How to analyse auto-enrolment default funds - January 2017 Accredited by - Nest Pensions

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How to analyse auto-enrolment default funds - January 2017 Accredited by - Nest Pensions
How to analyse
auto-enrolment
default funds

January 2017

Sponsor          Accredited by
How to analyse auto-enrolment default funds - January 2017 Accredited by - Nest Pensions
Contents
    Target audience                                    3

    Introduction                                       4

    Learning objectives                                5

    Part 1 – Analysis of the key factors to            6
    consider when reviewing default funds
    Default fund due diligence checklist               10

    Part 2 – Analysis of the most                      11
    commonly used default funds
    Part 3 – NEST and its default fund                 20

    Conclusion                                         28

    Test yourself for CPD                              32

    Acronyms

     ABI       Association of British Insurers
     AMC       Annual management charge
     CIO       Chief Investment Officer
     CPI       Consumer price index

     DC        Defined contribution

     ESG       Environmental, social and governance

     FCA       Financial Conduct Authority

     IC        Investment committee

     IGC       Investment governance committee

     MVO       Mean variance optimisation

     NEST      National Employment Savings Trust

     TCF       Treating customers fairly

     TER       Total expense ratio

     TPR       The Pensions Regulator

     RPI       Retail price index

     UFPLS     Uncrystallised funds pension lump sum
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How to analyse auto-enrolment default funds - January 2017 Accredited by - Nest Pensions
Target audience
This case study is written for professional financial
advisers and paraplanners responsible for researching and
recommending auto-enrolment pension schemes.
While not authorised to provide investment advice, this case study will also be of
interest to accountants and bookkeepers who are looking to provide their clients
with an enhanced service through the involvement of a regulated adviser and/or
by at least understanding what is available in the market to inform their clients.

This case study should not be considered as evidence to support any recommendations
or endorsement of any specific provider or scheme. Advisers should conduct their
own research and document their findings before recommending any solutions.

Authors

  Patrick Norwood                                 Richard Hulbert
  Insight Analyst                                 Insight Analyst
  (Funds)                                         (Wealth products)
  pnorwood@defaqto.com                            rhulbert@defaqto.com

                                                                                      3
How to analyse auto-enrolment default funds - January 2017 Accredited by - Nest Pensions
Introduction
    In this case study we independently review the defined contribution
    (DC) market place and more specifically the auto-enrolment
    propositions and their default funds.

    We highlight the key factors we feel advisers should understand, have an awareness of and be
    considering when reviewing the default fund on offer, especially as historically 9 out of 10 savers have
    remained in the default fund from inception to retirement.

    Being able to recommend a scheme after evidence-based analysis of the default fund places financial
    advisers in a very strong position with their client. We have split this case study into three parts:

           1. Analysis of the key factors to consider when reviewing default funds
           2. Comparison of the most commonly used default funds
           3. Specific focus on the National Employment Savings Trust (NEST)
              proposition

    In the first part we set the scene with background       This study will focus on the needs
    information relating to the auto-enrolment               of the first two groups.
    scheme landscape, scheme structures and
    variations. We then analyse and compare the              The overarching need for regulated advisers
    most commonly used default fund options                  is to be able to evidence ‘value for money’.
    available, across several different criteria. Finally,   This does not mean the cheapest solution,
    we look at NEST’s default fund offering with the         neither does it mean the best performing
    objective of helping readers to understand their         fund, but rather an assessment that includes
    approach and positioning compared to peers.              these elements but ultimately creates
                                                             a good outcome for the consumer.
    Auto-enrolment has now been with us for over
    three years, with some 200,000 large employers
    having already gone through staging. The
    market is now splitting into three groups:
                                                                             Evidence
                                                                          value for money
    1.   Employers still to stage: commonly
         these have fewer than 30 employees

    2.   Employers who have already staged and
         are dissatisfied with their current solution

    3.   Employers who have already staged and
         are satisfied with their current solution

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How to analyse auto-enrolment default funds - January 2017 Accredited by - Nest Pensions
Learning objectives
This case study is accredited by the CII/PFS and CISI for up to 60
minutes of structured CPD.

Reading this publication will enable you to:

   1       Understand the different default investment strategies available, focusing upon the
           accumulation phase

   2       Identify the main differentiating factors to be considered between the individual
           default investment propositions including:
           •    The investment management procedures and responsibilities
           •    Implications of in-house and outsourced management
           •    Clarity, robustness and repeatability of decision making
           •    How defaults are performing against benchmarks and peers
           •    Suitability of the default and identifying value for money

   3       Understand how the various default propositions in the market differ from each other
           to support market research and due diligence

For clarification, NEST has commissioned
Defaqto to undertake this review of default funds
in the auto-enrolment pension scheme market
place. A comparison of the NEST proposition
with its peers will help advisers understand
how the proposition fits in the market.

To do this, Defaqto has detailed the independent
assessment criteria and factors advisers
should be considering and evidencing to
impartially research default funds as part of
their compliant due diligence process.

                                                                                                  5
How to analyse auto-enrolment default funds - January 2017 Accredited by - Nest Pensions
INSERT IMAGE

    Part 1 – Analysis of the key
    factors to consider when
    reviewing default funds
    Scene setting
    With so many schemes available for the purpose of this study, we have focused on those most
    commonly used based on the value of assets under their management, namely:

          •   Aegon                                    •   NOW Pensions
          •   Aviva                                    •   Prudential
          •   B&CE (The People’s Pension)              •   Royal London
          •   Friends Life                             •   Scottish Widows
          •   Legal & General Investment               •   Standard Life
              Managers (LGIM)
          •   NEST

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How to analyse auto-enrolment default funds - January 2017 Accredited by - Nest Pensions
Key factors to consider
Below are the key factors we believe should be considered:

      1. Good governance, what this looks like and how it is evidenced
      2. The provider’s financial strength and/or capability
      3. The implications of
         in-house and outsourced investment management
      4. The investment management procedures and responsibilities
      5. The clarity, robustness and repeatability of decision making
      6. How defaults are performing against benchmarks and peers
      7. The suitability of the default fund and identifying value for money

We will go into detail for factors 3 to 7 above, which are those that are most related to investment (the
main focus of this study).

