How is the fund charge landscape likely to change in a 75bp world? Simon Chinnery, UK Head of DC, J.P. Morgan Asset Management, takes a view
‘We are where we are’ and it’s generally accepted why there is a price cap. Introducing all these new savers into the complex/murky world of pensions meant price would always be the main instrument to bang the drum with the cry ‘value for money’ echoing round the hills.
Easy for passive managers to get well beneath the price cap and with NEST as the benchmark, plenty of chest thumping around making it even cheaper with testosterone-charged cries of ‘bring on 50bps’!
But the introduction of this charge cap has highlighted the importance of selecting a default fund that is flexible and capable of adapting to the rapidly evolving world of pensions – in an inexpensive way.
There are multiple risks in DC and traditional designs have been rather Stone Age in their investment structure with high but pretty undiversified equity exposure for most of the investment journey, then a steep de-risk to gilts and cash. This has, and will, lead to a wide dispersion of returns and outcomes for members – not ideal. However, there is light at the end of the tunnel; greater diversification and greater flexibility.
Incorporating more diversification helps mitigate against equity volatility and can deliver good risk-adjusted growth with more members getting a better overall rate of return. Diversified growth funds of various hues have provided some diversification, albeit it many dampen down volatility perhaps to the longer term detriment of growth needed.
Currently the most common form of default fund for pension schemes is life-cycle. When first introduced, there was a prevailing expectation for equity investments to deliver an impressive 8% to 10% or more per year, with little attention paid to downside exposure. However, times have certainly changed.
Risks like longevity, inflation, interest rate and market volatility are not only multifaceted, but truly dynamic in that they ebb and flow in terms of their influence on a members’ portfolio. In addition, drawdown risk becomes greater near retirement, when assets are at their largest and consequently most vulnerable, so managing this risk is imperative. This means that glide paths that lack sufficient diversification may be forced into a concentration of risks and lack the flexibility to do anything about them.
If price is driven too low, the ability to access active strategies that have proven benefits in the world of defined benefit and wealth management will be limited or curtailed completely. We have undertaken research in the US into prioritising one risk in glide path design and have included funds that are concentrated, fee-sensitive passively managed strategies, run in the belief that this is a more efficient way to invest longer term. However this means that the portfolio is often more constrained in asset class choices, since certain types of investment are difficult or costly to access passively. We found that these less diversified glide paths can increase market and event risk, longevity risk and inflation risk i.e. not the best outcomes for those looking to retire.
These contrast with the way we think risks should be managed; dynamically, adjusting over time, as various risks rise and fall in magnitude across the glidepath. There needs to be greater diversification with greater exposure to extended and alternative asset classes.
So, how is the landscape likely to change in a 75bp world? The DC default investment model is quickly evolving beyond mechanistic lifecycle structures – there is a move towards more sophisticated target date fund solutions, which can still offer returns in a lower yield and lower fee world. I suspect we will see a further push for a charge cap to be more widely applied across the industry. Is this the right approach? Making sure end investors are not being ‘ripped off’ is critical but if income replacement levels fall, I still have a niggle- cheap investments for members but at what cost?
J.P. Morgan Asset Management