How to analyse auto-enrolment default funds - January 2017 Accredited by - Nest Pensions
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How to analyse auto-enrolment default funds January 2017 Sponsor Accredited by
Contents
Target audience 3
Introduction 4
Learning objectives 5
Part 1 – Analysis of the key factors to 6
consider when reviewing default funds
Default fund due diligence checklist 10
Part 2 – Analysis of the most 11
commonly used default funds
Part 3 – NEST and its default fund 20
Conclusion 28
Test yourself for CPD 32
Acronyms
ABI Association of British Insurers
AMC Annual management charge
CIO Chief Investment Officer
CPI Consumer price index
DC Defined contribution
ESG Environmental, social and governance
FCA Financial Conduct Authority
IC Investment committee
IGC Investment governance committee
MVO Mean variance optimisation
NEST National Employment Savings Trust
TCF Treating customers fairly
TER Total expense ratio
TPR The Pensions Regulator
RPI Retail price index
UFPLS Uncrystallised funds pension lump sum
2
Target audience
This case study is written for professional financial
advisers and paraplanners responsible for researching and
recommending auto-enrolment pension schemes.
While not authorised to provide investment advice, this case study will also be of
interest to accountants and bookkeepers who are looking to provide their clients
with an enhanced service through the involvement of a regulated adviser and/or
by at least understanding what is available in the market to inform their clients.
This case study should not be considered as evidence to support any recommendations
or endorsement of any specific provider or scheme. Advisers should conduct their
own research and document their findings before recommending any solutions.
Authors
Patrick Norwood Richard Hulbert
Insight Analyst Insight Analyst
(Funds) (Wealth products)
pnorwood@defaqto.com rhulbert@defaqto.com
3
Introduction
In this case study we independently review the defined contribution
(DC) market place and more specifically the auto-enrolment
propositions and their default funds.
We highlight the key factors we feel advisers should understand, have an awareness of and be
considering when reviewing the default fund on offer, especially as historically 9 out of 10 savers have
remained in the default fund from inception to retirement.
Being able to recommend a scheme after evidence-based analysis of the default fund places financial
advisers in a very strong position with their client. We have split this case study into three parts:
1. Analysis of the key factors to consider when reviewing default funds
2. Comparison of the most commonly used default funds
3. Specific focus on the National Employment Savings Trust (NEST)
proposition
In the first part we set the scene with background This study will focus on the needs
information relating to the auto-enrolment of the first two groups.
scheme landscape, scheme structures and
variations. We then analyse and compare the The overarching need for regulated advisers
most commonly used default fund options is to be able to evidence ‘value for money’.
available, across several different criteria. Finally, This does not mean the cheapest solution,
we look at NEST’s default fund offering with the neither does it mean the best performing
objective of helping readers to understand their fund, but rather an assessment that includes
approach and positioning compared to peers. these elements but ultimately creates
a good outcome for the consumer.
Auto-enrolment has now been with us for over
three years, with some 200,000 large employers
having already gone through staging. The
market is now splitting into three groups:
Evidence
value for money
1. Employers still to stage: commonly
these have fewer than 30 employees
2. Employers who have already staged and
are dissatisfied with their current solution
3. Employers who have already staged and
are satisfied with their current solution
4
Learning objectives
This case study is accredited by the CII/PFS and CISI for up to 60
minutes of structured CPD.
Reading this publication will enable you to:
1 Understand the different default investment strategies available, focusing upon the
accumulation phase
2 Identify the main differentiating factors to be considered between the individual
default investment propositions including:
• The investment management procedures and responsibilities
• Implications of in-house and outsourced management
• Clarity, robustness and repeatability of decision making
• How defaults are performing against benchmarks and peers
• Suitability of the default and identifying value for money
3 Understand how the various default propositions in the market differ from each other
to support market research and due diligence
For clarification, NEST has commissioned
Defaqto to undertake this review of default funds
in the auto-enrolment pension scheme market
place. A comparison of the NEST proposition
with its peers will help advisers understand
how the proposition fits in the market.
To do this, Defaqto has detailed the independent
assessment criteria and factors advisers
should be considering and evidencing to
impartially research default funds as part of
their compliant due diligence process.
5
INSERT IMAGE
Part 1 – Analysis of the key
factors to consider when
reviewing default funds
Scene setting
With so many schemes available for the purpose of this study, we have focused on those most
commonly used based on the value of assets under their management, namely:
• Aegon • NOW Pensions
• Aviva • Prudential
• B&CE (The People’s Pension) • Royal London
• Friends Life • Scottish Widows
• Legal & General Investment • Standard Life
Managers (LGIM)
• NEST
6
Key factors to consider
Below are the key factors we believe should be considered:
1. Good governance, what this looks like and how it is evidenced
2. The provider’s financial strength and/or capability
3. The implications of
in-house and outsourced investment management
4. The investment management procedures and responsibilities
5. The clarity, robustness and repeatability of decision making
6. How defaults are performing against benchmarks and peers
7. The suitability of the default fund and identifying value for money
We will go into detail for factors 3 to 7 above, which are those that are most related to investment (the
main focus of this study).
The implications of in-house and outsourced investment
management
Researchers should look at the investment Independence is considered essential by both
committee that has the remit to run and manage regulators (FCA and TPR) to reduce the possibility
the default fund and ascertain what, if any, of any potential for conflicts of interests.
conflicts of interests exist and how ‘value for Indeed, the FCA has regulated that contract-
money’ is being evidenced. For example, if XYZ based schemes should have an independent
is the pension provider and the default fund governance committee (IGC) that must publicly
only invests in funds from XYZ, then this may report to members on at least an annual basis.
affect analysis of independence and costs.
