With trustee investment governance, in many cases, being tested to the limit, not least in the early stages of
the pandemic, in this edition we focus on generating better pension outcomes through improved investment
governance and innovative investment thinking.
The investment governance premium
In the mid-noughties, two seminal governance papers estimated that by adopting an advanced level of
investment governance and applying this to innovative investment thinking, institutional investors, such as
pension funds, could add 1% to 2% per annum to long-run risk-adjusted returns.1
Of course, the level of investment governance employed by a decision making body, such as a Trustee Board,
Investment Committee or Defined Contribution (DC) Committee, is, by definition, commensurate with its collective
capabilities (including its specialist investment knowledge), the efficacy of its time management and how well
it organises itself. So, if a Trustee Board or Committee, with strong and diverse collective capabilities,2 can
organise itself to operate in a nimble fashion; focus on impactful strategic imperatives and not the minutiae or
that which is beyond its control; and intelligently share and capture the collective knowledge, experience and
expertise of all in the room, while encouraging challenge and debate, then more optimal investment and risk
management decisions should result. Of course, as no decision – no matter how optimal – is impactful without
timely implementation and efficient execution, following a decision through swiftly to its logical conclusion is just
as important.
As well as focusing investment governance on traditional asset classes and more mainstream investment
strategies, the investment governance premium is increasingly concentrated on and realised through harvesting
the illiquidity and complexity premia of heterogeneous illiquid real, private markets and alternative asset
classes.3 However, while much of the leading edge thinking around investment and risk management deriving
from best practice investment governance has been successfully applied and developed by many of the UK’s
larger and better resourced Defined Benefit (DB) and the very largest DC pension schemes,4 many of the UK’s
5,318 DB schemes5 and the overwhelming majority of the UK’s 28,360 DC schemes6 continue to lag their
exemplar brethren by some margin.7
Moreover, with ever greater complexity surrounding investment solutions and regulation, notably around
the integration to investment decision making of ESG risk factors and climate change risk management;
ongoing challenges to accepted economic and investment paradigms and norms, and often abrupt spikes
in market volatility – all compounded by a reluctance by DC savers to materially increase contribution rates8
and DB sponsors to up their Deficit Reduction Contributions (DRCs) – it’s evident that investment governance
increasingly needs to do more of the heavy lifting, if good retirement outcomes are to be achieved.
Outsourcing investment governance
Given the extraordinary demands on Trustee investment governance, exemplified in the early stages of
the pandemic, it’s perhaps unsurprising that UK DC continues to witness consolidation,9 largely driven by
occupational DC schemes transferring to master trusts,10 while many DB Trustees are starting to more fully
appreciate the attractions of Fiduciary Management (FM)11 as a solution to the, seemingly inexorable, DB
investment governance challenge.12 13 Although FM has principally been the investment governance model of
choice for smaller DB schemes,14 15 anecdotal evidence suggests that even £1bn+ DB schemes are increasingly
engaging with this model, with the very largest DB schemes, many with in-house investment teams, beginning
to gravitate to the Outsourced Chief Investment Officer (OCIO) model,16 to address increased regulatory and
investment complexity and rising operational costs. The £21.5bn British Airways pension scheme being the
most recent example of this embryonic trend.17
Not all outsourced investment governance solutions (or providers) are created equal
However, as outsourced investment governance solutions and providers come in all shapes and sizes, schemes
looking to outsource their investment governance are increasingly using independent third party search and
selection services18 to, not only determine which governance solution will work best for their scheme, but also
which of the many providers will best assist them to meet the scheme’s desired journey and end game.
Ultimately though, the validity of outsourced investment governance solutions rests on realised outcomes,
principally, risk-adjusted returns. Of course, for FM this must reflect the fact that each DB scheme has a unique
journey plan, comprising target investment return, risk tolerance and term to full funding. With this in mind, so
as not to compare apples with pears, investment consultant XPS, collected the net of fees returns on the 22
best ideas growth portfolios of 18 FMs. In 2020, as in many other years, XPS found that the difference in net
returns between the best and worst FM performers was around 10% (15% if including the outliers).19 Although all
FMs recouped their Q120 losses relatively quickly20 and generated positive returns for 2020 as a whole, almost
all underperformed global equities and a 60/40 equity/bond portfolio, in what proved to be a strong year for
equities and fixed income.21 Crucially, the vast majority of FMs (86%) outperformed the median Diversified Growth
Fund (DGF), arguably the most appropriate of the three benchmarks, not least given the multi asset nature of
FM portfolios, in both risk-adjusted and non-risk adjusted terms.22
Separately, in analysing those 12 FMs who account for around 90% of UK FM assets under management,
FM search and selection specialist, Isio, in adopting a similar methodology to XPS, found that during 2020 the
difference in cumulative return between the best and worst performer peaked at c.8% at 31 March, narrowing
to under 5% by the end of the year.23
FM performances in 2020 were, of course, principally determined by the level of equity and credit allocations
going into the early stages of the pandemic and the extent to which these were dynamically altered coming out
of a highly volatile first quarter. With little, if any, consensus by FMs around strategic asset allocation (SAA) and
with significant variations in the level of dynamism attaching their asset allocations (DAA), such a dispersion of
returns was perhaps inevitable.24 Take each FM’s average global equity holding and the changes made to this
allocation throughout the year. During 2020, one FM’s best ideas growth portfolio had over 60% on average
invested in equities while another had less than 5%, with every other manager being somewhere in between.
