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As the growth of defined contribution plans continues to outpace the defined benefit sector, the focus for those running defined contribution plan sponsors should be on meeting objectives, good governance and investment risk management. Consulting firm, Mercer, has some advice for the DC sector.

According to Mercer establishing best practices across all areas of defined contribution plan management is critical as DC plans become the primary engine for retirement for so many people around the world. It’s 10 steps that DC plans should take in 2014 are set out below

1. Redefine success: ultimately, a plan is successful if it meets plan sponsor objectives and delivers future financial security to participants

Move beyond flat metrics such as participation levels and deferral rates. Analyse all participant behaviours that ultimately drive retirement outcomes, and develop sophisticated metrics and interventions to improve those outcomes.

2. Take a broader, sophisticated approach to investment risk: A delegated investment solution may help manage risk through the lens of plan participants

Research in behavioural finance has shown that risk management involves more than just the prudent selection of a diverse set of investment options.

Support employees by tailoring the plan’s investment risk profile to participant demographics. If resource constraints exist, consider the appropriateness of employing a delegated investment solution for all or part of the plan.

A delegated approach to developing a demographically-based investment strategy leverages time while transferring fiduciary risk

3. Understand target date fund fiduciary responsibility

As an increasingly popular asset class within DC plans, target date funds have come under heightened scrutiny by the regulators and state departments (particularly in the US).

Consider whether or not the target date funds in the plan will lead to the desired retirement outcomes for the plan’s participant base.

4. Say goodbye to revenue sharing: paying administrative fees based on each fund’s level of revenue sharing may not stand up to scrutiny.

A red flag arises if some participants pay higher administrative costs simply because their fund options carry revenue sharing. Achieve transparency and level allocation of administrative fees by reducing or eliminating revenue sharing, or by allocating it back to participants.

5. Consider the impact of inflation on participants’ retirement readiness: don’t let inflation erode outcomes

Despite the low interest rate environment from 2000 to 2013, participants’ purchasing power decreased by more than 20 per cent according to a Mercer study.

Purchasing power erosion and its effect on retirement readiness can lead to workforce planning issues. Help participants address this risk by assessing the appropriateness of offering a diversified inflation option within the plan.

6. Help participants sleep at night: financial wellness can promote a more productive workforce

Employees face significant financial burdens throughout their working lifetimes, from home buying to college saving to retirement preparation. Helping them put their financial house in order not only helps them save for retirement, but can also improve engagement and decrease stress levels.

7. Address the diversification challenge: consider implementing custom funds to increase participant diversification while keeping the investment line-up lean

In an effort to avoid participant confusion and investment choice overload, 60 per cent of plan sponsors offer participants fewer than 15 investment choices and many are looking to reduce that number to 10 or less. Custom funds can provide participants with access to greater diversification through exposure to alternatives, opportunistic fixed income and real asset strategies without adding complexity to their investment decision-making process.

8. Reassess the market: the evolution of the DC market has driven changes in vendor position, strategy and focus

How long has it been since the plan was put out to bid? In response to market pressures and financial constraints many vendors have changed their strategy and target market. At the same time, plans have grown, and their needs evolved. It may be time to explore what is out there.

9. Think Beyond Borders: globalisation is here

International markets make up a larger percentage of the investable universe than US markets. Delivering streamlined access to global investment opportunities across the asset class spectrum helps address participant behavioural biases, leading to improved asset allocation decisions and ultimately enhanced retirement outcomes.

10. Keep pushing the communication envelope: employees are accessing information in new ways. Are plan communications keeping pace?

Employees are increasingly using mobile technology, and the best communicators are engaged in generational targeting and strategies based on behavioural finance. Looking ahead, the success of gamification in education and employee training can be applied to retirement and financial education. Assess how new approaches to communications and targeting can more effectively reach the various populations within the plan to help drive engagement.

Chief executive of Cardano UK, Kerrin Rosenberg, is a Monty Python fan. In the same eccentric vein as the famous satirists he has a healthy disrespect for the status quo and a quirky view of how pension assets should be managed, which for most funds includes a radical change in asset allocation.

In 2010 Cardano, which is a solvency and risk management firm in the UK and The Netherlands, produced a video series with Monty Python explaining the behavioural aspects of risk management.

Now the Cardano gang are back at work with Terry Jones and co. on a documentary that helps explain why the financial crisis occurred.