The FCA has placed a duty on IGCs to
The implication for in-house arrangements is scrutinise the ‘value for money’. An IGC has
that there may be a greater chance of a conflict a minimum of five members, the majority
of interest existing between the provider’s of whom must be independent, including
needs and those who are invested in the an independent chair, and must:
default fund. In addition, without independent
oversight, it may be more difficult for those • Act solely in the interests of
making investment decisions and/or managing relevant scheme members
the funds to be removed easily or prudently. • Act independently of the provider
7
Factors IGCs must report on include:
• Assessing the ongoing ‘value for money’ of the workplace pension
scheme
• Acting solely in the interests of relevant scheme members (savers)
• Raising any concerns with the provider’s board
• Escalating their concerns to the FCA, if necessary
• Reporting annually on what they have done
The TPR guidance is less around independence in-house with elements such as investment
and evidencing ‘value for money’ and more management outsourced to independent third
around requiring trustees to have strong parties. It is not unusual to find some form
governance and protecting member’s of independent scrutiny and reporting being
interests. Full details can be found in the undertaken on the in-house decisions, and
DC code, and advisers should familiarise these reports can aid the selection process.
themselves with this before recommending
a trust-based scheme. It can be found at: Impartial oversight and/or outsourcing to
independent third parties does not necessarily
thepensionsregulator.gov.uk/codes/code- increase costs, indeed the opposite can
governance-administration-occupational- sometimes be true. Importantly, they provide
dc-trust-based-schemes.aspx managers and trustees with the ability to
appoint professionals to meet specific needs and
Many schemes are run on a hybrid basis, whereby target them accordingly, with failure potentially
the overall strategy is designed and managed resulting in their prompt replacement.
The investment management procedures and responsibilities
There are three elements to consider here:
Investment strategy Working practices Individuals involved
1) Investment strategy One should also understand the control checks
in place to make sure the working practices are
This is not a simple case of selecting a passive being followed correctly and comprehensively.
philosophy over an active one. The key is to
match the strategy to the profile of the employer
and its employees. For example, if the workforce 3) Individuals involved
is primarily within 10 years of retirement, a This could potentially be more of an issue
high-risk strategy is unlikely to be appropriate with smaller trust-based schemes.
for the members or indeed a predominance
of options in the higher risk universe. One should look at the control and
influence individuals have and whether
their knowledge, experience and expertise
2) Working practices
is sufficient to make such decisions.
How robust, repeatable and independent
As a final check, one should also consider if the
are the working practices used to govern
combined process works in the best interests
the investment strategy? How can this be
of members.
evidenced and what breaches and changes
have there been in recent years?
8
The clarity, robustness and repeatability of decision making
Having a clear, understandable and documented some funds have reached saturation points
decision-making process is essential. where their size makes it difficult for them
to trade competitively, for example selling
Advisers should be checking that there is a a £1m shareholding in a company is a lot
documented (freely available) clear structure easier than selling a £50m holding.
and decision-making process in place. Questions
should be asked about how the processes Advisers should be looking for schemes that
are managed and compliance checked. In are not necessarily constrained by their size,
particular, when exceptions have occurred, irrespective of their performance. Those
what impact have these had on savers? schemes that can facilitate investment through
diversification of asset classes and investment
The nature of auto-enrolment is that with managers are quite often better able to meet
capital growth and ongoing contributions, the this need. In other words, exposure to, say,
value of the funds under administration will the UK stock market is provided through more
grow quickly and significantly. Historically, than one asset class, fund and/or manager.
How defaults are performing against benchmarks and peers
Many of the factors we have discussed so Some providers combine options A, B
far are subjective, and not all providers will and/or C with D (a volatility band) and
be able to answer all of your questions. this can be a good way to monitor both
Evidence-based analysis is therefore volatility (risk) and overall return.
critically important to evidence suitability
and value for money of the default fund. Advisers should also agree an appropriate
timescale for the benchmark assessment
Benchmarking provides a clear parameter period. Pension fund providers often talk about
by which initial and ongoing suitability can 20+ year returns, especially those investing in
be assessed and should be agreed with infrastructure projects (building railways, power
the client as being appropriate. Advisers stations etc). However, for many savers, 20 years
should also agree an appropriate timescale will be around half of their working life and
for the benchmark assessment period. advisers would be irresponsible to leave their
clients in a poor performing fund for that long.
At Defaqto, we consider anything less than
Providers preferred benchmarks three years’ performance to be insufficient to
vary greatly across the industry, draw any meaningful conclusion; ideally one
common examples including: should be looking at five or more years.
Irrespective of the provider’s preferred
A A
ssociation of British Insurers
benchmark, we suggest advisers recommend
Mixed Investment a benchmark that is relevant and easily
40-85% Shares understood by both employers and employees.
For many, we would expect this to be either
B Cash + x% pa option B or C, perhaps with D overlaid.
C Inflation (CPI or RPI) + x%
D Volatility
We also see some providers opting to use
composite benchmarks, ie different benchmarks
for different elements of the assets held. While
composite benchmarks may work well for
providers and fund managers, they are almost
incomprehensible to the average consumer
and therefore somewhat meaningless.
