Common investment questions answered

Whilst spending more time in our homes, many of us have reconsidered what we want from them and taken the opportunity to make changes. Equally, trustees may wish to reassess their scheme’s investment portfolio to make sure that it is well designed to deliver what is required in likely quite different economic circumstances.

There may be ways that you can improve your outcomes by lowering costs, or reducing risks. The benefits of acting on behalf of over £100bn of assets are greater value for money (i.e. lowering costs), and innovations in risk management, to help trustees design a portfolio that meets its scheme’s exact needs.

We’ve shared below the answers to some key questions you might have around your investment portfolio. For more detailed information or to discuss how Willis Towers Watson can support your scheme, please contact us.

Common questions

• Independent trustees’ perspective on fiduciary management
• Transaction costs – a convenient excuse for the status quo?
• I’ve de-risked – what next?
• Investment fees – how much do managers, consultants, administrators make?
• Selecting a fiduciary manager – which style best suits my scheme?
• Am I protected against the next market downturn?
• The investment world is changing more quickly than ever - how do we keep track of it all?
• How do we make sure our investments are sustainable / ESG friendly?
• How do I manage the costs of running my portfolio?

Appointing an independent professional trustee (IPT) to a board can significantly “raise the game” in terms of industry knowledge and decision making. It is also a good fit with adopting a fiduciary management model for implementing the investment strategy, for the reasons described below. The opposite argument – that an IPT can more or less replicate the services provided by a fiduciary manager – is unlikely to hold water, in light of the organisational structure required to run a portfolio on a day-to-day basis.

In practice, we find IPTs can be amongst the more vocal advocates for adopting a fiduciary model. Some may view the level of investment operational risk to be unacceptable without professionally managed processes; others appreciate the greater efficiency, risk management and scale benefits that a well resourced fiduciary manager can bring. The roles of the IPT and fiduciary manager complement rather than overlap with each other: the former’s job is to help the trustee board set the most suitable strategy, having regard to the sponsor covenant and membership profile, whereas the latter’s job is to execute that strategy effectively, drawing on its firm-wide scale and processes.

In the context of appointing and monitoring a fiduciary manager, an IPT will also play a prominent role. In particular, the IPT can draw out the differences between various types of fiduciary managers (the “Boutique FM”, “Consultant FM” and “Fund manager FM” models described by the Pensions Regulator), and comment on their suitability for the scheme. They will also provide input during the selection process, possibly alongside a third party evaluator. After the appointment, they can be a source of independent oversight in assessing the effectiveness of the fiduciary management on an ongoing basis.

When considering material changes to an investment portfolio (which may for example happen when appointing or replacing a fiduciary manager), trustees should seek to understand fully the costs that will be incurred in selling and buying assets. An obvious and sensible principle is that a change should only be made if the benefits overweigh these costs. In this context, “costs” do not refer only to direct payments to a third party (e.g. brokerage fees and stamp duty), but also other indirect costs that result in a fall in the post-trade value of assets (e.g. through bid-offer pricing).

In practice, comparing costs and benefits can be difficult, when one considers that the former are (more or less) measurable whilst the latter can be “probabilistic” in nature. As an example, consider the appointment of a fiduciary manager to implement a portfolio resulting in initial transaction costs of £200,000, half of which is in relation to stamp duty for real estate related assets. Following the change, the trustees will have a scheme with a marginally lower funding level, but an investment portfolio with better risk and return characteristics, as well as a better negotiated fee deal. It may be helpful to consider a notional “payback period” – for example, if each year the new portfolio is expected to generate an additional return of £50,000 and reduce ongoing fees by £50,000, then it would notionally cover the one-off transaction costs over two years, and anything delivered beyond that would be a clear “win”.

However, other things do not fit so easily into this comparison. In the same example, the new portfolio is exposed to less risk, so that following a significant downturn in markets the scheme might be £3m better off (covering the costs of making the change 15 times over). And should the stamp duty be included in full as a transaction cost, if this is already reflected in the purchase price of the real estate assets?

In many cases trustees find that, when considered in the right light, the benefits for improving the portfolio far outweigh the initial transaction costs, and the payback period is relatively short. By contrast, in cases where only the costs but not the benefits are taken into account, the result could be an out-dated portfolio that has fallen a long way from industry best practice, and is exposed to both unnecessary downside risk and the corrosive effects of high ongoing fees.

Many schemes have seen their funding level improve in recent years, following a rise in markets (including a rebound after the recent Covid-induced volatility) and the introduction of revised mortality improvement models. As a result, their trustees have reduced the investment return target. Whilst small de-risking changes can be effected simply by rebalancing across return-seeking and liability-matching allocations, for larger changes adapting a new approach may be more effective in reducing risk. In particular, at lower levels of target return, a scheme can invest predominantly in “contractual income assets” – investments that pay back a largely predictable level of income – in order to cover the payments they expect to make to members.