The implications of in-house and outsourced investment
management
Researchers should look at the investment             Independence is considered essential by both
committee that has the remit to run and manage        regulators (FCA and TPR) to reduce the possibility
the default fund and ascertain what, if any,          of any potential for conflicts of interests.
conflicts of interests exist and how ‘value for       Indeed, the FCA has regulated that contract-
money’ is being evidenced. For example, if XYZ        based schemes should have an independent
is the pension provider and the default fund          governance committee (IGC) that must publicly
only invests in funds from XYZ, then this may         report to members on at least an annual basis.
affect analysis of independence and costs.
                                                      The FCA has placed a duty on IGCs to
The implication for in-house arrangements is          scrutinise the ‘value for money’. An IGC has
that there may be a greater chance of a conflict      a minimum of five members, the majority
of interest existing between the provider’s           of whom must be independent, including
needs and those who are invested in the               an independent chair, and must:
default fund. In addition, without independent
oversight, it may be more difficult for those         •    Act solely in the interests of
making investment decisions and/or managing                relevant scheme members
the funds to be removed easily or prudently.          •    Act independently of the provider

                                                                                                            7
How to analyse auto-enrolment default funds - January 2017 Accredited by - Nest Pensions
Factors IGCs must report on include:
          •   Assessing the ongoing ‘value for money’ of the workplace pension
              scheme
          •   Acting solely in the interests of relevant scheme members (savers)
          •   Raising any concerns with the provider’s board
          •   Escalating their concerns to the FCA, if necessary
          •   Reporting annually on what they have done

    The TPR guidance is less around independence        in-house with elements such as investment
    and evidencing ‘value for money’ and more           management outsourced to independent third
    around requiring trustees to have strong            parties. It is not unusual to find some form
    governance and protecting member’s                  of independent scrutiny and reporting being
    interests. Full details can be found in the         undertaken on the in-house decisions, and
    DC code, and advisers should familiarise            these reports can aid the selection process.
    themselves with this before recommending
    a trust-based scheme. It can be found at:           Impartial oversight and/or outsourcing to
                                                        independent third parties does not necessarily
    thepensionsregulator.gov.uk/codes/code-             increase costs, indeed the opposite can
    governance-administration-occupational-             sometimes be true. Importantly, they provide
    dc-trust-based-schemes.aspx                         managers and trustees with the ability to
                                                        appoint professionals to meet specific needs and
    Many schemes are run on a hybrid basis, whereby     target them accordingly, with failure potentially
    the overall strategy is designed and managed        resulting in their prompt replacement.

    The investment management procedures and responsibilities
    There are three elements to consider here:

       Investment strategy                Working practices             Individuals involved

    1) Investment strategy                              One should also understand the control checks
                                                        in place to make sure the working practices are
    This is not a simple case of selecting a passive    being followed correctly and comprehensively.
    philosophy over an active one. The key is to
    match the strategy to the profile of the employer
    and its employees. For example, if the workforce    3) Individuals involved
    is primarily within 10 years of retirement, a       This could potentially be more of an issue
    high-risk strategy is unlikely to be appropriate    with smaller trust-based schemes.
    for the members or indeed a predominance
    of options in the higher risk universe.             One should look at the control and
                                                        influence individuals have and whether
                                                        their knowledge, experience and expertise
    2) Working practices
                                                        is sufficient to make such decisions.
    How robust, repeatable and independent
                                                        As a final check, one should also consider if the
    are the working practices used to govern
                                                        combined process works in the best interests
    the investment strategy? How can this be
                                                        of members.
    evidenced and what breaches and changes
    have there been in recent years?

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How to analyse auto-enrolment default funds - January 2017 Accredited by - Nest Pensions
The clarity, robustness and repeatability of decision making
Having a clear, understandable and documented      some funds have reached saturation points
decision-making process is essential.              where their size makes it difficult for them
                                                   to trade competitively, for example selling
Advisers should be checking that there is a        a £1m shareholding in a company is a lot
documented (freely available) clear structure      easier than selling a £50m holding.
and decision-making process in place. Questions
should be asked about how the processes            Advisers should be looking for schemes that
are managed and compliance checked. In             are not necessarily constrained by their size,
particular, when exceptions have occurred,         irrespective of their performance. Those
what impact have these had on savers?              schemes that can facilitate investment through
                                                   diversification of asset classes and investment
The nature of auto-enrolment is that with          managers are quite often better able to meet
capital growth and ongoing contributions, the      this need. In other words, exposure to, say,
value of the funds under administration will       the UK stock market is provided through more
grow quickly and significantly. Historically,      than one asset class, fund and/or manager.

How defaults are performing against benchmarks and peers
Many of the factors we have discussed so           Some providers combine options A, B
far are subjective, and not all providers will     and/or C with D (a volatility band) and
be able to answer all of your questions.           this can be a good way to monitor both
Evidence-based analysis is therefore               volatility (risk) and overall return.
critically important to evidence suitability
and value for money of the default fund.           Advisers should also agree an appropriate
                                                   timescale for the benchmark assessment
Benchmarking provides a clear parameter            period. Pension fund providers often talk about
by which initial and ongoing suitability can       20+ year returns, especially those investing in
be assessed and should be agreed with              infrastructure projects (building railways, power
the client as being appropriate. Advisers          stations etc). However, for many savers, 20 years
should also agree an appropriate timescale         will be around half of their working life and
for the benchmark assessment period.               advisers would be irresponsible to leave their
                                                   clients in a poor performing fund for that long.

                                                   At Defaqto, we consider anything less than
   Providers preferred benchmarks                  three years’ performance to be insufficient to
   vary greatly across the industry,               draw any meaningful conclusion; ideally one
   common examples including:                      should be looking at five or more years.

                                                   Irrespective of the provider’s preferred
   A A
      ssociation of British Insurers
                                                   benchmark, we suggest advisers recommend
     Mixed Investment                              a benchmark that is relevant and easily
     40-85% Shares                                 understood by both employers and employees.
                                                   For many, we would expect this to be either
   B Cash + x% pa                                  option B or C, perhaps with D overlaid.
   C Inflation (CPI or RPI) + x%
   D Volatility

We also see some providers opting to use
composite benchmarks, ie different benchmarks
for different elements of the assets held. While
composite benchmarks may work well for
providers and fund managers, they are almost
incomprehensible to the average consumer
and therefore somewhat meaningless.