9
Default fund due
diligence checklist
The most important factor when making recommendations is to
meet the client’s needs and objectives, whether they be individual
or corporate. It is good practice to consider, at least, the following
items in your research:
3
A Ascertain, agree and document advice needs
• Clients’ needs, objectives and aspirations
• Risk framework
• Timeframes
B Provider’s financial strength and capability
• Holds an attractive AKG rating and/or Master Trust Assurance (type 1 and 2)
C Scheme strengths and weaknesses
• Provides guaranteed acceptance of employers and employees
• Any age restrictions
• Any salary restrictions
• Ability to facilitate tax relief for all
• Alternative fund options available such as ethical and Sharia
D Investment management procedures and responsibilities
• Level of independence
• Whether investments are sourced in-house and/or from third parties and
the implications of the strategy
• Does the investment strategy match the client and their needs?
• Are there robust and repeatable working practices in place?
• Are the individuals involved suitably experienced and qualified and managed?
E Clarity, robustness and repeatability of default fund decision making
• Is there a documented and clear structure and decision-making process in
place?
• Is it being adhered to and how is it compliance managed?
• Is the fund of a size able to facilitate sufficient diversification and pricing to
operate in the client’s/saver’s best interests?
F Benchmarking
• Agree independent, relevant and easily understood benchmarks against
which performance can be measured
• Agree suitable timescales
• Put in place an action plan to follow if underperformance is identified
G Assess value for money and suitability
• Detail how the selected default fund compares to its peers in each of the
above areas
• Provide an overall assessment and summary of the decision-making
process and ultimate selection
H Set periodic review dates for
• Updating The Pensions Regulator
• Ongoing scheme and contribution suitability assessments
• Tri-annual reviews
• Trustee meetings
• Implementing additional employee benefits and pension/financial reviews
• Implementing additional business financial planning (key man insurance etc)
10Part 2 – Analysis of the
most commonly used
default funds
Default investments are the funds in which contributions to
workplace pensions will automatically be invested, unless employees
are given and exercise their own investment choice, in which case
there will be a range of funds from which they may choose.
According to Moneywise, 84% of savers are relying on their pension provider’s default fund to save for
their retirement, therefore it is very important employers choose a default fund that is appropriate
for them. When comparing the default offerings in the main growth phase across the different
organisations in this study, we used the funds shown in Table 1.
Table 1: Main default funds
Provider Fund name
Aegon Aegon Default Equity & Bond Lifestyle (ARC)
Aviva Aviva Diversified Assets Fund II
B&CE (The People’s Pension) Balanced Lifestyle Profile
Friends Life Friends Life My Future Growth
LGIM LGIM PMC Multi-Asset 3
NEST NEST 2040 Retirement Date Fund
NOW Pensions Diversified Growth Fund
Prudential Prudential Dynamic Growth IV
Royal London Royal London Governed Portfolio 4
Scottish Widows Scottish Widows Pension Portfolio Two
Standard Life Standard Life Active Plus III
11Benchmarks Investment process
Performance benchmarks vary greatly across As can be seen from Table 2 below, there is a mix
the default funds reviewed, with ABI Mixed of manager structures across the main default
Investment 40-85% Shares, cash plus 3% pa funds reviewed: some keep fund management
and composite benchmarks amongst the in-house, either using fund managers from
comparators used. Aviva and Standard Life elsewhere within their organisation or investing
do not have any performance benchmarks, directly in securities; a couple of default funds
but instead use volatility targets. NEST, completely outsource to external managers;
on the other hand, has both performance while others use both in-house and third-party
benchmarks and volatility targets. managers.
Table 2: Main default funds – fund manager structure and investment approach
Provider Fund manager(s) and investment approach
Aegon Aegon/BlackRock (passive)
Aviva In-house (active and passive)
B&CE (The People’s Pension) State Street Global Advisors (passive)
Friends Life BlackRock and LGIM (passive)
LGIM In-house funds (passive)
Amundi, BlackRock, LGIM, Northern Trust,
NEST
RLAM, SSGA and UBS (active and passive)
NOW Pensions In-house (active)
Prudential BlackRock (passive) and M&G (active)
Royal London In-house (active) and BlackRock (passive)
Scottish Widows Aberdeen, Scottish Widows and SSGA (passive)
Standard Life Mainly in-house funds (active)
Source: provider websites and factsheets
The main rationale for outsourcing to third- In terms of investment approach (active
party managers is that no one manager can versus passive fund management), there is
be the best across every single asset class, but also a mix. Active managers have the chance
instead one should source a specialist manager to outperform the respective index, but also
for each different area. The disadvantage of run the risk of underperforming it. Passive
this method is that third-party managers are managers, meanwhile, simply track the index
generally more expensive than managing and generally cost less. Looking at it from a ‘value
the funds in-house; however, this may well for money’ perspective, the passive strategy
be dependent on the available economies has the ability to control risk, diversification
of scale and negotiating position. and costs and is therefore worth considering
as an element within a default fund.
12Asset classes
Table 3 shows the high-level asset classes in which each of the main default funds invest.
Table 3: Main default funds – high-level asset classes used
Fixed
Provider Cash Property Commodities Equity Derivatives
income
Aegon Yes Yes Yes
Aviva Yes Yes Yes Yes Yes Yes
B&CE (The People’s
Yes Yes Yes
Pension)
Friends Life Yes Yes Yes
LGIM Yes Yes Yes Yes
NEST Yes Yes Yes Yes
NOW Pensions Yes Yes Yes
Prudential Yes Yes Yes
Royal London Yes Yes Yes Yes Yes Yes
Scottish Widows Yes Yes Yes
Standard Life Yes Yes Yes Yes Yes Yes
Source: provider websites and factsheets
As can be seen, all will contain equities, fixed income and cash. Some will also hold ‘alternative’ asset
classes to varying degrees. The advantages of such asset classes are the greater potential for higher
returns and diversification; however, they can also be more risky, expensive and less transparent.