Likewise, whereas one manager’s best ideas growth portfolio equity allocation was static over the year, another’s
shifted by almost 25%. However, as one would expect from the risk-controlled nature of fiduciary management,
most managers altered their equity allocations by less than 10% over the year and exhibited similar restraint in
their asset allocation shifts to corporate bonds. This heterogeneity also played out in the average allocations to
LDI assets and cash, which varied from around 3% to 84%, and to illiquid and alternative asset classes, from
2% to around 40%.25
Not that this dispersion in approaches to SAA and DAA is anything new. Indeed, over three years – a period
characterised by much lower levels of volatility than those experienced in 2020, but with equity weightings
again being a significant driver of returns – there was, according to XPS, a c.7% dispersion in annualised FM
performance, with almost all managers (86%), once again, outperforming the DGF median return.26 Separately,
Isio, in analysing three years of performance data for its 12 FMs, found that almost all (83%) had significantly
outperformed a low investment governance portfolio, and at a lower annualised risk than the benchmark.27
So, broadly speaking, fiduciary management, as a mechanism for advancing investment governance for DB
schemes, gets a firm tick, noting of course that the critical characteristic any scheme should seek in a FM is
one of trusted partner with a willingness to understand the scheme’s needs and focus on the journey ahead
by setting clear triggers for action.
The heterogeneity of the master trust universe is also evident from the c.6% dispersion of annualised three year
master trust growth phase default fund performances to 30 June 2020 (a point at which markets had yet to fully
recover from the rigours of Q120). According to investment consultant Hymans Robertson, this dispersion, which
was largely driven by relative equity weightings, was accompanied by significant variations in the levels of volatility
(10% to 15% p.a.) attaching to each of these performances.28 Additionally, given this data and the capital market
assumptions applied to each of the providers’ asset allocations, Hymans Robertson projected the likely (median)
fund values to be generated by each provider in 30 years time, along with a projected good (25th percentile), bad
(75th percentile) and very bad (95th percentile) outcome. Whereas the dispersion between the good outcomes
and the probable was particularly high – the best good outcome was projected to be almost 70% higher than the
worst, while the dispersion for the median outcomes was almost 40% – that for the bad and very bad outcomes
was, reassuringly, low.29
Of course, these results ultimately come down to the SAA and DAA adopted by each of the master trust
providers. Moreover, given the positive cash flow and long-term growth focus associated with DC, the case for
harvesting the illiquidity and complexity premia of certain illiquid real, private markets and alternative asset
classes, is particularly compelling.30 However, while some providers have fully embraced the long-run attractions
of these heterogeneous assets, others appear to be content to limit the number of diverse return drivers in
their growth portfolios and simply ride on the coattails of a buoyant equity market. That, for many, remains
concerning.31 For that reason, as an advanced investment governance solution, outsourcing to master trusts
receives a tentative tick.
Why does this matter?
Against the backdrop of almost static DB sponsor DRCs and DC contribution rates, it is readily apparent that investment governance needs to do more of the heavy lifting if good retirement outcomes are to become the
norm. The problem is that few schemes have the requisite governance bandwidth to replicate the advanced
investment governance and innovative investment thinking of the UK’s leading-edge DB schemes. Indeed,
recognising that scale, and with that an advanced level of investment governance, leads to better retirement
outcomes, has seen the DWP recently launch a consultation into accelerating consolidation within the
fragmented occupational DC market.32
However, although, on average, the outsourced investment governance solutions available to DB and DC schemes, which operate in an increasingly price competitive marketplace, have the potential to advance
investment governance sufficiently to help secure good retirement outcomes, adopting an outsourced solution shouldn’t be seen as an investment governance panacea. Indeed, given the dispersion between providers in terms of investment approach, notably towards strategic and dynamic asset allocation, which ultimately translates into significant variations in ,risk-adjusted returns, choosing between providers is absolutely crucial
if the foundations are to be laid for a retirement to be truly enjoyed.
In short, if the desired journey and end game are to be realised, then there’s no substitute for putting in the hard yards to identify which of the many providers best fits the bill. Suffice to say, the chances of doing this successfully are considerably enhanced by enlisting the help of an independent third party search and selection specialist.