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How to analyse auto-enrolment default funds - January 2017 Accredited by - Nest Pensions
Default fund due
     diligence checklist
     The most important factor when making recommendations is to
     meet the client’s needs and objectives, whether they be individual
     or corporate. It is good practice to consider, at least, the following
     items in your research:
                                                                                                   3
       A    Ascertain, agree and document advice needs
            • Clients’ needs, objectives and aspirations
            • Risk framework
            • Timeframes
       B    Provider’s financial strength and capability
            • Holds an attractive AKG rating and/or Master Trust Assurance (type 1 and 2)

       C    Scheme strengths and weaknesses
            • Provides guaranteed acceptance of employers and employees
            • Any age restrictions
            • Any salary restrictions
            • Ability to facilitate tax relief for all
            • Alternative fund options available such as ethical and Sharia

       D    Investment management procedures and responsibilities
            • Level of independence
            • Whether investments are sourced in-house and/or from third parties and
                the implications of the strategy
            • Does the investment strategy match the client and their needs?
            • Are there robust and repeatable working practices in place?
            • Are the individuals involved suitably experienced and qualified and managed?

       E    Clarity, robustness and repeatability of default fund decision making
            • Is there a documented and clear structure and decision-making process in
                place?
            • Is it being adhered to and how is it compliance managed?
            • Is the fund of a size able to facilitate sufficient diversification and pricing to
                operate in the client’s/saver’s best interests?
       F    Benchmarking
            • Agree independent, relevant and easily understood benchmarks against
               which performance can be measured
            • Agree suitable timescales
            • Put in place an action plan to follow if underperformance is identified
       G    Assess value for money and suitability
            • Detail how the selected default fund compares to its peers in each of the
                above areas
            • Provide an overall assessment and summary of the decision-making
                process and ultimate selection
       H    Set periodic review dates for
            • Updating The Pensions Regulator
            • Ongoing scheme and contribution suitability assessments
            • Tri-annual reviews
            • Trustee meetings
            • Implementing additional employee benefits and pension/financial reviews
            • Implementing additional business financial planning (key man insurance etc)
10
Part 2 – Analysis of the
most commonly used
default funds
Default investments are the funds in which contributions to
workplace pensions will automatically be invested, unless employees
are given and exercise their own investment choice, in which case
there will be a range of funds from which they may choose.
According to Moneywise, 84% of savers are relying on their pension provider’s default fund to save for
their retirement, therefore it is very important employers choose a default fund that is appropriate
for them. When comparing the default offerings in the main growth phase across the different
organisations in this study, we used the funds shown in Table 1.

Table 1: Main default funds

  Provider                                  Fund name
  Aegon                                     Aegon Default Equity & Bond Lifestyle (ARC)
  Aviva                                     Aviva Diversified Assets Fund II

  B&CE (The People’s Pension)               Balanced Lifestyle Profile

  Friends Life                              Friends Life My Future Growth

  LGIM                                      LGIM PMC Multi-Asset 3

  NEST                                      NEST 2040 Retirement Date Fund
  NOW Pensions                              Diversified Growth Fund
  Prudential                                Prudential Dynamic Growth IV
  Royal London                              Royal London Governed Portfolio 4
  Scottish Widows                           Scottish Widows Pension Portfolio Two

  Standard Life                             Standard Life Active Plus III
                                                                                                         11
Benchmarks                                          Investment process
     Performance benchmarks vary greatly across          As can be seen from Table 2 below, there is a mix
     the default funds reviewed, with ABI Mixed          of manager structures across the main default
     Investment 40-85% Shares, cash plus 3% pa           funds reviewed: some keep fund management
     and composite benchmarks amongst the                in-house, either using fund managers from
     comparators used. Aviva and Standard Life           elsewhere within their organisation or investing
     do not have any performance benchmarks,             directly in securities; a couple of default funds
     but instead use volatility targets. NEST,           completely outsource to external managers;
     on the other hand, has both performance             while others use both in-house and third-party
     benchmarks and volatility targets.                  managers.

     Table 2: Main default funds – fund manager structure and investment approach

       Provider                            Fund manager(s) and investment approach

       Aegon                               Aegon/BlackRock (passive)

       Aviva                               In-house (active and passive)

       B&CE (The People’s Pension)         State Street Global Advisors (passive)

       Friends Life                        BlackRock and LGIM (passive)

       LGIM                                In-house funds (passive)

                                           Amundi, BlackRock, LGIM, Northern Trust,
       NEST
                                           RLAM, SSGA and UBS (active and passive)

       NOW Pensions                        In-house (active)

       Prudential                          BlackRock (passive) and M&G (active)

       Royal London                        In-house (active) and BlackRock (passive)

       Scottish Widows                     Aberdeen, Scottish Widows and SSGA (passive)

       Standard Life                       Mainly in-house funds (active)

                                                                            Source: provider websites and factsheets

     The main rationale for outsourcing to third-        In terms of investment approach (active
     party managers is that no one manager can           versus passive fund management), there is
     be the best across every single asset class, but    also a mix. Active managers have the chance
     instead one should source a specialist manager      to outperform the respective index, but also
     for each different area. The disadvantage of        run the risk of underperforming it. Passive
     this method is that third-party managers are        managers, meanwhile, simply track the index
     generally more expensive than managing              and generally cost less. Looking at it from a ‘value
     the funds in-house; however, this may well          for money’ perspective, the passive strategy
     be dependent on the available economies             has the ability to control risk, diversification
     of scale and negotiating position.                  and costs and is therefore worth considering
                                                         as an element within a default fund.

12
Asset classes
Table 3 shows the high-level asset classes in which each of the main default funds invest.

Table 3: Main default funds – high-level asset classes used

                                            Fixed
 Provider                 Cash                                Property          Commodities         Equity             Derivatives
                                            income

 Aegon                    Yes               Yes                                                     Yes

 Aviva                    Yes               Yes               Yes               Yes                 Yes                Yes

 B&CE (The People’s
                          Yes               Yes                                                     Yes
 Pension)

 Friends Life             Yes               Yes                                                     Yes

 LGIM                     Yes               Yes               Yes                                   Yes

 NEST                     Yes               Yes               Yes                                   Yes

 NOW Pensions             Yes               Yes                                                     Yes

 Prudential               Yes               Yes                                                     Yes

 Royal London             Yes               Yes               Yes               Yes                 Yes                Yes

 Scottish Widows          Yes               Yes                                                     Yes

 Standard Life            Yes               Yes               Yes               Yes                 Yes                Yes

                                                                                                    Source: provider websites and factsheets

As can be seen, all will contain equities, fixed income and cash. Some will also hold ‘alternative’ asset
classes to varying degrees. The advantages of such asset classes are the greater potential for higher
returns and diversification; however, they can also be more risky, expensive and less transparent.

