Getting the investment strategy right for auto-enrolment

However, while the Maintaining the Momentum report rightly focused on engagement, the self-employed, creating more flexibility in workplace saving and getting millions more Britons saving for retirement, the review hardly talked about the adequacy of the investments underpinning the provision of auto-enrolment schemes.

While it did suggest the annual benefit statements should be more explicit and engaging, to help savers understand what they have got now and what they can expect to get in the future, there has to be more focus on what investment strategy sits behind workplace defined contribution (DC) provision.

There is, to put it crudely, no gold-plated outcome such as might be expected from a defined benefit scheme, where the scheme sponsor bears the investment risk themselves.

Nor can most employers afford such pledges now - consider the end state of BHS or Carillion, where the employers themselves fail.

A pension accumulation strategy is completely dependent on an individual's appetite for risk. Angie Kirkwood

With auto-enrolment being a DC-style solution where the individual bears the risk, thought has to be given as to whether the investment strategies - especially those of the default funds in which the majority of members sit - are robust enough to meet the needs of savers regardless of their age.

With the three-year reviews starting in 2018 of the largest auto-enrolment schemes, now might be a good time for financial advisers with corporate clients to suggest an analysis of the investment choices, and the make-up of the default fund - to see if it is meeting the needs of members.

Assessing the default fund

Getting the underlying investment right for the default fund is crucial, as more than 90 per cent of people are invested in their workplace's default fund, according to 2017 research by Hargreaves Lansdown.

This is across the board, regardless of sector or industry, says Chris Daems, director of Cervello Financial Planning. His advisory firm was involved heavily in helping employers to set up auto-enrolment schemes when the government brought it in.

He comments: "Our experience is the majority of individuals use the default fund provided, even in organisations where you might expect more self-selection to occur."

Moreover, people are likely to remain in the default fund. Paul Todd, director of investment development and delivery for the National Employment Savings Trust (Nest), comments: "When it comes to auto-enrolment, a scheme's main default strategy is a more important area of focus than the choices offered around it.

"That's because evidence from the UK and abroad shows 90 per cent of members are likely to stay in the fund they're first put in."

So the default has to work for everyone. Ms Kirkwood says: "A pension accumulation strategy is completely dependent on an individual's appetite for risk, expectations for retirement and where they are in the retirement planning journey.

"There is a wide choice available that qualify for an auto-enrolment plan, but the majority of people are invested in default funds."

This is why performance, risk, charges and suitability matter: there are millions of people pinning much of their retirement income hopes on the quality of their workplace's default scheme.

Last year, FTAdviser published the findings of research into the performance of auto-enrolment default funds across the market. Overall, default funds registered low-double digit positive performance during the past three and five-year periods. 

The key findings were:

• Overall, workplace pension default funds had a return, on average, of 10.2 per cent every year over the last five years.
• This is roughly 10 per cent more every year than opting to hold a pension in cash.
• Over this period, pension cash funds fell by 0.09 per cent every year.
• However, default funds underperformed the average global equity fund by 3.72 per cent every year.

On the last point, there is necessarily a difference between a pension fund with its necessary risk controls and the average global equity fund, which can be invested in racier stocks such as frontier markets, and therefore benefit from a much higher upside with impunity.

Diversification in the default

Default funds need to be invested as broadly as possible to smooth out the risks and provide as much growth as possible in the run-up to retirement.

Pension consultancies in decades past recommended a 70/30 or 80/20 approach to investing, putting the bulk of the money in low-risk, low-return assets such as index-linked bonds, gilts and high-grade corporate bonds, and the remainder in more racy equities.

The problem is while this was designed to lower investment risk and help schemes meet their liabilities, this sort of strategy just won't help a 16-year-old member who needs 50 years' worth of high investment growth to secure the best possible pension pot at retirement.

Mr Todd is grateful most default funds are moving away from the old 80/20 strategies. 

He comments: "There's a lot of variance in quality on offer in the UK auto-enrolment market but we are pleased to see more scrutiny being put on default funds, and a move away from traditional 'set and forget' 80/20 strategies.

"A dynamic strategy that diversified members' money across regions, asset classes and fund managers, with an understanding of the correlation between each, is important."

Avoiding too much home bias and spreading the risks and potential returns across a range of asset classes, geographies, investment styles and other factors will help create a suitable and robust default investment process.

Adrian Boulding, head of retirement strategy for Dunstan Thomas, is of the same mind as Mr Todd. He appreciates a wide range of investments, carefully put together, for default fund options.

He also believes strongly that managers should manage risk accordingly, rather than just creating an asset allocation strategy and leaving it to run its course.

However, he comments: "My criticism of diversified growth funds (DGFs) - today's popular choice for pension investment - is they do not make it clear whether the overseas exposure is hedged against currency movements or not.

"I like the DGFs for their wide reach, including investment in both mainstream and emerging foreign economies, which really helps to reduce volatility.

"But I am a strong believer that associated currency risk should be hedged away. Apart from a tiny minority who will retire to the Costa del Sol, we're all going to be retiring in the UK and paying our essential bills in sterling."

There is also the point of quality, not quantity - too much diversification can actually work against investors.

Mr Daems warns against choice for the sake of it. "While certain providers pride themselves on a wide range of fund choice, we need to ensure we focus on keeping costs relatively low, providing choice but also potentially limiting it so individuals are not overwhelmed by it, and ensuring we continue to review the appropriateness of default approaches.

"Our experience is that adding yet more investment options certainly does not increase engagement, and can often have the opposite impact."

