PENSION FUNDS – DB to DC
Retirement-date funds give pension provider more choice on asset allocation, writes Alex Catalano
There was great excitement when NEST, the government’s not-for-profit workplace pensions provider, announced that it was allocating 20% of its investment to real estate. In the UK, defined contributions pension schemes typically put very little money – maybe just 1% – into the asset class, so the prospect of tapping into a rich seam of capital had real estate fund managers buzzing.
“We think diversification and managing risk is important,” says Mark Fawcett, NEST’s chief investment officer. “What we are looking to do is build up a range of assets that give us the tools to do that. “We had a very strong competition with managers that could meet our operational requirements of daily liquidity.”
The 20% property allocation is for NEST’s ‘growth phase’ funds (see panel below); for foundation phase funds, the allocation is lower, at around 14%. However, these allocations will change as NEST brings other asset classes on board and manages risk. “So people shouldn’t assume that we’ll be 20% in real estate forever,” says Fawcett.
NEST’s real estate investment mandate went to Legal & General, which proposed a hybrid of its balanced UK property fund and its global REITs fund. NEST’s initial search involved separate mandates.
“The fact that we ended up choosing a vehicle that combined them was irrelevant, in that L&G won both sides of the competition – the direct UK and the global REITs,” says Fawcett.
NEST evaluated the managers on a variety of factors “including investment philosophy; was it coherent and did the investment process match up to it?” says Fawcett.
NEST’s key questions for managers
Other questions NEST asked of managers were: “How do they manage risk? How do they manage environmental, social and corporate governance risk, and particularly, how sustainable is that approach to real estate investment? And, obviously, did they have a strong team in place?
“Also, were we vulnerable to key-man risk, or was there a depth and breadth of experience? L&G scored strongly on all those factors,”says Fawcett. Industry gossip says that SWIP and Standard Life gave L&G the closest run for its money.
NEST’s investment in L&G’s funds hybrid is split 70:30 to direct UK property and global REITs respectively. That was what the pension provider’s asset allocation model spat out for pretty much all the scenarios it was fed.
But there were other factors that resulted in the bias to direct UK property: a UK inflation benchmark was one; good corporate governance another. In a fund, the manager – L&G, in this case – owns the properties on behalf of its client and manages them. “Whereas when you’re investing in REITs, the fund is investing in shares, and the properties are managed by the REITs, so we are slightly less close to the governance structure,” says Fawcett.
There has been a certain amount of backbiting and speculation about how much L&G will be paid. NEST doesn’t reveal details of the fund management fees it is paying, but Fawcett says: “Our annual management charge to members is 30bps.”
That includes the fund managers’ total expense ratio, not just their management fees (NEST is also charging members an 180bps fee on new contributions, until the set-up costs of the scheme are covered).
Performance fees have been ruled out for the foreseeable future. “I find such fees difficult both operationally and philosophically,” notes Fawcett. “Clearly 30bps is a low fee and therefore we have to seek very competitive fees from our fund managers,” he adds. “The gratifying thing is that every time we run a competition for a mandate, we get a high response rate.
Competitive fees not a deal-breaker
“So people know fees have to be competitive and that doesn’t discourage them from participating and wanting to be one of our managers. It’s great news. I think people realise NEST wants to deliver high-quality, low-cost pensions and the fund management industry is rising to the challenge.”
NEST wants to include other ‘real’ assets, but there are obstacles to overcome. Investing in infrastructure, for example, requires committing fairly hefty chunks of capital and NEST is still a tiddler, with only £30m of assets under management.
More to the point, the vehicles that can deal with DC pension funds’ requirements – such as daily liquidity – don’t exist. “That’s a challenge for social housing, infrastructure and any other real or less liquid assets – having both the operational structure in place and a sufficiently good understanding with the investment manager of how it is going to work,” says Fawcett.
“We hope to bring it in the next year or so. We haven’t seen any solution yet that can handle DC in a reasonable way, but I believe managers are trying to work towards that.
“With real estate, we’re now investing in 14, 15 asset classes. I think we’ve got a pretty full tool box. Things like infrastructure and social housing would be nice to have, but we’re in a position where we probably have a more diversified fund than the vast majority of default funds.”
Workplace auto-enrollment will gradually build up NEST egg
NEST – the National Employment Saving Trust – was set up two years ago as part of the government’s move to introduce auto-enrollment in pension schemes. The non-profit organisation runs DC pension schemes for both employers and individuals.
Since NEST opened for business a year ago, 1,000 employers have signed up and there are just under 500,000 members. The trust now manages around £30m of assets, but significant growth is expected.
Workplace auto-enrollment is expected to create 11m more savers and NEST is hoping to capture a big chunk of their contributions.
Its main pension products – the default option that most people will chose – are the retirement-date funds. Members’ money is invested in a fund that is based on the date they expect to reach the state pension age.
The funds invest in three phases, depending on how close the retirement date is. The initial, foundation phase lasts about five years, followed by a growth phase of about 30 years.
The latter consolidation phase comes when a member is about 10 years away from retirement and aims to prepare the pension pot for when the member takes it out.
“People who don’t want the retirement- date funds can invest in others,” notes NEST chief investment officer Mark Fawcett.
Currently, NEST offers five other options: an ethical fund; a Sharia fund; a higher-risk fund; a lower growth fund; and a pre- retirement fund, for people who start investing with NEST when they are only a few years off their retirement date.
“We haven’t yet decided to offer the individual asset classes as funds, because our research shows that there is no demand for that,” Fawcett says. “Why should we expect our members to be investment experts? That’s our job – to give them a good, diversified portfolio and manage the risk in that portfolio.”
Asset allocation will vary to fit funds’ phases
NEST’s asset allocation process is similar to those used by DB schemes. There is a “relatively complex” asset allocation model, says investment head Mark Fawcett, which factors in the outlook for returns, expected volatilities, correlations between different asset classes and also how much of its ‘risk budget’ NEST wants to use.
“We get a variety of different allocations for different levels of risk and our exposure to real assets and real estate in particular comes out of that,” Fawcett adds.
A quarterly meeting reviews the asset allocations. “That ties in with our investment committee cycle. So far we have introduced two new asset classes, first, corporate bonds and more recently, real estate. We’ve had one change in the allocation, due to raising the amount of the risk budget that we used last autumn.
“We’re not trying to time the market, so changes are not too frequent, but as we add asset classes or there’s a change in the risk environment, we will vary the allocation.”
The pensions in NEST are mainly in retirement-date funds and invest in three stages (see panel). The foundation phase, for younger members, aims to preserve capital and avoid investment shocks; the growth phase, the longest, is where most members will be; and the consolidation phase is for when members are heading towards retirement.
“The 30 odd funds in the growth phase will all have broadly similar allocations and that will vary over time,” says Fawcett. “The foundation phase has a significantly different allocation and in the consolidation phase we de-risk for people.
“For growth-stage funds, we have a risk budget of roughly 8-14% and can vary the amount of risk – as measured by volatility – between those levels. It doesn’t mean we’ll never go outside those, but it’s our comfort zone.”
NEST can also vary the asset allocations for each retirement-date fund. “We imagine certain
growth-phase funds will have different asset allocations, because we’re varying the risk compared to other funds.
“You could see a situation where a few cohorts of members have done particularly well in a bull market, so the investment committee decides it’s time to start de- risking and enter the
consolidation phase early to bag those gains,” says Fawcett.
“It just doesn’t make sense to me to start de-risking at the same point before retirement for every single cohort. That will happen over time, but at the moment we only have two years of investment and it’s hard to say whether anyone’s done particularly well.”