                                                                                                                                               13
Performance
     Performance numbers are now compared across the main default funds, in their
     main growth phase (unfortunately, NOW Pensions were unable to provide the data
     requested). Table 4 below shows ‘raw’ performance numbers for the funds.

     Table 4: Annualised returns

      To end November 2016                                1yr                2yr                3yr               5yr

      Aegon                                           14.93%              8.69%              9.42%                    -

      Aviva                                           13.15%              7.75%              8.69%             7.30%

      B&CE (The People’s Pension)                     18.86%              9.68%              8.57%                    -

      Friends Life                                    15.92%              9.38%              9.78%                    -

      LGIM                                            17.60%              8.74%              9.23%                    -

      NOW Pensions                                            -                  -                 -                  -

      NEST                                            17.21%              9.93%            10.76%             10.80%

      Prudential                                      15.35%                     -                 -                  -

      Royal London                                    11.34%              7.77%              8.33%            10.54%

      Scottish Widows                                 17.31%              8.52%              8.43%            11.56%

      Standard Life                                     6.06%             4.41%              5.54%                    -

                                               Source: data from Morningstar, ONS, B&CE and NEST; calculations by Defaqto

     These figures, however, are returns only and take no account of the fund’s volatility ie the risk
     taken in achieving these returns. Information ratios, which are fund return minus benchmark
     return divided by the volatility of these ‘excess’ returns, do take risk into account.

     These ratios have no units, but a higher number indicates better risk-adjusted
     performance. As mentioned earlier, though, there is no one benchmark for the whole
     industry. For this study, ABI Mixed Investment 40-85% Shares and inflation (CPI) plus
     3% are used. Tables 5 and 6 show information ratios with these benchmarks.

14
Table 5: Information ratios using ABI Mixed Investment 40-85% Shares benchmark

 To end November 2016                         1yr                2yr               3yr                5yr

 Aegon                                       1.13               1.02               0.75                   -

 Aviva                                       1.44               1.10               0.79              -0.27

 B&CE (The People’s Pension)                 0.28               0.22               0.16                   -

 Friends Life                                1.94               1.29               1.23                   -

 LGIM                                        1.65               0.74               0.59                   -

 NOW Pensions                                     -                  -                 -                  -

 NEST                                        1.35               1.04               1.04              0.65

 Prudential                                  0.87                    -                 -                  -

 Royal London                                -0.08              0.67               1.15              0.91

 Scottish Widows                             1.17               0.49               0.57              0.56

 Standard Life                               -0.99             -0.67              -0.29                   -

                                   Source: data from Morningstar, ONS, B&CE and NEST; calculations by Defaqto

Table 6: Information ratios using CPI plus 3% benchmark

 To end November 2016                         1yr                2yr                3yr               5yr

 Aegon                                       1.30               0.51               0.63                   -

 Aviva                                       1.04               0.43               0.59              0.38

 B&CE (The People’s Pension)                 0.90               0.44               0.38                   -

 Friends Life                                1.45               0.62               0.73                   -

 LGIM                                        1.63               0.58               0.71                   -

 NOW Pensions                                     -                  -                 -                  -

 NEST                                        1.59               0.69               0.89              0.85

 Prudential                                  1.31                    -                 -                  -

 Royal London                                1.14               0.51               0.64              0.82

 Scottish Widows                             1.15               0.41               0.45              0.69

 Standard Life                               0.40               0.13               0.34                   -

                                   Source: data from Morningstar, ONS, B&CE and NEST; calculations by Defaqto

                                                                                                                15
Information ratios penalise upside and downside        downside deviations and are the fund’s return
     volatility equally. Most people would consider         minus the risk-free rate divided by the downside
     volatility caused by high returns to be acceptable,    volatility. Sortino ratios for the main default funds
     but volatility due to low returns to be ‘bad’.         are shown in Table 7 below (again, these ratios
     Sortino ratios differentiate ‘bad’ volatility of       have no units, but a higher number indicates
     returns from total volatility by penalising only       better downside risk-adjusted performance).

     Table 7: Sortino ratios using 0.5% risk-free rate

      To end November 2016                                 1yr              2yr                3yr               5yr

      Aegon                                                2.53             1.46              1.74                   -

      Aviva                                                2.03             1.33              1.75               1.49

      B&CE (The People’s Pension)                          2.67             1.45              1.48                   -

      Friends Life                                         3.08             1.78              2.16                   -

      LGIM                                                 4.61             1.96              2.19                   -

      NOW Pensions                                            -                 -                  -                 -

      NEST                                                 4.00             2.32              2.81               2.87

      Prudential                                           2.34                 -                  -                 -

      Royal London                                         1.88             1.43              1.77               1.84

      Scottish Widows                                      2.18             1.18              1.35               1.50

      Standard Life                                        1.33             1.09              1.59                   -

                                              Source: data from Morningstar, ONS, B&CE and NEST; calculations by Defaqto

     It is generally agreed that longer-term numbers         Costs
     are more significant from a statistical point of
     view, although only four of the default funds           Charges are now compared across the main default
     have a five-year performance history. On a              funds. Many contract-based schemes charge a
     five-year basis, Royal London has the best              variable fund annual management charge (AMC)
     risk-adjusted performance against the ABI               and administration fee or service charge. Where
     Mixed Investment 40-85% Shares benchmark.               this is the case, we have used their maximum
     Over three years against the same benchmark,            standard fee as we expect this to be the common
     with a larger sample, Friends Life has the              fee charged for employers currently staging (Q3
     best risk-adjusted performance, with Royal              2016) who primarily have 30 or fewer employees
     London and NEST very close behind.                      (see Table 8).

     NEST has the best risk-adjusted performance
     against the CPI plus 3% benchmark, which
     is its own benchmark, over three and five
     years with Friends Life and LGIM quite close
     behind on a three-year basis. NEST also
     has the best risk-adjusted performance,
     looking at just downside risk, over three and
     five years, with Friends Life and LGIM again
     fairly close behind on a three-year basis.