13Performance
Performance numbers are now compared across the main default funds, in their
main growth phase (unfortunately, NOW Pensions were unable to provide the data
requested). Table 4 below shows ‘raw’ performance numbers for the funds.
Table 4: Annualised returns
To end November 2016 1yr 2yr 3yr 5yr
Aegon 14.93% 8.69% 9.42% -
Aviva 13.15% 7.75% 8.69% 7.30%
B&CE (The People’s Pension) 18.86% 9.68% 8.57% -
Friends Life 15.92% 9.38% 9.78% -
LGIM 17.60% 8.74% 9.23% -
NOW Pensions - - - -
NEST 17.21% 9.93% 10.76% 10.80%
Prudential 15.35% - - -
Royal London 11.34% 7.77% 8.33% 10.54%
Scottish Widows 17.31% 8.52% 8.43% 11.56%
Standard Life 6.06% 4.41% 5.54% -
Source: data from Morningstar, ONS, B&CE and NEST; calculations by Defaqto
These figures, however, are returns only and take no account of the fund’s volatility ie the risk
taken in achieving these returns. Information ratios, which are fund return minus benchmark
return divided by the volatility of these ‘excess’ returns, do take risk into account.
These ratios have no units, but a higher number indicates better risk-adjusted
performance. As mentioned earlier, though, there is no one benchmark for the whole
industry. For this study, ABI Mixed Investment 40-85% Shares and inflation (CPI) plus
3% are used. Tables 5 and 6 show information ratios with these benchmarks.
14Table 5: Information ratios using ABI Mixed Investment 40-85% Shares benchmark
To end November 2016 1yr 2yr 3yr 5yr
Aegon 1.13 1.02 0.75 -
Aviva 1.44 1.10 0.79 -0.27
B&CE (The People’s Pension) 0.28 0.22 0.16 -
Friends Life 1.94 1.29 1.23 -
LGIM 1.65 0.74 0.59 -
NOW Pensions - - - -
NEST 1.35 1.04 1.04 0.65
Prudential 0.87 - - -
Royal London -0.08 0.67 1.15 0.91
Scottish Widows 1.17 0.49 0.57 0.56
Standard Life -0.99 -0.67 -0.29 -
Source: data from Morningstar, ONS, B&CE and NEST; calculations by Defaqto
Table 6: Information ratios using CPI plus 3% benchmark
To end November 2016 1yr 2yr 3yr 5yr
Aegon 1.30 0.51 0.63 -
Aviva 1.04 0.43 0.59 0.38
B&CE (The People’s Pension) 0.90 0.44 0.38 -
Friends Life 1.45 0.62 0.73 -
LGIM 1.63 0.58 0.71 -
NOW Pensions - - - -
NEST 1.59 0.69 0.89 0.85
Prudential 1.31 - - -
Royal London 1.14 0.51 0.64 0.82
Scottish Widows 1.15 0.41 0.45 0.69
Standard Life 0.40 0.13 0.34 -
Source: data from Morningstar, ONS, B&CE and NEST; calculations by Defaqto
15Information ratios penalise upside and downside downside deviations and are the fund’s return
volatility equally. Most people would consider minus the risk-free rate divided by the downside
volatility caused by high returns to be acceptable, volatility. Sortino ratios for the main default funds
but volatility due to low returns to be ‘bad’. are shown in Table 7 below (again, these ratios
Sortino ratios differentiate ‘bad’ volatility of have no units, but a higher number indicates
returns from total volatility by penalising only better downside risk-adjusted performance).
Table 7: Sortino ratios using 0.5% risk-free rate
To end November 2016 1yr 2yr 3yr 5yr
Aegon 2.53 1.46 1.74 -
Aviva 2.03 1.33 1.75 1.49
B&CE (The People’s Pension) 2.67 1.45 1.48 -
Friends Life 3.08 1.78 2.16 -
LGIM 4.61 1.96 2.19 -
NOW Pensions - - - -
NEST 4.00 2.32 2.81 2.87
Prudential 2.34 - - -
Royal London 1.88 1.43 1.77 1.84
Scottish Widows 2.18 1.18 1.35 1.50
Standard Life 1.33 1.09 1.59 -
Source: data from Morningstar, ONS, B&CE and NEST; calculations by Defaqto
It is generally agreed that longer-term numbers Costs
are more significant from a statistical point of
view, although only four of the default funds Charges are now compared across the main default
have a five-year performance history. On a funds. Many contract-based schemes charge a
five-year basis, Royal London has the best variable fund annual management charge (AMC)
risk-adjusted performance against the ABI and administration fee or service charge. Where
Mixed Investment 40-85% Shares benchmark. this is the case, we have used their maximum
Over three years against the same benchmark, standard fee as we expect this to be the common
with a larger sample, Friends Life has the fee charged for employers currently staging (Q3
best risk-adjusted performance, with Royal 2016) who primarily have 30 or fewer employees
London and NEST very close behind. (see Table 8).
NEST has the best risk-adjusted performance
against the CPI plus 3% benchmark, which
is its own benchmark, over three and five
years with Friends Life and LGIM quite close
behind on a three-year basis. NEST also
has the best risk-adjusted performance,
looking at just downside risk, over three and
five years, with Friends Life and LGIM again
fairly close behind on a three-year basis.