This sort of approach, commonly described as Cashflow Driven Investment (CDI), can mitigate the downside risk more effectively than other ways of de-risking. By minimising the need to sell assets to pay benefits, the scheme is less exposed to changes in the market value of the underlying investments. The similarity to the sorts of assets held by insurance companies also helps to keep pace with bulk annuity pricing, allowing the scheme to lock down investment risk and wait for membership ageing (alongside transfers out of the scheme) to close the gap to an eventual buyout.

Implementing a CDI strategy properly requires the ability to source a range of complementary, secure, long-dated, income-generating assets. Diversification is just as important in managing risk in a CDI setting, as is using best-in-class managers to find the most reliable income streams in each specialist area. Our CDI portfolios are flexible and tailored to the requirements of each scheme, but typically include some or all of: government bonds, derivatives, investment grade credit, alternative credit, secure income assets, pensioner buy-ins and longevity hedging. Our mandates may also have an explicit goal of getting to a full buy-out within a particular timeframe, with support from our settlement transaction specialists throughout the journey. Making the most out of the advantages of CDI will also require an understanding of the integrated funding and investment framework, and establishing the right information feeds to the actuary so that liabilities can be valued consistently.

Those working in the pensions investment industry can be divided into a number of broad categories. Investment consultants and fiduciary managers help the trustees to decide which areas to invest in, and which asset managers to appoint. In their turn, asset managers select the individual investments (ranging from a share or bond issued by a company to more complex financial instruments) in line with their strategy, and make the trades to buy and sell accordingly. Other professionals work in areas that may be less visible to the trustees on a day-to-day basis, overseeing the systems and platforms needed for investment activity to take place: safeguarding assets, recording trades, reporting on performance, as well as meeting various legal and other compliance requirements.

For a typical investment portfolio targeting an annual return of 3% say, the total investment fees incurred may be of the order of 0.5% to 1% pa. In other words, a “simple” portfolio may target an annual gross return of 3.5% (by investing mostly in mainstream markets), whilst deducting around 0.5% of assets in fees. By contrast, a more “sophisticated” portfolio may target an annual gross return of 4% (by investing across a range of return sources, with the aim of delivering more stable outcomes), whilst deducting around 1% in fees.

A very rough indicative split of the total fees paid to different service providers may be along the lines of: 10-30% to the consultant or fiduciary manager, 30-50% to the asset manager for making selections, 20-30% incurred by the asset manager in making trades, and around 10% for other “back office” activities. The precise attribution would of course depend on the circumstances of each scheme. For example, a scheme moving from an advisory to a fiduciary model may see an increase in the consultancy / fiduciary fee (reflecting the higher level of activity and more comprehensive service) alongside a reduction in the asset manager fee (reflecting the better negotiating power of the fiduciary manager).

Generally speaking, we are seeing downward pressure on fees being applied across all of these areas. For fiduciary managers, this has come from increased competition from new entrants to the industry, as well as the requirement for re-tendering brought about by the Competition and Markets Authority. Asset managers – arguably the “biggest earners” in the industry to date – may now agree to substantial fee discounts in order to be included in the portfolios run by the larger fiduciary managers. New rules for full transparency of trading costs are also encouraging some streamlining of investment processes in order to reduce transaction costs. Finally, the launch of a number of investment platforms are also starting to reduce the cost of back office activity through greater economies of scale.

In the UK there are now over a dozen fiduciary managers (FMs) providing services to pension schemes. The Pensions Regulator groups these into three types: specialist / boutique firms whose sole business is based on fiduciary management services (“Boutique FMs”), firms linked to investment consultants / advisory firms (“Consultant FMs”), and fund managers who offer fiduciary management as part of their broad product range (“Fund Manager FMs”).

Each provider will of course argue that their model is optimal. In the case of Consultant FMs, the differentiating advantages include: experience in helping trustees to set the overall strategy (such as journey plans and de-risking triggers), understanding of pension-specific issues (funding implications, member options and insurance transactions) the use of best-in-class managers in each area (versus using a provider’s own funds), independence and transparency (with no commercial incentive to invest in more expensive products). The larger Consultant FMs will also enjoy scale advantages in the form of fee discounts and the ability to research and invest across a number of areas, with the flexibility to provide a tailored approach for schemes of all sizes.

Trustees that are looking to appoint a fiduciary manager should consider which model is most suited to their needs. A credible intermediary (e.g. a third-party evaluator or experienced independent trustee) can help with putting in place the right framework for the tender, including the identification of the right FM model from the outset.

When managing a pension scheme’s assets, trustees will have two high level aims: to deliver a required level of return, and to limit the potential for a significant deterioration in the funding position. Of these two aims, the first is relatively straightforward – any investment professional (even working as an individual) can blend the right proportions of equities and government bonds (say) to target any reasonable return. The second aim is far more difficult to get right, and future-proofing a portfolio against a range of possible adverse scenarios requires specialist expertise and substantial scale.