16
Table 8: Main default funds – charges

  Provider                             Common fee structure for savers
                                       0.50% pa
  Aegon
                                       A mixture of AMC (from 0.05%) and admin/service fee

                                       0.75% pa
  Aviva
                                       A mixture of AMC and admin/service fee

  B&CE (The People’s Pension)          0.50% pa

                                       0.75% pa
  Friends Life
                                       A mixture of AMC and admin/service fee

                                       0.50% pa
  LGIM
                                       A mixture of AMC and admin/service fee

                                       0.30% AMC
  NEST
                                       1.80% contribution charge

                                       0.30% AMC
  NOW Pensions                         Saver earning £18,000 or less: £0.30 monthly admin charge
                                       Saver earning over £18,000: £1.50 monthly admin charge

                                       0.75% pa
  Prudential
                                       A mixture of AMC and admin/service fee

                                       0.75% pa
  Royal London
                                       A mixture of AMC and admin/service fee

                                       0.75% pa
  Scottish Widows
                                       A mixture of AMC and admin/service fee

                                       0.75% pa
  Standard Life
                                       A mixture of AMC and admin/service fee

                                                                     Source: provider websites and factsheets

Clearly the AMC is not the total cost savers will    employers to apply before they offer specific
pay, and the total cost experience for them          rates. In the current environment where
should be considered in the advice provided.         employers going through staging primarily
                                                     have fewer than 30 employees, bespoke
The maximum AMC chargeable for pension               pricing on application seems unnecessary
schemes is 0.75%, although additional                as schemes will all be of a similar size.
charges can also be incurred, for example
through the pricing of trust funds. While            One also has to question how providers
some providers manufacture their schemes             operating bespoke pricing are meeting the
to the 0.75% charge, others operate a more           ‘treating customer fairly’ (TCF) rules, when
complex structure charging a combination of          an employee could be paying the same
fees, and advisers should be sure to include         contributions into the same fund but be paying
all of them in their evaluation process.             significantly different charges simply because
                                                     they have changed employer.
Advisers will find that some schemes do
not publicly state their fees, requiring

                                                                                                                17
In these circumstances, we suggest advisers err on the side of caution and consider using schemes
     that have a clearly defined and open charging structure. Tables 9, 10 and 11 below show the
     effect of these different charges by looking at the value of an illustrative pension pot over 10, 20,
     30 and 40 years. These calculations assume a starting salary of £25,000; increases of 2% pa; and
     investment growth of 6% pa. The amounts of employee and employer contributions are varied.

     Table 9: Illustrative pension fund values assuming 2% contribution rate

      Employee = 1%,                            Value at         Value at        Value at          Value at
      employer = 1%                               10 yrs           20 yrs          30 yrs            40 yrs
      No charges                                    £7,441        £22,610          £52,193          £108,440
      NEST                                          £7,191        £21,465          £48,591           £98,832

      NOW Pensions                                  £7,080        £21,187          £48,052           £97,875

      Aegon, B&CE and LGIM                          £7,246        £21,375          £47,769           £95,816

      Aviva, Friends Life, Prudential,
      Royal London, Scottish Widows                 £7,150        £20,790          £45,729           £90,165
      and Standard Life
                                                                                          Calculations by Defaqto

     Table 10: Illustrative pension fund values assuming 5% contribution rate

      Employee = 3%,                             Value at          Value at       Value at         Value at
      employer = 2%                                10 yrs            20 yrs         30 yrs           40 yrs
      No charges                                   £18,603           £56,524      £130,484          £271,099
      NEST                                         £17,978           £53,663      £121,477          £247,080

      NOW Pensions                                 £18,065           £53,974      £122,274          £248,841

      Aegon, B&CE and LGIM                         £18,114           £53,438      £119,422          £239,539

      Aviva, Friends Life, Prudential,
      Royal London, Scottish Widows                £17,876           £51,974      £114,321          £225,414
      and Standard Life
                                                                                          Calculations by Defaqto

     Table 11: Illustrative pension fund values assuming 8% contribution rate

      Employee = 5%,                             Value at          Value at       Value at         Value at
      employer = 3%                                10 yrs            20 yrs         30 yrs           40 yrs
      No charges                                   £29,765           £90,439      £208,774          £433,758
      NEST                                         £28,765           £85,861      £194,364          £395,328

      NOW Pensions                                 £29,050           £86,762      £196,496          £399,806

      Aegon, B&CE and LGIM                         £28,893           £85,501      £191,075          £383,263

      Aviva, Friends Life, Prudential,
      Royal London, Scottish Widows                £28,601           £83,158      £182,914          £360,662
      and Standard Life
                                                                                          Calculations by Defaqto

18
The numbers will, of course, vary with the assumptions used, although
      we have tried to make our inputs as reasonable and sensible as
      possible. We note the following observations:
      •    With current contributions and a smaller pension pot, NEST works
           out marginally best over the long term (20 plus years) compared to
           the other default funds in terms of overall charges, due to their low
           AMC plus their additional contribution charge having enough time
           to be sufficiently diluted
      •    Over the first 10 years, with current contributions, the schemes
           charging 0.5% and nothing else fare best as the time period is still
           too short for the dilution of the additional charges of NEST and NOW
           Pensions (on top of their lower AMCs) to have enough effect
      •    As contributions and pot sizes increase, NOW Pensions works out
           marginally better compared to the other schemes, especially over
           the longer term, with their low AMC but also their fixed admin
           charge having a decreasing effect with a bigger pot

Some of the more common fees to look out for that can be
applied to the employer and/or the employees are:

•   Application processing fee                    •   Change of contribution

•   Middleware costs                              •   Statutory communications

•   Initial fee(s)                                •   Retirement illustrations

•   Installation                                  •   Transfer illustrations

•   Subscription/membership                       •   Transfer costs (in and out)

•   Annual product fees                           •   Review costs

•   Annual management fees                        •   Changes in costs for individuals leaving
                                                      employer so scheme becomes paid up
•   Annual investment/fund fees
                                                  •   Exit fees for individuals on transfer
•   Allocation rates
                                                  •   Exit fees for individuals on death
•   Valuations
                                                  •   Exit fees for scheme/employer
•   Transactions per type/on time cost basis

