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The lower volatility of ultra-diversified absolute return funds can allow pension investors to stay in growth assets longer says Andy Dickson, investment director, UK business development, Standard Life Investments

Several convergent forces are driving the need to revisit DC default fund design. Falling bond yields and equity markets highlight major shortcomings in current DC default fund provision, and regulatory change hastens the need to act. Trustees and plan sponsors are searching for new and innovative strategies to competently navigate market, inflation and longevity risks, in order to ensure scheme members’ savings goals are reached.

As it currently stands, DC default provision in the UK is skewed firmly towards a passive investment approach. This is particularly true of larger schemes, where passive funds comprise an estimated 65 to 85 per cent of total assets. Why this bias?

Cost is an obvious explanation, given the premium paid for active fund management. Certainly recent experience would appear to validate this stance, as the traditional approach to active management has, of late, proved no more effective at avoiding substantial losses than a passive strategy, especially after fees. Even knowing that a manager has materially beaten the benchmark offers scant consolation to members disappointed at their retirement outcome if the market has fallen to the extent it did in 2008.

Crucially the same critical flaw resides in both active and passive designs; both are susceptible to extreme market swings that can obliterate in a moment the gradual returns achieved over a decade. Importantly, it is the decisions made regarding asset allocation that both dominate this risk and govern the broad return potential of most investment solutions. For this reason, DC decision-makers increasingly argue that asset allocation, not active security selection, is where active management could be of greatest benefit. Traditionally, balanced funds attempted to address this need but there are forceful arguments for active asset allocation to play a far greater role in DC default plans than has historically been the case.

Increasingly evident too, is the need for DC default fund designs to offer sufficient flexibility in accommodating rising longevity, and changing work/life/ retirement preferences that deviate from historical patterns

Increasingly evident too, is the need for DC default fund designs to offer sufficient flexibility in accommodating rising longevity, and changing work/life/retirement preferences that deviate from historical patterns. The lifestyling approach typically used for DC default investments often rigidly shifts risk rather than reducing it. Typically, switching members from equities to government bonds as they near retirement is intended to increase the certainty of income purchasable through an annuity. However, a delay to retirement plans or a subsequent period of high inflation could result in the income being worth much less than it might otherwise. Furthermore, the lifestyle fund shift to lower return assets at a time when an individual’s pension pot is reaching material size heavily impacts return prospects, meaning far more must be saved each year to achieve that person’s retirement goals. Impending auto-enrolment makes it even more crucial for DC schemes to provide a default fund option that satisfies a growing range of members’ investment needs, and can cope as those needs develop over time.

Investment managers have recognised these requirements and moved to address the historical weakness of balanced funds, specifically their limited ability to manoeuvre between assets. There are now several more actively managed diversified growth approaches that aim to further diversify risk across equities, bonds, property and assorted other growth-related assets. But the limited recent success of these solutions in delivering durable diversity and the persistent instability and uncertainty of economic growth since the financial crisis has driven even greater ingenuity.

Hence the great interest in the ultra-diversified approach taken by some absolute return funds that can navigate the uncertainty of markets, while delivering returns and dampening volatility. Some are designed specifically for pension funds to target specific returns with controlled levels of risk and high liquidity. Such AR funds are ideally suited to take advantage of market, inflation and volatility risks, and deliver expected retirement outcomes. To achieve this, AR funds not only invest in traditional asset classes such as equities, bonds and property, but may also use advanced asset classes such as duration, inflation and volatility, thus unlocking a far wider range of return-generating strategies than is available to traditional funds. A good AR fund can carefully construct a portfolio of strategies that work well together, but are not all correlated, to effectively spread risk and smooth investment returns irrespective of market conditions.

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