It’s not often that finance journalism covers the intersection of actuarial-ism and surrealism, but it’s about time.

Chief executive of Cardano in the UK, Kerrin Rosenberg, is considered a pension thought-leader and he believes what makes the firm different is its focus on making sure the savings of the end user doesn’t blow-up. The notion just begs for Monty Python imagery.

“What makes us different is our beliefs regarding finance and in particular the behavioural finance aspects and how people think about risk, we’re trying to help the end user prevent from blowing up,” he says.

To do this requires breaking a cycle which starts with the over-estimation of returns, institutional failure, system failure and eventually the end user losing out.

In practice it means better risk management, and a focus on a more predictable, realistic result that is not reliant on an “over-achieving economy”.

This calls for a radical change in asset allocation and subsequently very little interest rate risk and equities.

Rosenberg, who was an early pioneer of the use of derivatives, unconstrained equities and hedge funds, says asset allocations should include “a lot of other things” apart from equities and interest rate exposures, including hedge funds, private equity, different types of property, pharmaceutical income streams, and lending to mining.

“When you move away from having a strategic asset allocation it removes constraints and you can look at investments on their validity to the portfolio,” he says.

The problem

The UK pension market is facing what Rosenberg calls a £1 trillion legacy problem, with accrued rights embedded in the system as ‘personal rights’.

“The UK fund salary market just involves two bets – long equities and short interest rates, that’s been a lousy thing to do for 30 years. Since Cardano started in the market in 2006, that there has been a £500 billion deterioration in the industry. The system is at a high chance of failure, it can’t meet the pension promise.”

While Cardano describes the November report by the Department for Work and Pensions on defined ambition as a “major step forward to solving the UK pensions problem”, the system is still over-reliant on unrealistic expectations.

“What do we need? £260 billion of employer contributions in the next 13 years and we need equities to outperform bonds by 3 per cent for 60 years. To put that in perspective this is £20 billion a year, which is nearly half of the yearly dividends of the whole stock market. If either of those don’t come out it will fail. The added problem is now is we’re in de-cumulation so it’s very sensitive to what happens in the next 15 years.”

Cardano, which acts as a large in-house pension fund, was set up with the philosophy that the risk management techniques of banks could be brought to pension funds. Part of this approach means not relying on any one economic outcome.

“It’s about very small risks, no one big approach, and accessing different types of strategies to cover your angles and being careful to size all of the risks put on.”

The approach includes having a strong top down view of the world but also analysing many scenarios.

“We have many scenarios because we know we’ll get it wrong. We fund investments that do well in an environment but won’t lose a lot in the opposite market.”

Innovative mandates with managers are also a hallmark, and if a theme or product doesn’t exist, Cardano will work with managers to create it.

The approach includes an “intense” use of derivatives to manage risks, with the firm trading from Rotterdam. The benchmark is the liabilities of the fund.

“We are fully matched unless risks are worth taking,” he says. “The most disciplined act is that every year we buy protection when it’s cheap, it’s a discipline every year.”

The approach is similar to Bridgewater’s high-profile All Weather fund, but Cardano claims to have one third the volatility, thus giving it a stability advantage.

Rosenberg speaks of the results of the firm, with the liability benchmark in mind.

From June 2008 to December 2012, liabilities in the UK market increased by 9 per cent per annum.

“Our funds were up by 11.5 per cent net of fees. The average pension fund in the UK was 2.5 per cent below the 9 per cent. Our risk has been one third of the average pension fund.”

He says their average client will get out of their deficit hole in 10 years if that performance continues.

Further, the firm’s alignment is based on the deficit, with a performance fee paid on the reduction of the liability.

A performance fee on the balance sheet? Now that’s surreal.

Analysis of Bitcoin’s historical trading behaviour shows it has exchange rate volatility an order of magnitude higher than the volatilities of widely used currencies, undermining its usefulness as a unit of account or a store of value.

Bitcoin’s daily exchange rates exhibit virtually zero correlation with bona fide currencies, making it useless for risk management purposes and exceedingly difficult for its owners to hedge. Bitcoin appears to behave more like a speculative investment than like a currency.

Access this New York University paper here

Is Bitcoin a real currency

MSCI’s risk management tool, BarraOne incorporated 31 private real estate models and a macro-factor asset allocation model in 2013 and this year will add global private equity analysis giving it coverage across all asset classes.

