DC Default Funds Overly Exposed to Stock Market Volatility

Jul 14, 2020 | Member Blog, News

Andrew Brown

Andrew Brown, Andrew Brown, Columbia Threadneedle Investments

There is a general view that UK Defined Contribution (DC) default funds lack sophistication, certainly relative to their Defined Benefit (DB) counterparts and some more mature DC markets across the globe. Against the backdrop of today’s highly volatile markets and given that the short- to medium-term future is so uncertain, an appraisal of the investment strategies used by many UK DC schemes is certainly warranted as they become increasingly tested.

The shape of any market recovery after a large setback will be the focus for those looking to make forecasts, take advantage or protect their investments. Are we headed for a V-shaped recovery where markets bounce back quickly? A more protracted U-shaped recovery? Or a very protracted L-shaped recovery (following a 1930s-style depression, when investors had to wait decades to break even in nominal terms). Thankfully the latter appears unlikely as asset prices, particularly US equities, have bounced back markedly (at the time of writing).

Schemes predominantly or wholly exposed to equity markets during the growth stage, relevant to younger members in particular, rely on the longer-term trend for stock markets to outperform. They bear the risk of further equity market declines (not unrealistic in the short term) and at the same time will seek to avoid action that potentially locks in any losses. This highlights the need for good governance and the mitigation of investment risks.

Perhaps this is an opportune moment for schemes to revisit their default fund and its composition while considering its resilience over the past few months. We can’t predict the future, though a diverse range of return drivers and risk premia will reduce the disparity of expected returns and the volatility experienced by members’ pension pots.

The investment case for less liquid assets within a default option is compelling: they are not subject to the same volatility drivers as listed equities, provide stable long-term income streams above inflation, and widen the range of potential investment opportunities. The latter point is increasingly important as the number of publicly listed companies has fallen by almost half in the US since the 1990s and by a third in the UK since 2006*.

Many DC schemes make use of multi-asset or diversified growth funds, particularly during the consolidation phase prior to retirement. They provide access to a wider range of asset classes and include varying degrees of dynamic asset allocation. Their merits have, somewhat unfairly, been the subject of debate in a period where auto-enrolment has coincided with the longest bull market in history, with passive equities until now providing strong returns. As we enter a period of slow global economic growth, or even contraction, an awareness of risk and the benefits of a wider range of asset classes will become increasingly important.

* https://www.theglobaleconomy.com/United-Kingdom/Listed_companies/

The asset managers that make up the DCIF are committed to promoting investment best practice within DC pension schemes.