Experiencing the stomach punch of losses from volatile equities could cause younger members to opt out of pension funds and stop saving – or so the phenomenon of ‘loss aversion’ in behavioural finance suggests.
Nest’s ground-breaking portfolio approach, influenced by behavioural finance, is not being followed so closely by some other, more commercial DC plan providers, but they do appreciate the importance of minimising the shock factor for early investors. This has translated into action on both portfolio design and member communications.
Four years ago Fidelity launched Futurewise, a default DC fund for employers.
“Futurewise has the ability to drive good positive equity-like returns in a fund that manages volatility,” says Hugh Skinner, Fidelity’s director of DC business development. “We try and remove some of the shocks but also try and maximise investment return opportunities in those earlier years rather than have [members] pointing towards more risk-averse assets.”
Skinner is sympathetic to Nest’s aims, which for younger people in Nest’s ‘Foundation Phase’ of saving mean having fewer investments in growth-seeking assets.
“Nest doesn’t want to disincentivise people by seeing losses when they’ve put their money into it in the early stages. The worry is those people at the early stage will have greater concern that they can’t see their investments accruing positive returns year on year, if only incrementally relative to what they are would do with their money elsewhere.”
Putting younger members into low-return assets like bonds for their first five or ten years will manage volatility, he says, but Skinner also questions whether this will provide the opportunity at retirement to have accumulated enough money to serve them.
Underpinning Futurewise is a diversified growth fund (DGF), a multi-asset fund that uses volatility signals from the markets to switch between asset classes through cycles.
The DGF type of approach is also the bedrock of the workplace pension scheme solution at Punter Southall Aspire, a DC pensions business that Punter Southall, a UK pensions and investment consultancy, launched in February.
Punter works with employers to tailor scheme profiles – as does Fidelity – and its solutions are founded on multi-asset portfolios that Steve Butler, chief executive of the Aspire business, says are like a DGF structure.
Again, equity-like returns with lower volatility should give members a much smoother journey, Butler says.
“When younger members see headlines about how much equities have fallen, they would look at their fund and see that, although its value might have fallen a bit, it is not so dramatic as to put them off saving.
They are still getting the exposures they need as long-term investors.”
The portfolios are highly diversified, says Butler, with small percentages of money in about 12 asset classes. Perhaps with echoes of Nest’s approach to loss aversion, bonds – both illiquid and liquid – can make up as much as 50% of some Aspire portfolios. Equities and alternatives form the other portion.
Butler considers the “tactical overlay” of multi-asset investing as an “alternative”, but says the alternative exposure may also be to commodities, property and gold. “As with all multi-asset investing, it’s about bringing volatility down while giving maximum opportunity for the best returns. It’s all about diversification,” he says.
He also argues that putting younger members’ assets into lower-risk assets, like Nest, may not lead to the best outcome because they are missing out on several years of potential growth.
Randal Goldsmith, senior manager and research analyst at Morningstar, says most funds considered to be DGFs do manage to deliver a smoother return when they are not constrained by a benchmark.
“Most of the diversified growth funds I’ve come across are managed with an eye to maintaining a degree of absolute return consistency and controlling volatility,” he adds.
“Most I know of target a return such as Libor-plus. Behind that, they are not managing to a benchmark constraint and they apply a flexible allocation, sometimes using derivatives to hedge away market risk.”
He says there are many other funds around that can generally deliver smoother returns without being called diversified growth funds. These other funds tend also to be multi-asset products that are not benchmark-constrained.
Goldsmith points out that the Standard Life GARs fund, the UK’s most successful fund with a DGF-type of approach, was originally set up to manage Standard Life’s own pension scheme money. Its aim was to produce a smoother return path through difficult market conditions and it was its success that saw the strategy launched as a retail product.
All this suggests that the pensions industry, through the evolution of behavioural finance-inspired portfolio creation, has found ways to try and keep younger members in schemes once they are in them, even when markets are tough.
Auto-enrolment, introduced in the UK in 2012, means the pensions industry and government have to worry less about getting younger workers into pensions saving, but the industry does share in the challenge of getting people to save enough, and the cash-strapped younger segment is a particularly tough area.
Pension products are competing for money against student loan pay-downs, rising rents and mortgage deposits for the wallet-share of people in their 20s and 30s.
Employers and consultants need to coax people into the savings habit. Punter Southall is rolling out an online portal to members of all ages to engage them in personal finance. Emails are age-specific; in their 20s they will receive information about managing student debt, for example; in their 30s it’s about mortgages.
Butler’s feeling is that engaging younger people will continue to be an uphill challenge.
Skinner at Fidelity echoes this, saying: “People in their 20s do not talk about pensions around the dinner table.”
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