      Other factors to consider include:
      •    Time out of the market – before contributions are invested
      •    Time out of the market – fund switches
      •    Time out of the market – before transfer values are released
      •    Time out of the market – taking benefits

                                                                                                 19
Part 3 – NEST and its
     default fund
     NEST is an occupational defined contribution workplace pension
     scheme and was set up to facilitate automatic enrolment as part of the
     government’s workplace pension reforms under the Pension Act 2008.
     NEST was created to offer employers and their       September 2016
     workers access to a good quality pension
     scheme, with the intention of helping more          •   Uncrystallised funds pension lump sum
     people to save for retirement. Interestingly, it        (UFPLS) options to become more flexible
     was established with a public service obligation
                                                         •   Contributions can be received while benefits
     to accept any employer, which means that
                                                             are being taken (through UFPLS)
     every single employer has access to a qualifying
     pension scheme into which they can enrol their      •   Ability to pay lump sums as benefits
     eligible workers.
                                                         •   Changes to death benefits
     NEST is one of the qualifying pension schemes
     that employers can use to meet their new duties.
     It now serves more than 3.8m members across
     over 215,000 employers, and assets under            April 2017
     management (AUM) stood at around £1.2bn at
     the beginning of November 2016.                     •   Changes to annual contribution limits
     We anticipate that due consideration will be        •   Ability to facilitate transfers in and out (for
     given by employers, on behalf of their employees,       individuals and bulk)
     to NEST as a result of these legislation changes.

20
NEST's default strategy
In the case of NEST, around 99% of members             The availability of a standalone Sharia fund is
invest in the default funds. The default option for    useful for those employers who wish to meet
NEST’s members is one of the NEST Retirement           the potential needs of some of their Muslim
Date Funds.                                            employees and therefore avoid potential
                                                       discrimination issues. Of all of the auto-
There are around 50 of these funds in existence        enrolment qualifying pension schemes, 80%
at any one time, with each corresponding to            offer this specific fund option.
the year in which the member wishes to take
out some of their money tax free and convert           For those investors who do not want to use the
the remainder into retirement benefits eg if the       default fund, some pension schemes provide
member expects to take their money out in 2040,        no alternative while others provide access to
then they will save into the NEST 2040 Retirement      hundreds of funds. NEST sits somewhere in
Fund. The member can, however, switch to a             the middle as it provides a comprehensive but
different fund, free of charge, if they later decide   focused list of alternative investment funds.
they want to save for longer or take their money
out earlier. None of NEST’s peers uses this target     Although this case study focuses primarily on
date approach, using ‘life styling’ instead.           NEST’s default funds, many of their attributes
                                                       (eg the investment beliefs and team behind
NEST does offer other fund choices for members         them) will also apply to NEST’s other funds.
with certain beliefs or for those who want to take
greater or less risk with their investments than
the average. These are the:

•   NEST Ethical Fund

•   NEST Sharia Fund

•   NEST Higher Risk Fund

•   NEST Lower Growth Fund

•   NEST Pre-retirement Fund

                                                                                                         21
Investment strategy

     NEST was able to start with a ‘blank sheet of paper’ when designing its investment process and
     governance structure. It carried out a consultation process, looking at how similar schemes operate
     around the world and learning from them. NEST has also attempted to make its solution scalable and
     is part of a network of large non-profit schemes, which also includes APG and the Ontario Teachers’
     Pension Plan.

           NEST’s investment beliefs, and upon which its investment approach is
           based, are as follows:
           •   Understanding scheme member characteristics, circumstances and
               attitudes is essential to developing and maintaining an appropriate
               investment strategy
           •   As long-term investors, incorporating environmental, social and
               governance (ESG) factors is integral to the investment management
               process
           •   Taking investment risk is usually rewarded in the long term
           •   Diversification is the key tool for managing risk
           •   Risk-based asset allocation is the biggest driver of long-term
               performance
           •   Taking account of asset values and asset prices, economic
               conditions and long-term market developments enhances long-
               term performance and informs strategic decisions
           •   Indexed management, where available, is often more efficient than
               active management
           •   Good governance, including an appropriately resourced in-house
               investment function, is in the best interests of NEST members

22
Investment team

Mark Fawcett is the Chief Investment Officer (CIO) of NEST. Table 12 lists the other key members of
NEST’s Investment Directorate.

Table 12: Key members of the NEST Investment Directorate

                                    NEST Investment Committee
                                           (four Trustees)

                                                    CIO

                     Responsible                                             In-house
    Market risk                      Investment
                     investment                           Financial        investment          Manager
    and asset                         policy and
                                                          modelling          research          research
    allocation          (two           delivery
                                                            (two           technology            (one
       (two           members           (three
                       of staff)                          members              (two            member
    members                           members
                                                           of staff)        members             of staff)
     of staff)                         of staff)
                                                                              of staff)

In addition, there is an Investment Operations        The IC also monitors fund performance and
team of four. Their main duties are to monitor        operations to make sure that the Trustee is
the performance of the fund managers used             fulfilling its legal duties. The IC consists of:
by NEST, ensure portfolios are in line with
targets, implement asset allocations and make         •     Carolan Dobson (Chair)
recommendations for any changes.                      •     Sally Bridgeland
All investment decisions are overseen by the          •     Ian Armfield
Trustee through the Investment Committee (IC),
a group of Trustee members that meets quarterly       •     Graham Berville
to review investment decisions on a formal basis.
They decide on the recommendations of the CIO         Biographies of Mark Fawcett and the IC are
regarding several factors, including:                 published on nestpensions.org.uk

•     Investment objectives

•     Risk budgets

•     Strategic asset allocations

•     Fund manager selection

•     Fund manager monitoring

•     Investment costs

                                                                                                            23
Investment approach

     The life of each of the Retirement Date Funds is split into three different phases: Foundation, Growth
     and Consolidation, as shown in Table 13.

