The FCA has just published the template showing the data it wants schemes to publish as part of the overall Value For Money framework. One hundred and ninety rows relate to investment performance alone, and the template specifies 1147 values in total. One thing is for sure: trustees will have enough data to scrutinise. However, this raises the obvious problem of being unable to see what matters.

This tsunami of data is a necessary first step, but it also presents trustees with a problem. Trustees now need a framework to make sense of all this data. There will be some measures where the scheme they are responsible for is better than their peers and others where their scheme is worse. Trustees need to find a way to quantify what their scheme has delivered and whether it will likely provide the best member outcomes.

This begs an obvious question not addressed in the consultation: what is a better member outcome? Which of the one hundred and ninety-two measures of investment performance should they look at, what cohort is the most important, and how should they use finely sliced and diced asset allocation information?

In our opinion, a scheme is better if a member retires with more cash than they would have had in another scheme. We would have compared the annuity they can buy with their pot in a previous era. Although this is still a genuine concern, it’s not part of current thinking, so we should stick with the pounds and pence a member has when they retire.

A scheme’s ultimate output is the value of a member’s pot when they retire. It matters to members, so it should matter to trustees if they are looking after their members’ best interests. Restricting ourselves to the investment performance criteria, members are probably sensitive to significant losses in their final few years.

Measuring what’s been good

If trustees think their members will feel the best scheme is the one that has delivered the highest value, they should ask their scheme providers to provide them with an estimate of the value of a standard scheme member’s pot when they retire. This gives trustees a number that they can compare with other schemes.

This analysis requires a certain amount of abstraction. The consultant has to create the standard scheme member (SSM). The SSM will have made regular contributions that have probably increased with her earnings and salary progression. Their pot will have migrated through the glide path. Perhaps trustees should ask the consultants to create several SSMs retiring now but who joined at different stages. The SSM is another way to look at the cohort performance data, linking one period to another.

The terminal pot value for standard scheme members is a simple, all-encompassing value that allows one scheme to be compared with another. Its value can be easily computed from historical records.

Asset-allocation, asset-allocation, asset-allocation

Suppose multiple schemes use the same standard scheme member and estimate the final value of their pot. The difference in the terminal value is not going to be explained by shaving a few bps off the fees but is probably because of differences in the asset allocation of their assets. The difference will be a consequence of the glide path that has been applied. Almost every evaluation of the factors that drive long-term returns concludes that asset allocation is the dominant factor.

1. Brinson, Hood, and Beebower (1986, 1991) examined the returns of 91 large pension plans and found that asset allocation explained approximately 90% of the variation in portfolio performance. They concluded that market timing and security selection had a much smaller impact on overall returns.
2. Ibbotson and Kaplan (2000) analysed the performance of various asset classes over a long period. They confirmed the Brinson studies’ findings, highlighting asset allocation’s dominance in driving returns.
3. Vanguard has conducted extensive research on the importance of asset allocation. Their studies consistently show that asset allocation is the primary determinant of a portfolio’s long-term risk and return characteristics.

These studies and many others have solidified the consensus among financial professionals that asset allocation is the most crucial factor in achieving investment success.

The glide path is critical. DC scheme trustees should focus on how the asset allocation changes over time as members approach their retirement dates because this will most affect member outcomes.

It’s not immediately apparent what benefits glide-paths offer. Given how little attention members pay to the value of their pot, what utility do members get from less volatility in the value of their pot as they approach retirement? Do the supposed benefits of less volatility outweigh the probable loss of value?

Asset allocation can get complicated, and it’s easy to get wrapped up in the minutiae and lose sight of the critical factor: the split between cash and risky assets. Bonds are risky, and cash is the only safe asset when the focus is on the GBP value of a member’s pot. As schemes saw in 2022, allocating more to cash is the only way to protect a member from losses.

The composition of the risky asset portfolio is essential, but this plays second fiddle to the split between cash and other investments. A scheme glide path and the split between cash and risky assets will dominate all the other factors in determining the final value of a member’s pot.

What will be good?

If trustees want to know what will work in the future, they must look forward and estimate what value a scheme may offer. Forward-looking estimates are trickier but not impossible. Socius and other experts can use capital market assumptions in Monte Carlo simulations to estimate the range of terminal values a scheme may deliver.

The primary purpose of Monte Carlo simulations is not to predict the terminal value of an investor’s pot but rather to be able to compare one scheme with another and to stress test the assumptions.  What is the range of terminal values a scheme may offer? How large is the best outcome, and what’s the worst result?

Once trustees consider a scheme’s potential outcomes, they must assess risk. The worst outcome from a high-risk strategy may be better than the best from a low-risk one. De-risking and moving into cash as the member approaches retirement will reduce volatility but impair the growth potential. Is this a trade-off that benefits members?

At Socius, we have developed a framework to test, score, and rank all strategies, from vanilla glide paths to schemes that apply a risk management overlay to an individual member’s pot. We typically use a risk/return ratio that focuses on losses rather than overall volatility, like a  Sortino Ratio, to score strategies because they credit strategies that try to offer some protection.