Financial services firm Aon has warned of shortcomings in investment strategies used by defined contribution (DC) schemes which are matched to the risk profile of their members.
The firm said commonly used lifestyle strategies, broadly consisting of three phases (early career, mid-career and pre-retirement phases), were often still focused on pre-pension freedoms strategies geared towards an annuity purchase further down the line.
It said many DC schemes had not reconsidered the objectives of their underlying members in line with the post-freedoms world, which could lead to negative returns in the later part of their retirement saving strategy.
In the first of three papers focusing on the three stages of retirement saving, published on 13 February, the firm identified a number of ways DC schemes could be going wrong in investment decisions, for instance by being too home biased or price driven.
Chris Inman, head of DC investment advisory at Aon, said: “There is a clear need for DC schemes to check their investment objectives and to refocus on members and all their unique and evolving needs as well as the risks they are exposed to.
"We are advocating to schemes a three tier approach of ‘discover, develop and deliver’ in order that they can reach a clearer view of their members’ investment requirements.”
The firm said equity investments by DC schemes in the early part of the retirement journey were often undiversified, which could lead to a heightened exposure to local economies.
Any weighting of more than 10 per cent in UK equity could lead to a home bias which can be significantly impacted by local politics and economic factors such as Brexit, it said.
Besides, workers have more than enough exposure to the local market through their employment prospects, the value of their homes and so may not need further exposure within their pension savings, Aon stated.
Price-driven strategies meanwhile, applied a higher weighting to stocks with higher prices and a lower weighting to those with lower prices which can reinforce market bubbles, the firm said.
As a potential solution it pointed to factor investing such as smart beta or alternative indexation, which it said could help by weighting stocks by factors other than their price in an attempt to improve risk-adjusted returns.
Aon also pointed to currency hedging in equity investments, which it said was automatically applied by active equity managers but may not be present in passive equity mandates.
“As a result of the sterling’s recent depreciation (and therefore boost to unhedged investment returns) it is an opportune time to review DC arrangements,” it stated.
The firm challenged DC schemes to rethink what they were actually trying to achieve for members.
The firm stated in its report: “[A] deep understanding of what matters to members can be used to develop bespoke investment strategies that are tailored to their unique needs and objectives.
“Improving the value of membership in [a DC] scheme doesn’t necessarily mean using the cheapest investment strategies.