16Table 8: Main default funds – charges
Provider Common fee structure for savers
0.50% pa
Aegon
A mixture of AMC (from 0.05%) and admin/service fee
0.75% pa
Aviva
A mixture of AMC and admin/service fee
B&CE (The People’s Pension) 0.50% pa
0.75% pa
Friends Life
A mixture of AMC and admin/service fee
0.50% pa
LGIM
A mixture of AMC and admin/service fee
0.30% AMC
NEST
1.80% contribution charge
0.30% AMC
NOW Pensions Saver earning £18,000 or less: £0.30 monthly admin charge
Saver earning over £18,000: £1.50 monthly admin charge
0.75% pa
Prudential
A mixture of AMC and admin/service fee
0.75% pa
Royal London
A mixture of AMC and admin/service fee
0.75% pa
Scottish Widows
A mixture of AMC and admin/service fee
0.75% pa
Standard Life
A mixture of AMC and admin/service fee
Source: provider websites and factsheets
Clearly the AMC is not the total cost savers will employers to apply before they offer specific
pay, and the total cost experience for them rates. In the current environment where
should be considered in the advice provided. employers going through staging primarily
have fewer than 30 employees, bespoke
The maximum AMC chargeable for pension pricing on application seems unnecessary
schemes is 0.75%, although additional as schemes will all be of a similar size.
charges can also be incurred, for example
through the pricing of trust funds. While One also has to question how providers
some providers manufacture their schemes operating bespoke pricing are meeting the
to the 0.75% charge, others operate a more ‘treating customer fairly’ (TCF) rules, when
complex structure charging a combination of an employee could be paying the same
fees, and advisers should be sure to include contributions into the same fund but be paying
all of them in their evaluation process. significantly different charges simply because
they have changed employer.
Advisers will find that some schemes do
not publicly state their fees, requiring
17In these circumstances, we suggest advisers err on the side of caution and consider using schemes
that have a clearly defined and open charging structure. Tables 9, 10 and 11 below show the
effect of these different charges by looking at the value of an illustrative pension pot over 10, 20,
30 and 40 years. These calculations assume a starting salary of £25,000; increases of 2% pa; and
investment growth of 6% pa. The amounts of employee and employer contributions are varied.
Table 9: Illustrative pension fund values assuming 2% contribution rate
Employee = 1%, Value at Value at Value at Value at
employer = 1% 10 yrs 20 yrs 30 yrs 40 yrs
No charges £7,441 £22,610 £52,193 £108,440
NEST £7,191 £21,465 £48,591 £98,832
NOW Pensions £7,080 £21,187 £48,052 £97,875
Aegon, B&CE and LGIM £7,246 £21,375 £47,769 £95,816
Aviva, Friends Life, Prudential,
Royal London, Scottish Widows £7,150 £20,790 £45,729 £90,165
and Standard Life
Calculations by Defaqto
Table 10: Illustrative pension fund values assuming 5% contribution rate
Employee = 3%, Value at Value at Value at Value at
employer = 2% 10 yrs 20 yrs 30 yrs 40 yrs
No charges £18,603 £56,524 £130,484 £271,099
NEST £17,978 £53,663 £121,477 £247,080
NOW Pensions £18,065 £53,974 £122,274 £248,841
Aegon, B&CE and LGIM £18,114 £53,438 £119,422 £239,539
Aviva, Friends Life, Prudential,
Royal London, Scottish Widows £17,876 £51,974 £114,321 £225,414
and Standard Life
Calculations by Defaqto
Table 11: Illustrative pension fund values assuming 8% contribution rate
Employee = 5%, Value at Value at Value at Value at
employer = 3% 10 yrs 20 yrs 30 yrs 40 yrs
No charges £29,765 £90,439 £208,774 £433,758
NEST £28,765 £85,861 £194,364 £395,328
NOW Pensions £29,050 £86,762 £196,496 £399,806
Aegon, B&CE and LGIM £28,893 £85,501 £191,075 £383,263
Aviva, Friends Life, Prudential,
Royal London, Scottish Widows £28,601 £83,158 £182,914 £360,662
and Standard Life
Calculations by Defaqto
18The numbers will, of course, vary with the assumptions used, although
we have tried to make our inputs as reasonable and sensible as
possible. We note the following observations:
• With current contributions and a smaller pension pot, NEST works
out marginally best over the long term (20 plus years) compared to
the other default funds in terms of overall charges, due to their low
AMC plus their additional contribution charge having enough time
to be sufficiently diluted
• Over the first 10 years, with current contributions, the schemes
charging 0.5% and nothing else fare best as the time period is still
too short for the dilution of the additional charges of NEST and NOW
Pensions (on top of their lower AMCs) to have enough effect
• As contributions and pot sizes increase, NOW Pensions works out
marginally better compared to the other schemes, especially over
the longer term, with their low AMC but also their fixed admin
charge having a decreasing effect with a bigger pot
Some of the more common fees to look out for that can be
applied to the employer and/or the employees are:
• Application processing fee • Change of contribution
• Middleware costs • Statutory communications
• Initial fee(s) • Retirement illustrations
• Installation • Transfer illustrations
• Subscription/membership • Transfer costs (in and out)
• Annual product fees • Review costs
• Annual management fees • Changes in costs for individuals leaving
employer so scheme becomes paid up
• Annual investment/fund fees
• Exit fees for individuals on transfer
• Allocation rates
• Exit fees for individuals on death
• Valuations
• Exit fees for scheme/employer
• Transactions per type/on time cost basis
Other factors to consider include:
• Time out of the market – before contributions are invested
• Time out of the market – fund switches
• Time out of the market – before transfer values are released
• Time out of the market – taking benefits
19Part 3 – NEST and its
default fund
NEST is an occupational defined contribution workplace pension
scheme and was set up to facilitate automatic enrolment as part of the
government’s workplace pension reforms under the Pension Act 2008.