     Table 13: The different phases of NEST’s Retirement Date Funds

      Phase                Rationale                                Return target           Volatility target
                           NEST has a Foundation phase,             Keep pace with CPI      Long-term
                           created in response to their             inflation after all     volatility average
                           research which identified younger        scheme charges          of 7%
                           savers could react negatively
                           to large market falls and stop
                           contributing. Members joining
      Foundation
                           in their 20s will typically spend
                           up to five years here, where
                           the emphasis is on steadily
                           growing the balance rather than
                           having exposure to substantial
                           investment risk
                           Where the main growth in the             Exceed CPI              Long-term
                           fund is expected to come from –          inflation plus 3%       volatility average
      Growth
                           members could spend up to 30             after all scheme        of 10–12%
                           years in this phase                      charges
                           Lock in gains that members have          Keep pace with CPI      Reduce volatility
                           made over the previous phases            inflation after all     as the fund gets
                           by progressively switching out           scheme charges          closer to maturity
      Consolidation
                           of higher risk assets – begins
                           roughly 10 years before the fund
                           matures
                                                                                                     Source: NEST

     Following the Pension Freedom reforms announced in 2014 and enacted a year later, NEST
     will change to targeting a drawdown portfolio at retirement instead of cash and bonds (which
     would have bought an annuity). Funds for retirement at 2020 or before are still targeting
     cash, while those based on retirement after 2020 are now targeting income drawdown.

     Chart 1: The glide path of the default fund strategy

                  Foundation                             Growth                           Consolidation
                    phase                                 phase                              phase

              Objective = Keep pace              Objective = Exceed                Objective = Keep pace
              with CPI (inflation)               CPI + 3% per annum                with CPI after all charges
              after all charges                  after all charges over            while progressively
                                                 the long term                     dampening volatility
              A low volatility
              approach designed to               Targeted use of asset             There is a progressive
              acclimatise younger                classes expected to               move from higher risk
              savers to investing                grow in value relative            assets towards lower
                                                 to CPI more than                  risk asset classes
                                                 other investments

        Typically the first 5 years for savers          Main term                   Typically the 10 years
          joining in their early to mid 20s                                           before retirement
24
This lifecycle differs from that of the other         is that the latter will begin moving out of
main default funds in that none of them has a         the main growth phase at a set number of
phase similar to Foundation, instead starting         years before the expected retirement date.
with the main growth phase. The advantage             In the case of the NEST funds, however, the
of the NEST lifecycle, as mentioned above, is         transition from one phase to another will be
that large market falls in the early years, which     ‘dynamically’ managed rather than relying
could dissuade people from continuing to save         on a set rule. This means commencing the
in the middle and later years, are less likely. The   transition earlier or later, depending on
disadvantage of this approach is that members         prevailing economic and market conditions.
miss out on any large market gains in the early
years, or these would be at least restricted          Table 14 shows how the Retirement Date Funds
(although, as pots are small at this point, there     invest across the different asset classes. They
may in fact be a negligible impact on outcomes).      use external fund managers in all cases rather
                                                      than the funds being managed ‘in-house’.
The second main difference in lifecycle
between NEST and the other default funds

Table 14: Retirement Date Funds – fund managers and investment approaches

 Asset class                       Fund manager                         Investment approach

 Global developed equities         UBS Asset Management                 Passive
 Emerging market equities          HSBC Global Asset Management         Passive

 Emerging market equities          Northern Trust                       Passive

 Gilts                             State Street Global Advisors         Passive

 Short-dated gilts                 LGIM                                 Buy and hold

 Index-linked gilts                State Street Global Advisors         Passive

 Sterling corporate bonds          Royal London Asset Management        Active

 Emerging market debt              Amundi Asset Management              Active

 UK direct/global listed
                                   LGIM                                 Active/Passive
 property

 Low-risk sterling liquidity       BlackRock                            Active
                                                                                            Source: NEST

                                                                                                           25
As can be seen, NEST spreads its investments              Quarterly reviews take place in between the
     across a greater range of managers than the               annual updates, where the in-house team
     other default funds. Their fund manager turnover          looks at the macroeconomic background,
     has been low and NEST will tolerate short-term            financial markets, sentiment and latest asset
     underperformance as long as the manager                   class valuations, together with any tactical
     keeps to their stated process and style.                  adjustments around the policy allocation
                                                               that might be made. In the first stage of the
     As mentioned earlier, the disadvantage of                 reviews, these inputs are discussed by the key
     using third-party managers is that this method            members of the Investment Directorate. Any
     is generally more expensive than managing                 decisions are then made during the second
     in-house, although NEST states that it is able            stage at a meeting between just the CIO, Head
     to negotiate favourable terms as a result of its          of Asset Allocation and Head of Economics.
     fund size and expected future contributions.              These potential changes are analysed from a
                                                               risk point of view before being implemented.
     As alluded to above, the asset allocation for
     each Retirement Date Fund will depend on its              The latest asset allocation for the growth phase is
     point in the lifecycle, together with prevailing          shown in Chart 2.
     economic and market conditions. The policy
     (strategic) asset allocation is determined partly         Compared to the other default funds reviewed,
     through mean variance optimisation (MVO).                 this puts NEST’s fund just above the average in
     NEST, however, recognises the limitations of MVO,         terms of diversification (see Table 3). However,
     in particular the occurrence of corner solutions          NEST is evaluating whether to add additional
     and its sensitivity to the inputs used, therefore it      asset classes, including high yield bonds, low
     combines this with risk-diversified optimisation.         carbon equities and infrastructure, which would
     These policy asset allocations will be reviewed           put it towards the more diversified end, although
     quarterly and are typically adjusted once a year.         NEST won’t diversify just for the sake of it.

