A debate is taking place in the defined contribution (DC) pension world about the potential for investment in alternative and illiquid assets to improve member outcomes. 

By focusing on member outcomes, the debate starts from the right place. The job of a pension scheme is, after all, to provide enough money to fund members’ requirements when they retire. 

 

To achieve better member outcomes DC investments should be diversified but the current preoccupation with alternative and illiquid assets appears to be misplaced. Our research shows that many schemes are not nearly as diversified as they could be and that there is plenty of scope to spread risk and capture opportunities here before considering more exotic options.

This subject was discussed in our recent webinar about how to build better member outcomes in DC pension schemes. The session raised several points about asset allocation; with equities near record highs, inflation on the rise and the pandemic continuing to affect markets.

 

In the webinar we discussed the potential for complacency to creep into strategic asset allocation decisions, most likely driven by tremendous 10-year equity bull run in an era of ultra-low interest rates. But, past performance does not predict the future. 

 

 


Equity portfolio allocation by country

Data from Mercer’s European Asset Allocation Insights 2021 shows that developed markets make up 87% of UK schemes’ equity allocations with only small allocations to other sectors such as emerging markets.

 

A quick look under the bonnet indicates concentration risk built into these strategies. For example, the United States accounts for more than half of global equities and the US market has become dominated by a small group of technology stocks. This makes UK pension savers disproportionately reliant on the judgement of a few US chief executives.

 

Looking beyond their equity portfolios DC schemes should be market-aware and dynamic when it comes to asset allocation. This means considering regularly whether your strategy is positioned to capture medium-term market dislocations. Of course, the ability to select and monitor the components of portfolios depends a great deal on the size of a scheme’s governance budget.

 

It’s therefore no surprise that many UK DC schemes rely on diversified growth funds (DGFs) to gain access to different asset classes. It is critical to make sure these funds offer true diversification and access to the return drivers you require.

equity portfolio allocation

Core vs idiosyncratic diversified growth funds

 

Our European Asset Allocation Insights data also shows that just under half of UK schemes invest in core DGFs with the average scheme allocation approaching a sizeable 40%. But not all DGFs are as diversified as others, many of these funds have a high correlation to major equity markets.

 

If you want to diversify away from more traditional assets to meet your objectives then picking the right DGF is critical. Idiosyncratic DGFs are far less correlated to standard equity markets as they incorporate different return drivers, although this does come at the cost of higher management fees. In contrast to the core DGF data, we found that only 3% of schemes have exposure to idiosyncratic DGFs.

core vs idiosyncratic

Some large schemes will have the resources to blend their own individual asset class allocations but most schemes will need help in making these judgements. When deciding who should advise you, consider whether consultants have a dedicated global research function that is forward-looking.

 

Some points you will need to consider are when markets will reach an inflexion point, the outlook for inflation, the potential effects of the pandemic and the climate emergency. A set and forget strategy is always risky and, given the current climate, now is a good time to review your asset allocation and protect member outcomes.

 

In addition to the above, other option is for schemes to outsource their investment strategy implementation. This path combines the purity of asset allocation with far less implementation and governance burden for the scheme. Once this route is considered, some schemes may decide that their members are best served by opting for a master trust solution.

 

In summary, we believe there is still plenty of scope for DC schemes to introduce more diversification before the alternative and illiquid assets currently under discussion. This includes diversifying exposures within the equity investments that make up the bulk of their portfolios.

 


In the current market context, we would advise trustee boards to review investment strategies to ensure they are positioned to achieve the right outcomes for members. Standing still is not an option.

Phil Parkinson
Head of DC

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