BarraOne, which is widely used among investors for risk analysis and management, started as an equities analysis tool, but now includes data across most asset classes.

Peter Shepard, executive director and head of multi-asset class and alternatives research at MSCI, who led the development of the new Barra Integrated Model, says the model now does two things: it covers all asset classes, and incorporates the main drivers of risk and return.

The additions reflect the many facets that drive asset classes as well as the way they interact, acknowledging that alternatives is not a single asset class, but then neither is fixed income.

In the context of factor-based asset allocation private equity has more in common with equities than say real estate.

The impact of adding alternatives is significant, Shepard says.

“By weight alternatives is about 10-15 per cent of the average portfolio, but by risk, especially active risk is it more like 90 per cent of risk.”

MSCI will work with the Burgiss Group for its private equity data and will add global private equity to the US private equity data it already incorporates in the model.

The new integrated model now also incorporates the main drivers of risk and return.

“At the highest level we have identified the main drivers of risk return. These are generalised equity (public and private), pure alternatives, and for fixed income we have credit, interest rates and break-even inflation.”

Pure alternatives are defined as the things that capture the market, such as the strategy component of hedge funds.

“There is a surprising amount of commonality among strategies, it’s the strategy beta.”

While credit is an area where credit and equity could be a single factor, the crisis showed that spreads in credit were driven by liquidity which was hard to understand in terms of underlying equity. For this reason, while they are “two sides of the same coin”, they were identified as separate factors.

One of the important facets of the factor methodology is that while it acknowledges the model needs to incorporate detail, such as that German and Greek bonds are not the same, it doesn’t need that detail on a daily basis.

“It attributes risk to macro factors and a residual factor which is like the highlight on a dashboard telling you to look beyond the hood,” Shepard says.

“There are four tiers with more factors depending on what question you are asking. The residual is there to tell you if you need to ask a question, that is a new feature added to BarraOne. “

It is used in two settings, the standard risk setting and the context of risk-factor based asset allocation, he says.

MSCI recently acquired IPD, with data across real estate and infrastructure and farmland and timberland.

“This has been a great benefit to us. In real estate the three golden words are location location, location. For us the three rules of success are data, data data.”

It has also changed the methodology as it applies to private assets, so that they are “de-smoothed”, to account for the subjectivity of private asset valuations being based on a model rather than a market transaction.

“The key is that in the long run valuations and value have to come together,” he says. “There is much higher standalone and correlation risk and this has implications for asset allocation. Private real estate being uncorrelated with other markets is not reflected in the data once you account for smoothing.”

The risk-adjusted benefit of being able to rebalance a portfolio is worth tens of basis points, according to new research that assigns risk and return measures to liquidity so it can be analysed alongside other portfolio decisions. The award-winning research is now being used by large sovereign wealth funds, to determine the value they should put on allocations to illiquid assets.

In their paper, Liquidity and portfolio choice: a unified approach, authors Will Kinlaw, Mark Kritzman and David Turkington, use “shadow allocations” of liquidity treating it as an asset or liability depending on the purpose.

They say that liquidity can be deployed for offensive or defensive purposes, where an offensive use improves the optimality of the baseline (examples would be tactical or dynamic asset allocation), and the defensive restores optimality (such as rebalancing).

The purpose of the use of liquidity, will determine whether it is treated in the study as a liability or asset. For a defensive allocation of liquidity it becomes a shadow liability.

The authors use this framework to analyse liquidity, and the implications for asset allocation.

Because there is limited data, and theory, when it comes to shadow liquidity assets, the authors relied on simulations for their case studies.

One example considered a case where an investor could continually rebalance compared to where they couldn’t.

Thousands of Monte Carlo simulations later, they found that the risk-adjusted benefit of being able to rebalance is worth about 40 basis points.

“Being able to rebalance is an important use of liquidity, and this shows that benefit,” Will Kinlaw, senior managing director and head of the portfolio and risk management group at State Street Global Exchange, says.

“This research shows that liquidity is a concern for all investors, and it’s just not to meet cash needs, but it’s to capitalise on opportunities.”

Kinlaw, and his co-authors Mark Kritzman chief executive of Windham Capital Management and professor at MIT Sloan School and David Turkington a fellow State Street managing director, won the 2013 Peter L. Bernstein award for the paper published in the Journal of Portfolio Management.

