Charlotte Moore surveys how leading schemes are approaching the new investment universe.
Master trust schemes are now responsible for managing the retirement savings of millions of employees across the UK. Almost all will be saving into their scheme’s default strategy, making master trusts’ investment decisions some of the most important in pensions.
Among the key trends are providers embedding sustainable investing principles in their auto-enrolled default funds. There is increasing demand from the government for them also to invest in illiquid assets such as venture capital and infrastructure.
Mark French, director at Willis Towers Watson, says: “Sustainable investing is driving much of the agenda because pension providers have established their policy and now want to implement these objectives.”
Risk is a key sustainable investment consideration for schemes. Nico Aspinall, CIO of the People’s Pension, adds: “Schemes want to avoid owning stranded carbon assets which means divesting coal as well as ensuring oil and gas majors understand climate change is real.”
There is a lot of variation between schemes over how these sustainable investing practices are implemented, including how funds are designed and what level of engagement with companies is expected.
But while there is variation on how sustainable investing is implemented, cost considerations mean the investment options are relatively curtailed.
This is not only because the charge cap keeps a lid on the investment management fees. Nigel Dunn, partner at LCP, says: “Master trusts also compete for market share based on price.” Aspinall adds: “The competition on price is real.”
This tight cost control pushes schemes towards cheaper investment options. French says: “Almost all default funds, whether they are master trusts, contracted out schemes or those designed by trustees have significant allocations to passive equities.”
He continues: “These pricing constraints of defined contribution schemes mean pension providers are looking to achieve sustainable investment with the cheapest possible strategy.”
Since passive is the principal equity asset allocation option, incorporating sustainable investing is achieved by tilting these indices towards companies with strong environmental, social and governance factors. Some schemes also expect managers to engage with the poor ESG performers to improve their characteristics, says French.
James Monk, head of DC investment at Aon, says: “Some schemes focus on wider ESG risks while others focus primarily on climate factors.”
Alyshia Harrington-Clark, head of DC, master trusts and lifetime savings at the PLSA, says: “The majority of schemes are currently focusing on climate-related factors rather than broad ESG characteristics.”
Dunn adds: “It’s better for a scheme to tilt its portfolio towards environmental factors rather than social and governance characteristics.” That’s because these factors are much easier to measure with more consistent global data.
French says: “The proportion of assets invested sustainably is still low because the transition process is ongoing. There is a considerable pool of assets which have yet to be changed.”
For example, some of the larger provider master trusts have more than £15 billion in assets which need to be switched. “The challenge is transitioning these assets without incurring too many costs,” adds French.
The ambition, however, is not to shift all of the equity assets into sustainable indices. French says: “Most schemes are aiming to shift half of their equity portfolios with asset transitions linked to their net zero carbon targets.”
If schemes were prepared to take a more active approach, they might find strategies which were more effective at having a positive impact on the planet and society as well as generating returns. Impact investing might be one such strategy.
Aspinall says: “Impact investors put impact on the same level as returns. In other words, returns at no unreasonable price.”
One way this can be achieved is for an active manager to select those companies with a mediocre ESG score and aim to improve this through active engagement with the company to change corporate behaviour.
If successful, the company’s share price would be likely to increase as its ESG characteristics improved, making it more attractive to other investors. In other words, it is a highly active form of fundamental investing.
Monk says: “Actively managed impact investments will become an increasingly important part of the master trust design.” Managers of these strategies are adept at communicating the benefits of their strategy compared to a more standard benchmark: “This can make a particularly compelling story for the scheme member,” he adds.
Aspinall says: “The most likely portfolio design will be a barbell approach with some allocated to impact investments and the majority of assets invested in indices with exclusions and tilts toward stocks with strong ESG characteristics.”
While overall investment management budgets will remain constrained, master trusts with sufficient scale will be able to allocate to these more expensive strategies.
Monk says: “We believe including these strategies will add value to our members’ portfolios both through improved returns and sustainability credentials.”
Venture capital and infrastructure
It’s not only the integration of sustainable investment principles which is challenging the current design of default funds but also the government’s recent calls for pension schemes to participate in an ‘investment big bang’.
This calls on companies to invest more in venture capital and infrastructure to help the country to boost economic productivity after the pandemic.
Aspinall says: “There is appetite from schemes to expand their investment universe by investing in illiquid assets but it will only be a certain proportion of our funds.” This is the direction of travel conferred by the scale in large master trusts, he adds.
“But venture capital funds are so risky – you make ten bets on the understanding that four will give you your money back and one pays you the returns – schemes wouldn’t allocate more than 5% of their portfolio,” says Aspinall.
It’s also unrealistic for the government to expect a commitment to venture capital will increase UK assets. The bulk of the venture capital market opportunities are located in the US.
It’s equally unrealistic to expect DC pension schemes to focus infrastructure investments on the UK. Aspinall says: “It’s sub-Saharan Africa which really needs investment in bridges and roads as well as India. The unintended consequences of the government asking pension schemes to invest in venture capital and infrastructure is that assets flow to the rest of the world rather than the UK.”
In addition, the UK’s master trust sector is still very young. Harrington-Clark says: “The master trusts are in a phase of growth and innovation as they consider new assets to add to the universe.”
Dunn says: “Assets in master trusts have grown rapidly over the last three years and some are still in the phase of building up their teams as their portfolios continue to grow.”
Master trusts lack the experience of managing a broader investment universe. Dunn continues: “Venture capital and infrastructure are very different to unitised securities involving closed funds and capital calls. It involves much greater governance.”
Illiquidity is also an issue. Harrington-Clark says: “DC is closer to a retail pension where savers could, in theory, withdraw all their assets at once so that’s an important consideration for master trusts.”
There’s also a challenge for infrastructure: figuring out where it would fit in a DC portfolio. Dunn says: “Infrastructure is a better fit for a mature defined benefit fund because it provides a regular income.”
But DC needs growth assets to increase the size of the members’ pot before they reach retirement. “Infrastructure is a good fit for an at-retirement product where that steady income would work well,” Dunn concludes.