NEST was created to offer employers and their September 2016
workers access to a good quality pension
scheme, with the intention of helping more • Uncrystallised funds pension lump sum
people to save for retirement. Interestingly, it (UFPLS) options to become more flexible
was established with a public service obligation
• Contributions can be received while benefits
to accept any employer, which means that
are being taken (through UFPLS)
every single employer has access to a qualifying
pension scheme into which they can enrol their • Ability to pay lump sums as benefits
eligible workers.
• Changes to death benefits
NEST is one of the qualifying pension schemes
that employers can use to meet their new duties.
It now serves more than 3.8m members across
over 215,000 employers, and assets under April 2017
management (AUM) stood at around £1.2bn at
the beginning of November 2016. • Changes to annual contribution limits
We anticipate that due consideration will be • Ability to facilitate transfers in and out (for
given by employers, on behalf of their employees, individuals and bulk)
to NEST as a result of these legislation changes.
20NEST's default strategy
In the case of NEST, around 99% of members The availability of a standalone Sharia fund is
invest in the default funds. The default option for useful for those employers who wish to meet
NEST’s members is one of the NEST Retirement the potential needs of some of their Muslim
Date Funds. employees and therefore avoid potential
discrimination issues. Of all of the auto-
There are around 50 of these funds in existence enrolment qualifying pension schemes, 80%
at any one time, with each corresponding to offer this specific fund option.
the year in which the member wishes to take
out some of their money tax free and convert For those investors who do not want to use the
the remainder into retirement benefits eg if the default fund, some pension schemes provide
member expects to take their money out in 2040, no alternative while others provide access to
then they will save into the NEST 2040 Retirement hundreds of funds. NEST sits somewhere in
Fund. The member can, however, switch to a the middle as it provides a comprehensive but
different fund, free of charge, if they later decide focused list of alternative investment funds.
they want to save for longer or take their money
out earlier. None of NEST’s peers uses this target Although this case study focuses primarily on
date approach, using ‘life styling’ instead. NEST’s default funds, many of their attributes
(eg the investment beliefs and team behind
NEST does offer other fund choices for members them) will also apply to NEST’s other funds.
with certain beliefs or for those who want to take
greater or less risk with their investments than
the average. These are the:
• NEST Ethical Fund
• NEST Sharia Fund
• NEST Higher Risk Fund
• NEST Lower Growth Fund
• NEST Pre-retirement Fund
21Investment strategy
NEST was able to start with a ‘blank sheet of paper’ when designing its investment process and
governance structure. It carried out a consultation process, looking at how similar schemes operate
around the world and learning from them. NEST has also attempted to make its solution scalable and
is part of a network of large non-profit schemes, which also includes APG and the Ontario Teachers’
Pension Plan.
NEST’s investment beliefs, and upon which its investment approach is
based, are as follows:
• Understanding scheme member characteristics, circumstances and
attitudes is essential to developing and maintaining an appropriate
investment strategy
• As long-term investors, incorporating environmental, social and
governance (ESG) factors is integral to the investment management
process
• Taking investment risk is usually rewarded in the long term
• Diversification is the key tool for managing risk
• Risk-based asset allocation is the biggest driver of long-term
performance
• Taking account of asset values and asset prices, economic
conditions and long-term market developments enhances long-
term performance and informs strategic decisions
• Indexed management, where available, is often more efficient than
active management
• Good governance, including an appropriately resourced in-house
investment function, is in the best interests of NEST members
22Investment team
Mark Fawcett is the Chief Investment Officer (CIO) of NEST. Table 12 lists the other key members of
NEST’s Investment Directorate.
Table 12: Key members of the NEST Investment Directorate
NEST Investment Committee
(four Trustees)
CIO
Responsible In-house
Market risk Investment
investment Financial investment Manager
and asset policy and
modelling research research
allocation (two delivery
(two technology (one
(two members (three
of staff) members (two member
members members
of staff) members of staff)
of staff) of staff)
of staff)
In addition, there is an Investment Operations The IC also monitors fund performance and
team of four. Their main duties are to monitor operations to make sure that the Trustee is
the performance of the fund managers used fulfilling its legal duties. The IC consists of:
by NEST, ensure portfolios are in line with
targets, implement asset allocations and make • Carolan Dobson (Chair)
recommendations for any changes. • Sally Bridgeland
All investment decisions are overseen by the • Ian Armfield
Trustee through the Investment Committee (IC),
a group of Trustee members that meets quarterly • Graham Berville
to review investment decisions on a formal basis.
They decide on the recommendations of the CIO Biographies of Mark Fawcett and the IC are
regarding several factors, including: published on nestpensions.org.uk
• Investment objectives
• Risk budgets
• Strategic asset allocations
• Fund manager selection
• Fund manager monitoring
• Investment costs
23Investment approach
The life of each of the Retirement Date Funds is split into three different phases: Foundation, Growth
and Consolidation, as shown in Table 13.
Table 13: The different phases of NEST’s Retirement Date Funds
Phase Rationale Return target Volatility target
NEST has a Foundation phase, Keep pace with CPI Long-term
created in response to their inflation after all volatility average
research which identified younger scheme charges of 7%
savers could react negatively
to large market falls and stop
contributing. Members joining
Foundation
in their 20s will typically spend
up to five years here, where
the emphasis is on steadily
growing the balance rather than
having exposure to substantial
investment risk
Where the main growth in the Exceed CPI Long-term
fund is expected to come from – inflation plus 3% volatility average
Growth
members could spend up to 30 after all scheme of 10–12%
years in this phase charges
Lock in gains that members have Keep pace with CPI Reduce volatility
made over the previous phases inflation after all as the fund gets
by progressively switching out scheme charges closer to maturity
Consolidation
of higher risk assets – begins
roughly 10 years before the fund
matures
Source: NEST
Following the Pension Freedom reforms announced in 2014 and enacted a year later, NEST
will change to targeting a drawdown portfolio at retirement instead of cash and bonds (which
would have bought an annuity). Funds for retirement at 2020 or before are still targeting
cash, while those based on retirement after 2020 are now targeting income drawdown.
