How to interrogate a pension scheme’s approach to diversification

How to interrogate a pension scheme’s approach to diversification

Advisers have a clear role to play in helping clients choose the most suitable pension scheme for their workers’ needs.

In part, this is about getting under the skin of the scheme’s approach to diversifying members’ portfolios. 

At NEST, we use a multi-asset approach because we know our members want to grow their money, but they also have a strong desire to keep it safe. The aim is to improve risk-adjusted returns for them.

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So, when interrogating investment approaches for auto enrolment, what should advisers look out for when it comes to diversification?

Most advisers recognise the importance of looking at how far a fund diversifies across asset classes.

But it’s also vital to weigh up the types of risks the fund may be exposed to. A fund’s sensitivity to interest rates, foreign exchange rates, stock market movements and commodity prices, for example, are all important drivers of risk. 

There are also ‘extra-financial’ factors that can introduce risk into portfolios: these might include environmental factors such as emissions regulations, and social factors like international labour laws. 

Advisers can help their clients by assessing whether a strategy truly distinguishes between these different risk and return factors, or whether it simply duplicates the same risk in different places.

We believe that good investment governance can drive appropriate diversification across asset classes.

That’s why our investment beliefs are at the heart of our investment approach. Key among these are: 

  • Diversification is a key tool for managing risk.
  • Risk-based asset allocation is the biggest driver of long-term performance.
  • As long-term investors, incorporating environmental, social and governance (ESG) factors is integral to the investment management process. 

In combination, these beliefs stress the importance of understanding how different securities and their associated risks work together within a given asset class. 

As an example, many of those saving through auto enrolment will be exposed to at least one major common risk – the growth of the UK economy.

It makes sense to try to diversify some of that risk when it comes to how their pensions are invested.

Our risk management framework makes us look for global growth opportunities as well as UK-based growth on behalf of our members.

To achieve genuine diversification, NEST uses a wide range of building blocks to make up our member-facing funds of funds.

Our in-house investment team at NEST combines the building blocks using our carefully calibrated risk management framework. 

The building blocks used in our default strategy currently include:

  • Global developed equities. 
  • Global emerging market equities. 
  • Global emerging market debt.
  • Gilts including 10 single year gilt funds, index-linked gilts. 
  • A sterling corporate bond fund.
  • A UK direct property fund and global real estate investment trusts (REITs) fund.

We’re also in the process of adding a high yield bond fund to this toolkit and we continue to look for other opportunities to refine our approach to diversification within our low cost remit.

You can find out more about how to compare and measure default funds in the recent Defaqto report, How to analyse auto-enrolment default funds, which was commissioned by NEST.