Defined contribution: an alternative route to investing

Transcription

1 Defined contribution: an alternative route to investing Stephen Bowles, Head of Defined Contribution, and David Heathcock, Head of Life Company Operations, Schroders DC investing looking beyond the why Who d be an economist? While many of the recent headlines have been reserved for lambasting those macro chaps, as they ponder the direction of the global economy, the micro discipline fairs little better. The theories of rational economic households, constantly maximising their utility, seem to bear little relation to the everyday world. As individuals we consistently fail the rationality test, and our approach to long term savings is no different. Recognition of this failing has slowly crept into the design of long term savings, most recently within pension provision. For example The Pensions Act 2008 brings with it auto enrolment and the implicit recognition that we sometimes need to be prompted to reach a rational decision, or at least a decision that s in the public interest. Dave s Big Society might work when it comes to getting the snow shifted from outside your house, but the reality is that for most of us shifting our money into a pension is whole different kettle of fish. The realisation that the member may not be best placed to take investment decisions is pretty old hat. The response to this realisation - the ubiquitous default fund, which invests the members contributions in a pre determined manner, is equally ingrained. Therefore the question of why we need a default is not the one we look to answer in this article, we instead look to analyse how we can deliver an appropriate default. The reality is, that even the current generation of professionally led default solutions are sub-optimal. That s not to dismiss out of hand the progress that has been made, there have been huge strides in default design, away from a reliance on single asset class, index based benchmarks, towards multi-asset funds with real return targets. The aim, to provide better risk adjusted returns for what in reality are quite risk averse investors and broadly so far these objectives are being delivered. We are heading in the right direction. The barriers we are coming up against now are not, as has been the case in the past, a result of a lack of intellectual rigour being applied to the problem. The barriers we are coming up against now are practical, operational and regulatory and they prevent the default designer from bringing to bear all of the investment tools that, in a perfect world, could be used. So what direction should we now take and how might we deliver better solutions to DC members? How - the challenge of harnessing alternative asset classes in DC The shift that we have seen in recent years from all equity solutions to diversified growth funds has seen the positive harnessing of investment in a wide range of alternative asset classes such as hedge funds, private equity, property, infrastructure, high yield, commodities, currency and catastrophe risk. These other asset classes provide different sources of return which are not necessarily positively correlated to equity markets and therefore can provide diversification benefits.

2 Example risk premia for typical alternative assets Expected return over cash Private Equity Property Infrastructure High Yield Commodities Absolute Return Strategies Currency Catastrophe risk Equity Illiq uidity Term Credit Volatili ty Active skill Ins urance Source: Schroders for illustration only. Members of defined contribution schemes have traditionally found accessing these markets difficult because alternative asset classes are characterised by being largely illiquid, having large minimum investment requirements, and by being either unlisted, an unregulated holding or sold in the form of an over the counter (OTC) derivative. This means they are removed from the potential investment universe for DC schemes either because of operational or regulatory constraints. The traditional challenge in determining the components of a default fund has been viewed as balancing the liquidity needs of members with the investment benefits offered through diversity. The portfolio is viewed as needing to be kept liquid as market convention dictates that trading should be daily or potentially weekly but no less regularly than that. The only practical way of achieving this is by blending the conventional asset classes like equities, bonds and cash which tend to be liquid with the alternative asset classes. Illustrative DC Portfolio Structure Alternatives Bonds Equities Source: Schroders for illustration only. The resulting fund can withstand regular outflows because redemptions can be met from liquidating conventionals, this only becomes a problem if redemptions are of the scale that the investment model is distorted because the alternatives cannot be redeemed in time to meet the cashflow demand. 2

3 Delivering alternative exposures in DC The operational constraints created by the administration requirements of a DC scheme mean that an investment manager needs to offer an investment solution in the form of a collective investment scheme. For a DC investor the options would be a unit trust under either the UCITS or NURS regime, or a unit-linked life fund. For each of these fund structures there are regulatory restrictions relating to the ability or extent to which a fund can invest in alternative asset classes. The result is that it becomes challenging, to say the least, to construct an all alternatives solution, when using any one of these vehicles in isolation. So why are so many default finds constructed as life funds? The difficulty for DC schemes to purchase alternative-only mandates from a manager is that blended DC default solutions are predominantly offered through unit-linked life funds. There are a number of reasons for this trend: Firstly the contract-based market is tied to offering funds through a long-term insurance contract. Secondly, the regulatory regime surrounding unit-linked life funds is a lot more favourable than that of other fund structures where there are strict limits on the maximum holdings size. Thirdly, increasingly distribution in DC has shifted away from direct relationships with fund managers and more towards distribution through the open-architecture platforms operated by the large insurers, again therefore funds are predominantly constructed as life funds. The regulatory inconsistency Trustees of an occupational pension scheme are treated as professional investors and the FSA does not differentiate between the trustees of a defined contribution or defined benefit scheme. However, in updating the permitted links rules that govern life funds in October 2007 the FSA created a distinction, calling DB trustees institutional investors and DC trustees retail investors and thereby reduced the investment flexibility available to DC investors to access unregulated investments through a life fund structure. This change to the treatment of DC investors has resulted in increased protections which also has the impact of acting as a significant barrier to investing in a variety of alternative investments. These restrictions: limit investment in unregulated collective investment schemes to 20% of the value of the fund; impose the requirement that the fund must price regularly (an interpretation of which is at least once a fortnight); and ensure that all of the underlying holdings themselves meet the permitted investment test. A further consequence of the FSA s application of permitted links rules on DC trustees is that it limits the opportunity to create blended solutions. In a perfect world trustees would select their preferred managers of conventional asset classes and blend these with their preferred alternatives manager. However the lack of credible propositions in the alternative investment space makes it difficult for schemes to break apart a diversified solution in this manner. In addition it becomes difficult to buy either a broad alternatives only fund or the single asset class components without tripping up on regulatory restrictions imposed by the FSA. The outcome is that a DC scheme is only really able to hand a manager a combined mandate for their allocation of both conventional and alternative asset classes, such as a Diversified Growth portfolio. However investing in an alternatives only pooled fund, although potentially attractive in terms of investment rationale, would not currently be possible. 3