One of the more important, and practical, implications of the study is it frames liquidity into the language of risk and return. This means it can be examined in the same context as other portfolio decisions.

“It shows that liquidity is ‘X’ so you know what you are foregoing. You can ask how much to allocate to illiquidity, or you can also frame it in the context of ‘given our allocations how much should we demand from illiquid assets’,” Kinlaw says. “We are working with a number of clients including a large sovereign wealth fund, which is using it to assess what premium to demand from illiquid assets. It has very practical applications.”

In the past liquidity has been assessed as a separate part of the portfolio.

“But we think this makes for arbitrary decisions regarding risk and return,” Kinlaw says. “What we are doing is accounting for reality, liquidity does have risk and return characteristics.”

The authors are not arguing that liquidity should trump other portfolio assessments, but that risk and return assumptions should be adjusted for liquidity.

“Some investors ask isn’t it already priced in, for example Treasury bonds versus mortgage instruments. And this is true, but only for the average investor. Every investor has different needs and liquidity profiles.”

By way of example, Kinlaw says given an asset or portfolio and its return is forecast with perfect insight, then if the asset is completely illiquid, it can’t be traded, then the return you get will reflect the forecast.

But if it is tradeable, then at the end of the year the return is not that of the asset, but something higher because it can be traded.

“It is a measure of the benefit the investor has from holding the asset,” he says.

The analysis has implications for asset allocation and portfolio construction decisions.

The authors looked at model portfolios with allocations to listed equities, fixed income, private equity and hedge funds, which are considered illiquid because of lock-up periods.

“Portfolio optimisations show an allocation to 80 per cent hedge funds and private equity. This is because the optimiser only sees risk measured as standard deviation. It doesn’t account for many things, including liquidity. Our model layers in liquidity considerations in the shadow asset allocation, which results in a reduction in the allocation to those assets.”

The winning paper was chosen through a blind review process by an independent committee that included Gary Gastineau (ETF Consultants), William Goetzmann (Yale School of Management) and Ronald Kahn (Blackrock).

Each year conexust1f.flywheelstaging.com interviews CIOs and executive staff of the world’s largest asset owners, gaining insight into their investment strategy, asset allocation and demands from managers. In 2013 funds were focused on costs, increased portfolio look-through, “partnering” with managers and how to position fixed income exposures. This selection of quotes from CIOs of some of the world’s largest investors reflects the mood of 2013.

“If you give managers freedom to make more decisions, they frequently make more poor decisions. Having said that, I think we have also gone too far in giving them boundaries.”

Chris Ailman, chief investment officer of $170-billion Californian Teachers Fund, CalSTRS.

“If you give managers freedom to make more decisions, they frequently make more poor decisions. Having said that, I think we have also gone too far in giving them boundaries.”

A lot of fund manager selection can be about who rings the personal assistant of the CIO the most.”

“Valuation is relatively basic but the majority of investors don’t pay attention to it; they favour glamorous stocks and that’s accepted because of the short-term pressures.”

“The secular bull market in bonds, over three decades old now, is over.”

“We do believe that better governance means better returns.”

Our philosophy for active or passive management is based on efficiencies of the market, the ease of replicating the benchmark, cost and the ability of active managers to add value.”

“Good investment ideas draw capital, but so do bad ones. When it comes to investing, there is sometimes a first-mover disadvantage.”

We primarily invest in price/valuation gaps where we are confident that gap truly exists. We are more contrarian in our investing than trend or momentum driven. We were long equities in March 2009 when the natural position was the foetal position.”

“We have some old-fashioned economics to ground what we’re doing and why sustainability matters,” she says. “It is ground-breaking stuff this investment beliefs work. We want to be engaged owners. This is a transformation, it’s like the oil tanker turning around.”

“We spend of a lot of time evaluating performance and analysing our costs and fees. It’s prudent and it’s what Project SAVE is all about.”

“We will increase our private equity holdings further, no doubt about it.”

“We want to take more risk when we can…”

“The hedge fund strategy is an evolving area where we are working with the university.”

“If you believe in an emerging market, we feel this should reflect itself in an appreciation of the currency.”

Canada Pension Plan Investment Board (CPP Investments)

Norges Bank Investment Management

Healthcare of Ontario Pension Plan (HOOPP)

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