Jiten Parekh, partner, and Jo Sharples, chief investment officer, DC Solutions, Aon explore the latest trends in DC default investment strategies
Defined contribution (DC) schemes’ default investment options are coming under ever greater scrutiny. From the Financial Conduct Authority’s value for money framework, to the government’s ongoing pensions review, investment strategies are firmly in the spotlight.
How a DC scheme manages its investments directly affects members’ savings. For example, the difference in 2023 between the top performing and lower performing master trusts’ five-yearly returns was over four percent a year. Across the whole of a working life, that could mean as much as 50 percent variation in a member’s income at retirement.
Schemes are beginning to respond. Aon’s 2024 Defined Contribution Survey, Five Steps to Better Workplace Pensions, found that almost a third (32 percent) of respondents intend to review their scheme’s investment strategy over the next year. Value for money is likely to be a major component of that review, with 61 percent of respondents saying that ensuring their DC scheme delivers good value for money is a key priority.
Aon surveyed 214 respondents involved in running DC schemes, including trustees, pension managers and HR professionals. Overall, they are responsible for combined assets of over £60 billion and represent more than a million DC savers.
Our findings show that, although DC schemes are evolving their approach to default investment, there is still work to do when it comes to evaluating performance, meeting members’ needs and exploring a wider mix of asset classes.
Default Strategies Need Scheme-Specific Goals
As schemes grow their assets under management, and more employees become increasingly reliant on DC savings to fund their retirement, default investment design needs to be based on a clear understanding of what the strategy needs to achieve for its members. Although only 12 percent of respondents monitor their default investment option against tailored scheme-specific targets, this is the best way of understanding if it is on track to deliver a good outcome for members across their working lives.
To make sure that the default strategy is meeting its targets, schemes need to be able to assess aggregate returns across all their investments. However, only 29 percent of respondents said they are currently doing that, compared to the 70 percent that monitor separate component funds against benchmarks.
By monitoring component fund performance only, schemes are missing the bigger picture of whether the default strategy is helping members remain on track to achieve their retirement goals.
Broadening Investment Options
Value for money in pensions is now a key focus, but good value is not the same as low cost. Over time, we have seen the annual investment charges that members pay for the default option fall- the median is now 0.28 percent. But this needs to be seen in the wider context of the default investment strategy. Low costs may mean members are missing out on opportunities that would deliver better returns over the long term.
For example, the UK government wants to encourage DC schemes to invest more in illiquid assets such as infrastructure and private markets, with the aim of boosting both returns for members and economic activity in the UK. This could mean better outcomes over the long term but is likely to mean an increase in investment charges.
Deciding whether to invest in more diverse assets such as illiquids will ultimately be a scheme-specific choice. Default investment strategies must remain focused on member needs and outcomes, and that means schemes need a clear understanding of what they want to achieve through illiquid investments. Making sure that they offer genuine diversification and add value to the investment strategy will be crucial, as will working with investment managers with the right skills to identify and act on opportunities.
Although 10 percent of DC schemes are already investing in illiquid assets and a further 25 percent intend to, many schemes remain unsure or undecided about their role. A quarter of respondents said they did not know if their scheme was considering illiquid assets, and 39 percent said this was not under consideration at all.
The majority of members rely on the default investment option, and in most cases the default looking to target just ‘growth’ is no longer fit for purpose. A more thoughtful approach is needed, one that identifies what income members require at retirement, and uses that as the target against which the default performance is measured both in terms of returns and volatility – something becomes ever more important as members pots grow.
Download Aon’s 2024 DC Pension Scheme Survey here.