How diverse are DC default strategies?

Punter Southall Aspire has published a report looking at the disparities in DC default fund approaches. Kim Kaveh analyses the data.

As the majority of defined contribution (DC) members are saving into their scheme’s default fund, provider decisions on how to structure these strategies will have a significant impact on member outcomes.

According to research conducted by Punter Southall Aspire, published last month, DC providers have taken very different investment approaches in the growth and consolidation phases.

Funds varied in design and construction, investment risk and volatility, asset allocation strategy, return benchmarks, management and, most notably, performance.

Split into two sections, Punter Southall’s analysis – based on data from sister company CAMRADATA – examined the growth and consolidation phases of nine contract-based schemes across eight providers in the market as at 31 March 2019: Aegon, Aviva, Fidelity, Legal & General (L&G), Royal London, Scottish Widows, Standard Life Investments, and Zurich.

The funds had assets under management of between £940m and £14bn, depending mainly on their launch dates, which ranged from 2006 to 2018.

Performance data in the growth phase for the three years to 31 March 2019 showed that Fidelity’s default had the highest returns at 11.37%, closely followed by Zurich at 11.33%. A similar story played out over one year, although flipped, with Zurich generating 9.51% in returns, followed by Fidelity, at 8.32%.

Interestingly, the smallest funds were Zurich’s at £944m, and Fidelity’s, at £1.3bn. L&G and Scottish Widows had the biggest funds, both at around £14bn.

At the other end of the spectrum were Standard Life’s default which generated 5.43% in returns over three years and Royal London, at 8.44%. The lowest returns over one year were from Standard Life at 3.32%, and Scottish Widows at 5.04%.

It is important to note that one-year data does not necessarily provide a reliable insight into a particular fund’s prospects for performing well in the future, as it does not reveal enough information about a scheme’s ability to guide an investment portfolio through a full market cycle.

Risk levels

Allocation to equities, bonds and other asset classes varied dramatically between the default funds, depending mainly on the targeted risk levels and the range of investment tools used, and this helps to explain some of the variance in performance.

While Zurich’s fund did not have the highest level of three-year risk, at 8.43%, this was higher than average, with a 79% allocation to equities. Meanwhile, Standard Life adopted the lowest level of risk at 5.23%, with a 42% allocation to equities.

However, it did not necessarily correlate that higher equity exposure meant more returns. L&G had the lowest exposure at around 35% of its total asset allocation, but had 9.14% in returns over three years.

In general, the growth phase of the average default option was designed with significant exposure to equities to maximise growth, Punter Southall Aspire found. The average allocation to equities among the defaults was around 66%, with Scottish Widows’ and Fidelity’s defaults having the highest exposure at 85%.

The default options also held a significant portion of fixed income assets, with an average allocation of 25%. L&G had the highest allocation to fixed income at 45%, while Royal London had just a 6% allocation to this asset class.

Most of the defaults did not use alternative investments, mainly due to cost constraints as a result of the 0.75% DC charge cap.

The average percentage of the overall allocation to alternative investments was almost 6%, with Standard Life and Royal London placing the highest weights, at 24% and 18% respectively. The alternative investments included allocations to commodities, property and absolute return strategies.

Consolidation phase

Punter Southall Aspire also analysed returns over the consolidation phase – which covered five years before retirement – and at-retirement default fund portfolios.

L&G’s default fund had the highest returns over the three-year period in the consolidation phase with 9.14% in returns, although at a relatively higher level of risk (6.5%) compared to the other defaults. This was followed by Aviva’s Future Focus 2 Fund, used for its Unisure platform, which had 8.78% in returns, relative to 6.12% risk.

The lowest return was from Standard Life’s default at 5.07%, relative to the risk taken (4.77%). This was followed by Royal London at 5.20% relative to risk taken (4.04%), and Fidelity at 5.45% relative to risk taken, which was 4.40%.

Meanwhile for the three-year returns at the at-retirement stage, L&G had the highest at 9.14%, although at a relatively higher level of risk, at 6.50%. Royal London produced the lowest return (2.56%), relative to the risk taken (4.18%).

The report also noted that the more diversified and sophisticated the default option, the higher the total cost. Therefore, providers need to ensure consistent performance and efficient protection from market volatility to create value for money and justify the higher fees.

Chief executive Steve Butler says that, as Independent Governance Committees – which scrutinise contract-based schemes for various approaches including investment – govern the funds analysed, it would be expected that they would all be quite similar in their approaches, but are clearly not.

He said: “I think the thing that stands out the most to me is that, in the growth stage, how much variance there is in the amount of equities.”

He also noted that another risk is that most people do not know when they are going to retire.

“Basing an investment strategy on targeting a very specific day, and to have the right investment structure when you don’t know when that day is going to be, is quite dangerous.

“The danger is, a lot of the funds would reduce your equity risk as you approach retirement, and they might reduce that risk over a 10-year period. If you decide to work for another 10 years, you’ve de-risked unnecessarily; you’d lose more money by de-risking too early than anything less.”

Furthermore, Butler noted that businesses must have strong communication efforts to get people to think about when they are going to retire, all of the things they need to plan retirement appropriately, and then “providers can match the investment strategy off the back of people actively communicating”.