This article is part of the Morningstar's Guide to Active vs Passive Investing. Click here for our edit on how the experts use the tools at their fingertips, finding out whether you prefer one to the other and examining how to blend active and passive investing for profit.
Do you know what is in your workplace pension scheme? The vast majority of workers choose not to engage with their retirement savings plan – with 99% of workers who have been auto-enrolled into a pension over the last two years opting for the default scheme on offer.
These pensions are defined contribution (DC) schemes, which determine the pay-out at retirement based on the amount you contribute during your working life. Two years ago auto-enrolment was introduced to ensure that every worker in the UK was offered a pension scheme by their employer. Starting with the largest companies, employers have automatically enrolled their workers into DC pension schemes. The smallest companies in the UK – the last to fulfil the requirements – will auto-enrol their workers in 2018. By that point, around 10 million people will eventually be enrolled into schemes.
So far, 99% of those who have been enrolled have opted for the default scheme – either in the pension scheme run by their employer or the Nest default scheme. Nest is the Government run pension provider for employers who wish to outsource the management of their scheme.
New legislation being introduced next April will mean all default schemes face a charge cap of 0.75% a year, which will have an impact on the sorts of assets they can invest in. There are some concerns about the restrictions this may place on pension schemes – as it goes against modern portfolio theory. This dictates that in order to maximise portfolio returns, investors must take on a calculated amount of risk; a combination of uncorrelated assets in order to ensure an attractive retirement income.
In particular, there is concern that active funds will be eradicated when the price cap is introduced.
“A price cap could place even further downward fee pressure on the investment component of the default,” said Steve Bowles, Schroders head of institutional defined contributions.
“Beta is cheap, alpha is not. DC is an environment where it is real outcomes that matter, rather than relative performance.”
Forcing pension funds into a purely passive portfolio could mean that outcomes suffer. Many pension funds are expected to opt for strategic beta funds – seen as the halfway house between passive and active management in order to boost these returns. Cleverly selected strategic beta funds could offer just as much upside as expensive actively managed funds.
“Increasing price pressure will impact some actively managed, diversified default fund options. This may result in an increase in smart beta,” said Aegon investment director Nick Dixon.
“The important aspects will be demonstrating value for money and making sure the default fund addresses the primary needs of investors.”
One of Nest’s core investment beliefs is that “investing passively in an asset type or a particular market is generally better value than paying a premium for a fund manager to actively select individual securities”.
“We do a lot of research before we set out procuring a fund to fully understand what the market can deliver and at what cost. Active stock picking is an option in any market, but the real challenge is finding the managers who are going to consistently deliver in line with their mandate,” said Mark Fawcett, Chief Investment Officer for Nest.
“We use a blend of active and passive management and we focus on approaches where we can have confidence in long term, scalable performance. This includes using alternative index management or smart beta.”
When there is an active option which does offer outperformance, the scale of pension funds should ensure that they can negotiate active management for the price of passive funds. Large scale core funds can be cheaply run by asset managers and offered to institutional clients for less than 0.5%.
However, not all asset managers are comfortable discounting their actively managed funds to bargain bucket prices.
Mark Burgess, Chief Investment Officer of Threadneedle said that good active management is more expensive because of its nature.
“We have clients globally that are comfortable paying 0.75% a year and more for our funds,” he said. “We can’t offer our significant outperformance for the same rate as passive funds.”
