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Strange brew without active management

Many commentators have suggested the only viable investment style for stakeholder pensions is passive management.

I would argue that act ive management not only has a role to play but will be an ess ential ingredient in making stakeholder attractive to pro viders, advisers and investors.

It has been the contention of many that, as providers will need to be competitive on charges, so stakeholder products will offer only index-trac king investment options. What is more, passively managed funds have other advantages. Many find them easier to understand – and to explain – than actively-managed funds. They are also regarded by many as low risk as they should not expose members to the risk of underperformance.

So is active man agement irrelevant for stakeholder? I think not. While cost is a key issue, it should not be the only factor. Offering only passive inv estment has potential disadvanta ges for members and pro vi ders.

Most important, of course, members lose the opportunity to achieve higher returns through active management. Or, from a bear&#39s perspective, they lose the opportunity to limit the effect of market falls on their investment.

A provider choosing to offer only a passive product limits its ability to differentiate that product from those of its competitors. This increases the pressure to compete on other factors, particularly char ges, potentially leading to lower profitability.

Also, many providers offering index tracking for the first time will be faced with the challenge of achieving the critical mass needed to ensure accurate tracking while managing the performance distortions caused by new cash flows. Outsourcing to an est ablished index fund manager may solve this but this is likely to impact on cost competitiveness. Also, the tracking performance of some existing providers has not been as accurate as one might hope.

Despite the advantage to the member of potentially higher returns from active management, providers and trustees of stakeholder sch emes will rightly be concer ned about the risk of underperformance of the manager&#39s in-house funds. Trustees and employers will be concerned about the potential impact on members&#39 benefits and may also be limited in their ability to charge the costs of changing managers to the scheme.

A solution to this, popular in the US and becoming quite common in the UK, is the use of multi-manager structures. While this does not remove the risk of underperformance from active management, it does give members the opportunity of changing investment manager and/or investment style without having to uproot the entire contract.

It also enables stakeholder members to have access to fund management groups that have chosen not to establish themselves as stakeholder providers. This latter point may increase in relevance if, as many expect, the stakeholder market becomes concentrated in the hands of a few large players.

In fact, without the use of multi-manager structures, this concentration may be against investors&#39 interests as it will limit the available choice of investment.

Providers offering multi-manager funds will benefit from the reduced risk of losing business through poor performance. They also gain the opportunity to improve their product differentiation and so perhaps margins.

In order to maximise these advantages, providers will need to ensure the range of managers and styles is div erse. There is little merit in offering a range of managers which are likely to perform similarly, so reducing the ability of the member to switch managers to improve performance.

But what about the cost? Including active management will clearly increase overheads. Outsourcing it and spreading it across a range of managers is likely to be more expensive than managing it in house.

Given the uncertainty over volumes, providers can be forgiven for being nervous about taking on additional external costs until they are certain they will be able to cover their own expenses.

Costs can be mitigated through the use of existing pooled funds although the rigid requirements for how these funds are managed, priced and charged may present a challenge for some managers. Pooled funds ess entially need to be single-priced, deal daily and, for maximum flexibility, be free of all charges at the fund level. This allows the stakeholder provider to reprice the fund as it sees fit.

Our discussions at Phillips & Drew with a number of pot ential stakeholder provi ders have led us to believe not only that a multi-manager structure is affordable for stakeholder but that some providers will be offering it from next April . We expect this type of arrangement will grow in popularity as and when the market expands and providers have more certainty about their likely success. Investment managers will also want to ensure they tie-up with stakeholder providers that are likely to deliver strong growth in assets.

Costs will always be an issue and are likely to require compromises by both sides. Stakeholder providers will need to recognise the value of offering a range of external managers in terms of benefits to members, product differentiation and business risk red uction. Investment managers will need to recognise the cost pressures and uncertainties facing stakeholder providers and to be prepared to share some of the risk that asset volumes might fall short of exp ectations, so reducing revenues for both parties.

Finally, from an adviser&#39s perspective, stakeholder products that offer only passive funds present a much reduced opportunity to offer advice to members and employers on the merits of different products and/or funds.

Given that the willingness of investors to meet additional advice costs may be limited, this may be seen as an advantage by some. Hopefully, others will recognise the benefits to members of the multi-manager approach and develop their advice accordingly.


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