There are two main ways to enhance portfolio resilience. The first is diversification – investing across a range of asset types which derive their returns from different economic sources will significantly reduce the effect of a fall in the mainstream equity or bond markets. Doing this well requires a well-resourced research function to identify best-in-class specialists in each area, as well as the negotiating power to keep fees to a reasonable level. The second way is to incorporate explicit protection – for example strategies that deliver a positive return when markets fall, using options to achieve a specific pay-out profile or to gain exposure to “flight-to-safety” assets. However, putting in place effective protection strategies can be challenging, and the costs can outweigh the benefits if an overly simplistic approach is adopted. The key here is to target these strategies in the right place and at the right time, whilst minimising the costs of implementation.

A scheme operating on its own is unlikely to have the scale and resources to be able to implement the above risk management strategies in the most cost effective manner. This could result in unacceptable risk exposure, the loss of a substantial part of the portfolio’s potential upside, or a reliance on less reliable approaches such as making market timing calls. By contrast, in a fiduciary management model, trustees can draw on economies of scale to protect their schemes properly, regardless of asset size. With member profiles maturing and many sponsors focusing on avoiding a contribution spike, limiting the downside exposure should now be a key focus when deciding how to invest. Better funded schemes may also start to consider using insurance options (such as pensioner buy-ins).

Trustees of DB pension schemes will have noticed the significant increase in legislative requirements affecting how they operate, and the expectation of more rules and regulations to come. In the context of managing a scheme’s investments, these include the incorporation of ESG, stewardship and sustainability, changes to the Statement of Investment Principles, GDPR and derivative reporting requirements, and upping the requirements on trustee knowledge and understanding. Collectively, these translate into higher standards for what lay and professional trustees alike should do, disclose and know. Some increased activity will also come as a result of Brexit, as we await a raft of pensions legislation previously put on hold, and deal with the regulatory uncertainty of operating outside the EU.

The investment approach will also need to adapt to wider developments in relation to greater pensions freedoms, GMP equalisation, and the switch in the inflation measure from RPI to CPI. At the same time, faced with volatile market conditions, portfolios can be made more resilient by diversifying into “new” markets, such as China. The increased requirement for expertise and governance time, against the background of a gradual “brain drain” of long-serving in-house DB pensions and investment executives approaching their own retirement, has been one of the factors behind the trend towards a streamlined operational model, under which compliance is delegated to a fiduciary manager. This allows the trustees to focus on the overall investment strategy - making maximum use of their understanding of the circumstances of their members and sponsor - without being bogged down in legislative and technical detail, or running the risk of non-compliance or late compliance.

There are many paths to investing sustainably, with the most commonly taken being: ESG integration (including a wider set of environmental, social and governance information when making decisions), stewardship (caring about and staying involved in the investments held) and impact (looking at the real world consequences of the investments for society, people and the planet alike).

Recent and pending regulation will increasingly require trustees to consider sustainability when investing scheme assets, and to disclose their approach publicly. At the same time, the impending breakdown of the climate has become headline news, generating grassroots concern and interest from members - including those in DB arrangements – and putting pressure on trustees and scheme sponsors to respond.

When deciding on the right way forward, some important questions need to be considered. Firstly, is sustainability a key driver in delivering better long-term investment outcomes, or do the trustees see the impact as at best neutral from a purely financial perspective? Likewise, should each board come to their own decision on what it means to integrate sustainability effectively, or does pooling assets with other investors create a more effective platform for change?

The rapid developments in this area mean that the approach taken by managers, consultants and fiduciary managers across the industry can be markedly different. Trustees need to see through “greenwashing” and ineffective integration, to identify providers who truly understand the case for sustainability, and have strengthened their approach in this area. We at WTW have long held that sustainable investing leads to improved outcomes (financial, member, societal, and environmental) - a belief backed by empirical evidence and woven into our investment philosophy.

In an environment of potentially low future returns, it is more important than ever to carefully manage the costs of running a scheme’s portfolio. Trustees also have a fiduciary duty to ensure that the fees paid for investment services represent value for money. However, rather than simply “minimising spending”, the mantra should be “paying only for things that improve the outcome”.

For instance, if a particular investment strategy is expected to deliver extra return through the application of a specialist skill (e.g. through active management) then that skill could well be worth paying for, not only for the enhanced return (net of all the associated fees) but also because it allows for less risk to be taken elsewhere in the portfolio. Similarly, whilst a stable funding level progression is desirable for many schemes, for others (e.g. those paying out a large proportion of assets each year, or those with weaker covenants) it is absolutely critical – this leads to a strong case for including a manager that can generate a differentiated type of return, contributing to a more stable outcome at an overall scheme level. Doing so may incur higher fees than a more simplistic investment strategy, but the improvement in portfolio resilience, particularly during a market downturn, could justify the incremental fees many times over.

The ideal outcome, of course, is to have a robust portfolio, but to also achieve significant fee savings. Reducing costs without making portfolio compromises will feed straight into the net return “bottom line”, and should be seen as a no-brainer. Some approaches for achieving this are obvious: for example, negotiating the best possible fee deals with the asset managers. Other approaches are less obvious: for instance, replicating more expensive strategies more cheaply, by implementing “hedge fund like” strategies using mechanical trading rules. All of these things require substantial scale and strong relationships with the asset management industry - by pooling assets with other pension schemes, both large and small schemes can benefit from substantial fee savings relative to going it alone.