Defaults and DGFs – the balance of prudence

Long before the Pensions Regulator introduced the concept of Integrated Risk Management, trustees balanced covenant, funding and investment risk. In order to attempt to achieve that balance, increasingly in the last 10 years, trustees have considered investment in Diversified Growth Funds (DGF’s), which seek to provide equity like returns without the volatility. The issue with volatility for DB schemes being the need to mark to market triennially and the potential for having to disinvest at a poor point in the equity cycle (ie. when they are down).

I am going to park whether they (DGFs) actually do their job for the time being (that is subject of another day/blog).

The natural extension of trusteeship thinking was to consider applying the logic of “smoothed positive returns” to their DC default arrangement. This is what many trustee boards have done. They have implemented a default strategy using a DGF engine for growth which is lifestyled to cash/gilts for decumulation (the correct method for that is probably again another blog).

The question for today is, does this benefit the member? The Trustee has an obligation to look for best/good member outcomes and Value for Money (VFM). These phrases are repeated in Code of Practice 13 (covering DC Governance) in several places.

Is a fund that tries to manage volatility targeting the best outcome, or just trying to avoid the worst? With most defaults lifestyled, is the cyclical volatility of equity risk not already managed by a staged exit? With a mixture of lifestyling and DGFs the Trustee may ensure the member doesn’t get the worst returns, but it will certainly restrict the potential of the optimal outcome. There seems to be an element of double prudence in this approach.

Then there is VFM. The DGF probably costs between 50 and 75 basis points. This, against 20 to 30 basis points for a passive equity tracker. Is the downside protection worth this cost? The Trustee could construct a simple growth engine for half the cost of the DGF. Is this strategy providing VFM?

DGFs have had a rough relative ride with recent bull equity markets. Trustees need to consider the input that goes in to model for such funds, not just what comes out at the other side. The DC member wants to maximise their fund, they are not looking for liability focused DB thinking. Those members who were defaulted into DGFs returned as low as 1-2% when equities were 20%+. That is some differential to explain in your Chair’s Statement.

From recent experience, trustees are frequently looking to tinker with what is in place, rather than look at a fundamental default review. The Trustee should be mindful of ensuring the decisions of their predecessors remain sound, or if a more significant change is required. The responsibility to the members should not be sacrificed for tick-box consideration. A clear transparent strategy which is low cost and with an element of diversification is not difficult to achieve or maintain.

Chris Roberts
Chris Roberts

Chris' experience includes complex investment strategy reviews, scheme wind ups, PPF transitions, defined contribution trusteeship, working with overseas parents and negotiating complex recovery plans.