Moreover, too much diversification, while intending to minimise risk, can end up maximising underlying fund and transaction charges as well as potentially limiting the benefit of any upsides in markets or yield. 

Matthew Phillips, managing director at Thomas Miller Investment, explains: "Diversification mitigates some of the effects of risk but too much can also dial the returns down.

"It will dilute the returns from a more concentrated portfolio and one will need to understand how the portfolio is going to achieve the returns."

Dan Kemp, chief investment officer for Morningstar, goes further: "By over-diversifying, a multi-asset solution will hug the benchmark and create unnecessary costs."

Independent governance committees

The creation of independent governance committees (IGCs) has been a boon for auto-enrolment schemes, according to Angie Kirkwood, senior policy manager for Scottish Widows.

With the implementation of the IGCs to oversee schemes, investment fund performance and charges are reviewed regularly, as well as ensuring that the fund managers are doing what they should be doing, in terms of governance.

The auto-enrolment review by the DWP highlighted the need for the industry to do more to help schemes deliver. Commenting on behalf of the Pension Quality Mark, chairman Gregg McClymont says: "Even when the review's proposals have been fully implemented, contributions will not be enough to ensure a good retirement income."

The 242 schemes in the UK that have the Pension Quality Mark cover 1.4m employees, reflecting what the PQM board believes to offer high-quality contribution levels, governance and communications.

Why should people give up on investment returns above bonds when they are in their late 50s or 60s, and could still have decades of life in front of them? Baroness Altmann

Moreover, there are other regulations being brought to bear on what can be put into a default, and how that should be managed - for example, does the default fund use listed securities, such as exchange-traded funds?

For Mr Boulding, the recent implementation of Mifid II is supposed to make costs, charges and underlying investment products clear, simple and appropriate for the end investor.

All advisers and clients should be able to see the key investor information document (Kiid) required under Mifid II, he said, and understand the risks, but even here a fund could simply list something such as currency as a risk, rather than implement a process to manage it in the portfolio.

The default therefore has to be regulatory robust but meaningful in terms of asset allocation strategy and charges. 

But it also has to be simple enough a strategy to be able to explain to members. Vince Smith-Hughes, retirement specialist for Prudential, explains: "The relatively small contribution levels and nature of scheme members joining, means auto-enrolment schemes need to be simple.

"There is little benefit in confusing members with a huge array of fund choices, and a default fund investing in a mix of equities, bonds and commercial property offers the prospect of providing good, long-term returns.

"Plus, many savers are likely to be low-risk savers, so funds' risk profiles must reflect this."

The path to retirement

According to Nest's Mr Todd, members' returns can be boosted by retirement if schemes understand and "proactively manage the interplay or risk and return in member's portfolios, including the impact of environmental, social and governance risks".

For him, this means managing volatility so it neither erodes savings nor the trust people have in pension saving. "Members want smoother, more predictable returns and that requires effective risk management."

This is why there is often the so-called 'glide path' to retirement, whereby the portfolios are managed in such a way that risk diminishes the nearer one gets to retirement because the portfolio gradually moves from a higher equity investment to a less risky asset mix.

This can be a good way to ensure people's hard-earned savings are given the maximum possible growth boost early on, and the maximum possible protection as they move into the decumulation stage. 

Glide paths have worked well in the US for many years. For example, in the US, Prudential's Day One Fund range's asset allocation follows a glidepath that becomes more conservative as the Fund’s target date approaches, by reducing exposure to equity investments and increasing exposure to fixed income investments.

The glidepath for each fund continues to adjust allocations for about 10 years past the target date, when the asset allocation of each fund will be similar to that of the Day One Income Fund (see figure 1).

Figure one: Pru's Day One Funds illustrative glide path

However, the glide path for the UK market post-freedoms isn't as clear-cut as it may have been back in the 1990s, when most people simply superannuated at retirement or took an annuity at age 75.  

With more people choosing to remain invested post-scheme pension age - and maybe even continue working into their 70s - simply moving people to a bonds-cash mix is sub-optimal.

Even if they do wish to take some pension income, they may wish to opt for drawdown, and take a measurable income from the portfolio each month. Therefore they will need some growth assets to ensure they do not run out of money early on in retirement.

It's a difficult line to tread, getting the tactical changes right for each individual in the run-up to retirement and then beyond into the decumulation stage.

"Aligned with the fund choice, it is also important to ensure the lifestyle strategy for moving into different assets closer to retirement is aligned to the client's expectations in retirement", Ms Kirkwood says. "Our experience is that engagement tends to increase the closer to retirement the client gets."

Some providers have tried to make this path easier by creating target-date or lifestyle funds whereby the de-risking is done gradually at set points, to avoid the cliff-edge changes at retirement.

Sadly, according to former pensions minister Baroness Ros Altmann, many of these are "simply not fit for purpose" - largely because the lifestyle funds do not really fit modern lifestyles and the target date are targeting the wrong retirement date.

She explains: "It is disappointing that the industry has not come up with new approaches that encompass the flexibility of people's lives nowadays.

"Also, given the dramatic fall in interest rates and uncertainties in fixed income markets, it is unclear why people think switching into bonds for 10 years before a certain date, at which many people may well not be retiring, is sensible.

"Why should people give up on investment returns above bonds when they are in their late 50s or 60s, and could still have decades of life in front of them?"

For this reason, Ms Altmann believes the lifestyle approach needs to be reconsidered - no doubt more innovation will be brought to the market in the near future to meet the different needs of this growing proportion of society.

simoney.kyriakou@ft.com