     Chart 2: 2040 Retirement Date Fund asset allocation at end June 2016

                                                    3.6
                                    1.1
                                  1.0         7.5

                                       14.5
                                                               48.4
                                       5.4
                                              18.5

                  Emerging market equities           Developed market equities        Property

                  Emerging market debt               £ corporate bonds                Gilts

                  Index linked gilts                 £ liquidity
                                                                                    Source: NEST

26
Risk framework                                        The internal market also keeps costs down for
                                                      members leaving the scheme and those just
There are asset class ranges/limits and the NEST      joining. New member contributions can be used
Investment Directorate would need permission          to balance allocations and for paying cash lump
from the IC if it wished to move outside these.       sums to members taking their money out. Finally,
                                                      the internal market can be used to maintain the
NEST uses the MSCI BARRA risk-package
                                                      target asset allocation or re-balance the funds.
for the analysis of risk in its portfolios.
                                                      Transaction costs for the default funds are
Costs                                                 between 0 and 0.083% and costs for other fund
                                                      choices are between 0 and 0.098%. The costs
The total costs of scheme membership are              for each fund are detailed in Appendix three of
(1) direct member-borne costs and charges,            the NEST scheme annual report and accounts
and (2) portfolio transaction costs.                  2015/6 available on its website. NEST constantly
                                                      monitors and analyses costs and spreads.
As already mentioned, NEST’s member charges
consist of:                                           NEST is unique in that it is free for employers
                                                      to use and any UK employer can use
•   A contribution charge of 1.8%, deducted           NEST to meet its workplace duties.
    from all contributions made to the scheme

•   An AMC of 0.3%, applied to all AUM. This          Governance
    includes all custodian, legal and accounting
    costs and is also the total expense ratio (TER)   NEST is a trust-based pension scheme,
                                                      regulated by TPR and it appears to be meeting,
Transaction costs and dealing spreads across          if not exceeding, the various governance
the 50 or so default funds will vary depending        standards and duties imposed on it.
on the asset allocation. However, they have
been structured to minimise trading costs             NEST is one of the schemes that should
for the scheme, such as trading spreads               be applauded for making much of the
and brokerage fees. NEST has done this by             governance due diligence data required
creating an internal market between the               by advisers available on its website.
different Retirement Date Funds such that
the funds which are reducing exposure
to certain asset classes will transfer those
investments to the funds still adding to them.

                                                                                                         27
Conclusion
     This case study first looked at the key factors we believe should be
     considered when reviewing or selecting a default fund:

           •    The investment management procedures and responsibilities
           •    The implications of in-house and outsourced management
           •    The clarity, robustness and repeatability of decision making
           •    How the default funds are performing against benchmarks and peers
           •    The suitability of the default funds and identifying value for money

     The case study then looked at and compared             group of competitors. The main strengths
     the most commonly used default pension                 of NEST’s Retirement Date Funds are:
     funds from an auto-enrolment point of view.
     We saw a great variety in terms of benchmark,          •   The investment team behind these funds
     manager structure (in-house manager, third-                is experienced and well-resourced
     party managers or a mix), investment approach          •   Risk-adjusted performance in the main
     (active, passive or both), level of diversification,       growth phase of the lifecycle has been very
     performance and charging across the funds.                 good versus peers over the longer (and
     With some of these attributes, such as manager             more statistically meaningful) time periods
     structure and investment approach, the choice
     of provider and fund might come down to the            •   With an increasing investment time period,
     investment beliefs of the employer or their                NEST’s overall charges become more
     adviser. In terms of the other more objective              favourable in relation to most of the other
     features ie risk-adjusted performance and                  big default funds by virtue of the dilution of
     charges, however, some providers and funds                 the contribution charge over the longer term
     are clearly more competitive than others.
                                                            •   These funds have a volatility target as well
     Finally, this case study looked at NEST’s                  as a performance benchmark (the other
     default pension funds in more detail,                      default funds tend to have one or the other)
     comparing them to their most relevant peer

28
The key areas where NEST’s Retirement Date Funds differ from the other
      default funds looked at are:
      •    None of the others has single-year Target Date funds
      •    NEST has a Foundation phase, created in response to their research
           which identified younger savers could react negatively to large
           market falls and stop contributing. Members joining in their 20s
           will typically spend up to five years here, where the emphasis is
           on steadily growing the balance rather than having exposure to
           substantial investment risk. While mitigating negative market risk
           it is possible that market gains won’t be reflected, however should
           this happen this strategy is unlikely to have a notable impact as the
           pot size of savers in their 20s is usually small
      •    Switching out of the main growth phase in the run up to retirement
           does not automatically commence at a pre-set point before
           retirement, but instead can be started slightly sooner or later,
           depending on prevailing market conditions

The evidence shows that NEST’s Retirement Date Funds can hold their own against their
peers and are worthy of consideration alongside other schemes by corporate clients and
professional advisers on behalf of their clients, irrespective of the employer’s size of scheme.

                                                                                                   29
Learning objectives
     This case study is accredited by the CII/PFS and CISI for up to 60
     minutes of structured CPD.

     Reading this publication will enable you to:

        1       Understand the different default investment strategies available, focusing upon the
                accumulation phase

        2       Identify the main differentiating factors to be considered between the individual
                default investment propositions including:
                •    The investment management procedures and responsibilities
                •    Implications of in-house and outsourced management
                •    Clarity, robustness and repeatability of decision making
                •    How defaults are performing against benchmarks and peers
                •    Suitability of the default and identifying value for money

        3       Understand how the various default propositions in the market differ from each other
                to support market research and due diligence

30
Test yourself for CPD
In order to assess your knowledge following completion of this publication, why
not work your way through the following questions? All the answers can be found
within the content of this publication.

  1    Name the two regulators of auto-enrolment pension schemes.

  2    What is the main concern with a default fund using funds primarily from the scheme provider?

  3    Name four common benchmarks used by default funds.

  4    List the main reasons why many default funds utilise passive (index) funds.

  5    At what percentage are pension default funds annual management fees capped?

                                                                                                      31
6      What does IGC stand for and which scheme type does it apply to?

        7      Which regulator utilises the DC Code and which scheme type does it apply to?

        8      Does ‘value for money’ mean the cheapest solution?

     This publication is accredited by the CII/PFS and CISI for up to
     60 minutes of structured continuing professional development (CPD).

       Name

       Signature

       Date

       CPD time recorded

32
NEST.
The provider of last resort.
Unless you’re after an award-winning pension scheme.

At first glance, NEST might not be the first provider
you’d consider recommending to your clients.
But if you’re looking for a pension with an innovative
investment approach, independently accredited
governance and a substantial collection of industry
awards you might want to take another look.

NEST. Think you know us?
Think again.
Find out more

©NEST Corporation 2016. All rights reserved. NEST will only accept employers electing to use the scheme for the purposes of meeting their duties under
the Pensions Act 2008 and subject to them accepting our Employer Terms and Conditions. This information does not constitute financial, investment or
professional advice. We do not make any personal recommendation or give advice to employers, their workers or third parties on how to make investment
decisions. The NEST trademarks and trade names used above are owned by NEST Corporation and should not be used in any way without our permission.

                                                                                                                                                         33
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34
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