Defined Contribution

DC: why market wobbles can lead to bad behaviour

17/11/2015

Our consumer research suggests that the August dive in markets – when the MSCI World Index lost 11% in a fortnight – has knocked the confidence of many DC savers. For those with a default fund heavily orientated towards equities, particularly the many in index funds, their pension pot will have taken a dive from which it has yet to recover.

While only the more alert DC members are likely to be aware of the impact of the market’s wobbles on their pensions, we think they should set alarm bells ringing for those who look after them on their behalf. DC trustees, independent governance committees and employers may struggle to explain to members that the volatility they have endured is a price worth paying to achieve the growth they need to meet their retirement ambitions. Even more so if there is little sign of recovery in sight by the time they have to report to members.

This can make life difficult for trustees and others charged with the duty of overseeing the scheme and, more particularly, the default fund. One thing that would make life much easier for schemes would be if the saver’s default fund could be managed to provide smoother returns in the first place. An investment vehicle that provided growth, while also aiming to reduce the trauma of turbulent markets, would vastly improve communication with members.

Most experts would probably acknowledge that a diversified portfolio is one of the best platforms for achieving the stable growth that many pension savers need. The ability to use a wide range of assets, from government bonds and equities to commodities and absolute return funds, should both improve the prospects for growth and reduce the likelihood of loss. 

But, however well designed initially, a rigidly diversified portfolio is seldom best positioned as the environment changes. Ideally, asset allocations should shift to address conditions as they are encountered. The only truly effective way of achieving such dynamism, we believe, is for the asset allocation to be actively managed. That way it can adopt a defensive position when the need arises – such as in August – and can be quickly readjusted to benefit from upward moves in asset prices when the market recovers.

We know that this sort of intelligent asset allocation is even more important for the typical investor than clever stock picking. It is why we think, in a world increasingly aware of costs, the limited fee budget available for the default fund is better spent on expertise in choosing the asset line-up than individual stocks. This can only really be provided if the fund is steered by expert managers.

Luckily, our experience is that all the dynamic features needed to run a successful diversified growth portfolio can be combined in a default that costs significantly less than the maximum fee mandated by the government’s charge cap. Indeed, by adopting innovative ways of gaining access to asset returns, we believe asset management fees can be reduced to less than 0.5%.

We think such a fund should generate fewer heart-stopping moments than a pure equity fund, but also provide a more intelligently-managed balance between risk and reward than a rigidly diversified growth fund. Using such an approach should make for a smoother journey for members (see chart). And that is important because, while investment risks may loom large in the short term, they are likely to prove much less serious than the risk of not achieving enough growth over the long term. We believe a dynamically-managed diversified growth portfolio can go a long way to ensuring the former do not fatally undermine the latter, helping to provide just the right balance for many savers in DC defaults.

This article is taken from the Winter 2015 edition of the Pension Newsletter to view click below.