Chart 1: The glide path of the default fund strategy
Foundation Growth Consolidation
phase phase phase
Objective = Keep pace Objective = Exceed Objective = Keep pace
with CPI (inflation) CPI + 3% per annum with CPI after all charges
after all charges after all charges over while progressively
the long term dampening volatility
A low volatility
approach designed to Targeted use of asset There is a progressive
acclimatise younger classes expected to move from higher risk
savers to investing grow in value relative assets towards lower
to CPI more than risk asset classes
other investments
Typically the first 5 years for savers Main term Typically the 10 years
joining in their early to mid 20s before retirement
24This lifecycle differs from that of the other is that the latter will begin moving out of
main default funds in that none of them has a the main growth phase at a set number of
phase similar to Foundation, instead starting years before the expected retirement date.
with the main growth phase. The advantage In the case of the NEST funds, however, the
of the NEST lifecycle, as mentioned above, is transition from one phase to another will be
that large market falls in the early years, which ‘dynamically’ managed rather than relying
could dissuade people from continuing to save on a set rule. This means commencing the
in the middle and later years, are less likely. The transition earlier or later, depending on
disadvantage of this approach is that members prevailing economic and market conditions.
miss out on any large market gains in the early
years, or these would be at least restricted Table 14 shows how the Retirement Date Funds
(although, as pots are small at this point, there invest across the different asset classes. They
may in fact be a negligible impact on outcomes). use external fund managers in all cases rather
than the funds being managed ‘in-house’.
The second main difference in lifecycle
between NEST and the other default funds
Table 14: Retirement Date Funds – fund managers and investment approaches
Asset class Fund manager Investment approach
Global developed equities UBS Asset Management Passive
Emerging market equities HSBC Global Asset Management Passive
Emerging market equities Northern Trust Passive
Gilts State Street Global Advisors Passive
Short-dated gilts LGIM Buy and hold
Index-linked gilts State Street Global Advisors Passive
Sterling corporate bonds Royal London Asset Management Active
Emerging market debt Amundi Asset Management Active
UK direct/global listed
LGIM Active/Passive
property
Low-risk sterling liquidity BlackRock Active
Source: NEST
25As can be seen, NEST spreads its investments Quarterly reviews take place in between the
across a greater range of managers than the annual updates, where the in-house team
other default funds. Their fund manager turnover looks at the macroeconomic background,
has been low and NEST will tolerate short-term financial markets, sentiment and latest asset
underperformance as long as the manager class valuations, together with any tactical
keeps to their stated process and style. adjustments around the policy allocation
that might be made. In the first stage of the
As mentioned earlier, the disadvantage of reviews, these inputs are discussed by the key
using third-party managers is that this method members of the Investment Directorate. Any
is generally more expensive than managing decisions are then made during the second
in-house, although NEST states that it is able stage at a meeting between just the CIO, Head
to negotiate favourable terms as a result of its of Asset Allocation and Head of Economics.
fund size and expected future contributions. These potential changes are analysed from a
risk point of view before being implemented.
As alluded to above, the asset allocation for
each Retirement Date Fund will depend on its The latest asset allocation for the growth phase is
point in the lifecycle, together with prevailing shown in Chart 2.
economic and market conditions. The policy
(strategic) asset allocation is determined partly Compared to the other default funds reviewed,
through mean variance optimisation (MVO). this puts NEST’s fund just above the average in
NEST, however, recognises the limitations of MVO, terms of diversification (see Table 3). However,
in particular the occurrence of corner solutions NEST is evaluating whether to add additional
and its sensitivity to the inputs used, therefore it asset classes, including high yield bonds, low
combines this with risk-diversified optimisation. carbon equities and infrastructure, which would
These policy asset allocations will be reviewed put it towards the more diversified end, although
quarterly and are typically adjusted once a year. NEST won’t diversify just for the sake of it.
Chart 2: 2040 Retirement Date Fund asset allocation at end June 2016
3.6
1.1
1.0 7.5
14.5
48.4
5.4
18.5
Emerging market equities Developed market equities Property
Emerging market debt £ corporate bonds Gilts
Index linked gilts £ liquidity
Source: NEST
26Risk framework The internal market also keeps costs down for
members leaving the scheme and those just
There are asset class ranges/limits and the NEST joining. New member contributions can be used
Investment Directorate would need permission to balance allocations and for paying cash lump
from the IC if it wished to move outside these. sums to members taking their money out. Finally,
the internal market can be used to maintain the
NEST uses the MSCI BARRA risk-package
target asset allocation or re-balance the funds.
for the analysis of risk in its portfolios.
Transaction costs for the default funds are
Costs between 0 and 0.083% and costs for other fund
choices are between 0 and 0.098%. The costs
The total costs of scheme membership are for each fund are detailed in Appendix three of
(1) direct member-borne costs and charges, the NEST scheme annual report and accounts
and (2) portfolio transaction costs. 2015/6 available on its website. NEST constantly
monitors and analyses costs and spreads.