4 Diversified Growth Portfolio Alternatives Only Portfolio Equity Property Commodities Hedge Funds and Currency Cash Convertibles High Yield Debt Emerging Market Debt Private Equity Infrastructure ABS Hedge Funds Commodities Infrastructure Property Leveraged Loans Active Currency High Yield Debt Emerging Market Debt Catastrophe Risk Convertible Bonds Private Equity Cash -Equities and alternatives portfolio -Designed as a total growth solution -Correlated to the equity market -Daily liquidity -Unit-linked life fund -All underlying holdings meet the permitted investment test -Alternatives only portfolio -Designed to be held alongside equities -Low relationship with the equity market -Quarterly liquidity -Luxembourg domiciled Special Investment Fund -Not a permitted link Source: Schroders for illustration only The inconsistency and difficulty in this approach is that there is no restriction for a DC investor accessing these asset classes through an occupational pension scheme via other unitised investment vehicles in a regulatory environment outside of the life fund regime. For example a DC trustee body not restricted to using a life company structure could theoretically (and ironically) select a high octane, quarterly dealing commodity hedge fund as a default fund. This could bring a level of risk, not to mention a fiduciary due diligence burden, too great to contemplate. Whilst at the same time the regulatory regime would place significant barriers to a life company portfolio constructor creating a diversified solution that could combat these risks in the form of a managed pool of alternatives such as that illustrated above. However, in the life fund environment the fund of fund solution can be built and a diversified solution embracing alternative asset classes can be delivered but only by a single provider. This limits an investor to the few players who can deliver a credible diversified alternative investment solution but also means a scheme needs to be additionally comfortable with that manager of alternative assets approach to managing conventional asset classes. So what can be done? If there is appetite from the manager of the alternative assets to act as an open-architecture portfolio constructor on behalf of a scheme, the manager could create a fund which holds their own internally managed alternative assets alongside conventional asset classes managed by an external manager, then there is a way out. By combining the structure of a unit-linked life fund and that of a NURS a fund manager is able to access a larger universe of alternative investments and then make them available to a DC investor either directly or as a fund link through an investment platform. This solution will deliver the required result for an investor large enough to justify a bespoke portfolio or it could be offered as a white label offering through the investment consulting community. 4

5 A solution used for the Schroders Diversified Growth Fund 20% Assets directly held by the life fund expands the investment universe beyond that permitted in the NURS 62% Approved securities and regulated CIS 18% NURS 20% of 80% Up to 38% in unapproved securities and unregulated CIS Unit-linked Life Fund However, this solution is not as flexible as a scheme being able to access either a diversified alternatives fund or a single alternative asset class directly. Since regulation allows this indirect access to alternative investments to a DC scheme then a case can be made that regulation should be changed to permit the same investment flexibility to members of defined contribution schemes as is afforded to DB schemes. Looking for a new how for tomorrow So where does all this leave us? The investment argument is becoming difficult to ignore. The benefits of an actively managed diverse basket of assets are clear. We can target more appropriate objectives and deliver better risk adjusted investment outcomes for members. Additional tools and techniques are available, which from an investment standpoint there is little logical argument for ignoring. The issues we now face boil down to the impact these tools have on solution complexity, as well as the operational and regulatory barriers that prevent their practical use. Increasing complexity is undoubtedly a price we will have to pay if we are serious about improving investment outcomes. The pertinent issue is whether complexity is an acceptable reason to continue with sub-optimal investment solutions? The reality is the problems we face in DC are complex and they require sophisticated solutions, to pretend we can shoe horn some equities and bonds in and hope they solve the problem is at best naive. Such solutions are neither effective nor simple and we run the very real risk of simply smothering the DC member with love. Yes there is a clear correlation between more sophisticated solutions and the complexity of those solutions, the issue is whether this really matters. If we put in place professionally led solutions, which are being designed and monitored by expert practitioners, then the task becomes not one of communicating the complexity, but rather communicating the aims and objectives. Not an easy task but one that should be well within the remit of the calibre of professional now inhabiting the DC space. A more practical problem is that many of the tools that are applied in other investment environments, and that we would like to adopt within DC design, fall foul of the specific regulatory and operational requirements of our market. Again the question to answer is whether these issues should be limiting the extent of the solutions that can be applied and therefore driving the solution debate? For example do we need daily dealing and pricing in DC pensions? It s hard to think of another instance where a savings product was so explicitly capable of capturing an illiquidity premium, but so singularly failed to do so, for no obvious reason and to no obvious benefit to the participants. 5

6 We no longer lack intellectual rigour in DC investment design. What we seem to be lacking today is the right mind set across the industry to deliver change. We need to move beyond putting up lazy barriers to change. To finish on an analogy, most individuals don t really understand the medical treatments that are recommended to them, but they do trust the professional recommending it and they broadly understand what the outcome is supposed to be. Why should investing be any different? Important Information: The views and opinions contained herein are those of Stephen Bowles, Head of Defined Contribution and David Heathcock, Head of Life Company Operations at Schroders, and do not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.. This document is not suitable for retail clients. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Limited (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA Registration No England Authorised and regulated by the Financial Services Authority. For your security, communications may be taped or monitored. 6