The long-term success of the group money purchase market could rest on how well defined contribution providers deal with the issues that will inevitably arise during the current period of volatility and negative returns
The trend away from defined benefit (DB) schemes in favour of defined contribution (DC) stakeholder and contracted-in money purchase schemes (Cimps) is accelerating at a time of volatile markets and negative returns. This will prove a tough test for the systems DC providers and trustees have put in place to identify and sack underperforming investment managers.
Where the managers do an acceptable job but markets are falling, it will also raise questions over the influence of disgruntled, but perhaps unsophisticated, scheme members who may associate short-term poor performance with the managers rather than the markets. How well providers deal with these issues may dictate the long-term success of the group money-purchase market.
What providers need to offer, and employers and scheme members should demand as a right, is a robust, quantifiable system for each stage of the monitoring process. It is important that DC schemes establish and maintain a clear line of communication with scheme members on this issue.
The education of DC scheme members has long been recognised as a priority by leading providers but this task was never going to prove easy. It is particularly difficult where the scheme is launched at a time of falling markets. All the glossy brochures in the world are not going to appease employees whose unit-linked funds are worth less at the end of the year than the contributions paid, unless they can be made comfortable with the concept of volatility and can understand the difference between absolute and relative returns.
The selection of asset managers based on demonstrable expertise is comparatively easy to explain. What is more difficult to manage and document is the deselection process. A good monitoring system will incorporate a series of triggers that require further investigation and, in some cases, almost certain dismissal.
The most obvious trigger is a significant change in personnel. Unfortunately, many funds are suffering a double blow at present because the volatility of investment markets is matched by the volatility of investment managers. Not a week goes by without the press reporting the sudden disappearance of yet another star manager who will spend the required six months or so on gardening leave only to re-emerge in charge of a new hedge fund. When a lead manager resigns, a damage limitation exercise may be possible. When whole teams defect, the damage may be irreparable.
In the US, under ERISA pensions law, a significant change in personnel is an automatic trigger to cancel the contract between the fund management group and the pension fund trustees. This is not yet the case in the UK. To avoid uncertainty, the contract between the manager and the provider or trustees must be explicit in setting the remit for the manager and the parameters in which investment decisions can be made.
One of the most serious problems identified in recent years is the habit some managers develop of investing well outside their brief and expertise. Ironically, this can lead to a sudden outperformance, which is cheered by all and prompts a rush of new clients. A monitoring system that tracks buying and selling patterns should spot such deviations a mile off and act quickly. But it is a brave adviser or trustee who sacks a manager who appears to be at his or her zenith.
In this context, it is important to consider to what extent those responsible for DC schemes should promote the appointment of high-profile fund managers to members. While there may be comfort value in knowing that your UK equity fund is run by a household name, this can be undermined by the fall from grace of said company.
It may be better if employees are encouraged to think in terms of asset classes rather than investment managers. This approach keeps scheme members' attention focused on the asset allocation of their pension funds and the importance of managing the allocation at different stages before retirement. It also allows those in charge of hiring and firing the managers to get on with their job without too much fuss. Under this system, the scheme members are asked to trust that those responsible will maintain the best managers for all asset classes and it will not be a matter of great significance if the UK equity manager changes from, for example, Merrill Lynch to Schroders.
This approach also helps to keep the number of funds on offer to a manageable level. A basic DC pension scheme should offer at least one fund for each major asset class, plus a lifestyle or default option that makes automatic asset allocation decisions for the scheme member. The more sophisticated schemes could offer different risk rated funds for each asset class and, if required, different styles.
The focus on asset classes will also deter the tendency of scheme members to invest in this year's star manager, even where the manager's style is too risky or the fund's underlying assets inappropriate for their age and the number of years to annuity conversion. The communication exercise need not go into great detail about each fund manager but instead can focus on the characteristics of each asset class and explain how members can utilise these to achieve their investment aims and maintain the appropriate balance between capital protection and capital growth.
Advisers who are involved in the choice of pension schemes should understand the nature of their responsibility towards scheme members and consider whether they could be held responsible for poor performance if the members decide to pursue the case through the courts. Litigation over fund performance is not uncommon in the US but is still rare in the UK. Given the way the UK follows trends in the US pension and investment market, some would argue that it is only a matter of time before UK pension funds (in the case of DB schemes) and scheme members (in the case of DC schemes) become more litigious. The recent appearance of Merrill Lynch in the docks is an understandable concern for the fund management industry.
To avoid litigation, it is vital to document the investment process with care. Trustees are required to draw up a statement of investment principles (SIP) with the aid of a professional adviser. It is essential that this adviser is appointed directly by the trustees and not by the sponsoring employer. The SIP sets out the investment aims, the balance between different kinds of suitable investments and the need for diversification between these investments. In the case of DC schemes, the SIP must also include details of the investment choice for members.
The documentation is particularly important in the context of the increasingly popular multi-manager services where the trustees appoint a third party to hire, monitor and fire the asset managers.
In this situation, while the trustees retain ultimate responsibility for the performance of the pension fund, they no longer have any direct contact with, or control over, the underlying managers. Instead, their concern is with the performance of the multi-manager provider.
To date, the pension lawyers have concluded that provided the selection of the managers, or the multi-manager provider, is prudent, the regulators and the courts should be satisfied the trustees have clearly discharged their duties and are not responsible for the performance of the fund.
The next article will examine how multi-manager stakeholder and Comp schemes can monitor performance and replace managers who fall short of their agreed remit.
Education of DC scheme members has long been recognised as a priority.
It is vital that employees understand the reasons behind short-term underperformance.
In the US, a change in investment personnel cancels contract between the fund manager and scheme trustees.
The forces at play in investment - most obviously, regulatory change, uncertain markets and shifting demographics - are as strong today as they were when Professional Adviser launched its sister magazine Multi-Asset Review in 2017.
Regulator has visited some firms already
Platforms react to Fidelity blocking Income Focus purchases
Chris Hill's letter to Treasury
Cash balance surges