As already mentioned, NEST’s member charges
consist of: NEST is unique in that it is free for employers
to use and any UK employer can use
• A contribution charge of 1.8%, deducted NEST to meet its workplace duties.
from all contributions made to the scheme
• An AMC of 0.3%, applied to all AUM. This Governance
includes all custodian, legal and accounting
costs and is also the total expense ratio (TER) NEST is a trust-based pension scheme,
regulated by TPR and it appears to be meeting,
Transaction costs and dealing spreads across if not exceeding, the various governance
the 50 or so default funds will vary depending standards and duties imposed on it.
on the asset allocation. However, they have
been structured to minimise trading costs NEST is one of the schemes that should
for the scheme, such as trading spreads be applauded for making much of the
and brokerage fees. NEST has done this by governance due diligence data required
creating an internal market between the by advisers available on its website.
different Retirement Date Funds such that
the funds which are reducing exposure
to certain asset classes will transfer those
investments to the funds still adding to them.
27Conclusion
This case study first looked at the key factors we believe should be
considered when reviewing or selecting a default fund:
• The investment management procedures and responsibilities
• The implications of in-house and outsourced management
• The clarity, robustness and repeatability of decision making
• How the default funds are performing against benchmarks and peers
• The suitability of the default funds and identifying value for money
The case study then looked at and compared group of competitors. The main strengths
the most commonly used default pension of NEST’s Retirement Date Funds are:
funds from an auto-enrolment point of view.
We saw a great variety in terms of benchmark, • The investment team behind these funds
manager structure (in-house manager, third- is experienced and well-resourced
party managers or a mix), investment approach • Risk-adjusted performance in the main
(active, passive or both), level of diversification, growth phase of the lifecycle has been very
performance and charging across the funds. good versus peers over the longer (and
With some of these attributes, such as manager more statistically meaningful) time periods
structure and investment approach, the choice
of provider and fund might come down to the • With an increasing investment time period,
investment beliefs of the employer or their NEST’s overall charges become more
adviser. In terms of the other more objective favourable in relation to most of the other
features ie risk-adjusted performance and big default funds by virtue of the dilution of
charges, however, some providers and funds the contribution charge over the longer term
are clearly more competitive than others.
• These funds have a volatility target as well
Finally, this case study looked at NEST’s as a performance benchmark (the other
default pension funds in more detail, default funds tend to have one or the other)
comparing them to their most relevant peer
28The key areas where NEST’s Retirement Date Funds differ from the other
default funds looked at are:
• None of the others has single-year Target Date funds
• NEST has a Foundation phase, created in response to their research
which identified younger savers could react negatively to large
market falls and stop contributing. Members joining in their 20s
will typically spend up to five years here, where the emphasis is
on steadily growing the balance rather than having exposure to
substantial investment risk. While mitigating negative market risk
it is possible that market gains won’t be reflected, however should
this happen this strategy is unlikely to have a notable impact as the
pot size of savers in their 20s is usually small
• Switching out of the main growth phase in the run up to retirement
does not automatically commence at a pre-set point before
retirement, but instead can be started slightly sooner or later,
depending on prevailing market conditions
The evidence shows that NEST’s Retirement Date Funds can hold their own against their
peers and are worthy of consideration alongside other schemes by corporate clients and
professional advisers on behalf of their clients, irrespective of the employer’s size of scheme.
29Learning objectives
This case study is accredited by the CII/PFS and CISI for up to 60
minutes of structured CPD.
Reading this publication will enable you to:
1 Understand the different default investment strategies available, focusing upon the
accumulation phase
2 Identify the main differentiating factors to be considered between the individual
default investment propositions including:
• The investment management procedures and responsibilities
• Implications of in-house and outsourced management
• Clarity, robustness and repeatability of decision making
• How defaults are performing against benchmarks and peers
• Suitability of the default and identifying value for money
3 Understand how the various default propositions in the market differ from each other
to support market research and due diligence
30Test yourself for CPD
In order to assess your knowledge following completion of this publication, why
not work your way through the following questions? All the answers can be found
within the content of this publication.
1 Name the two regulators of auto-enrolment pension schemes.
2 What is the main concern with a default fund using funds primarily from the scheme provider?
3 Name four common benchmarks used by default funds.
4 List the main reasons why many default funds utilise passive (index) funds.
5 At what percentage are pension default funds annual management fees capped?
316 What does IGC stand for and which scheme type does it apply to?
7 Which regulator utilises the DC Code and which scheme type does it apply to?
8 Does ‘value for money’ mean the cheapest solution?
This publication is accredited by the CII/PFS and CISI for up to
60 minutes of structured continuing professional development (CPD).
Name
Signature
Date
CPD time recorded
32NEST.
The provider of last resort.
Unless you’re after an award-winning pension scheme.
At first glance, NEST might not be the first provider
you’d consider recommending to your clients.
But if you’re looking for a pension with an innovative
investment approach, independently accredited
governance and a substantial collection of industry
awards you might want to take another look.
NEST. Think you know us?
Think again.
Find out more
©NEST Corporation 2016. All rights reserved. NEST will only accept employers electing to use the scheme for the purposes of meeting their duties under
the Pensions Act 2008 and subject to them accepting our Employer Terms and Conditions. This information does not constitute financial, investment or
professional advice. We do not make any personal recommendation or give advice to employers, their workers or third parties on how to make investment
decisions. The NEST trademarks and trade names used above are owned by NEST Corporation and should not be used in any way without our permission.
33Send us your feedback
Your feedback is extremely important to us and we would be grateful if, after
completing this publication, you would take a few minutes to complete a short survey.
Your answers will be treated in the strictest confidence and the results of this will help
the development of future publications.
The survey can be accessed at:
https://www.snapsurveys.com/wh/s.asp?k=144610976149
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