Development and diversification

The UK pensions landscape looked very different six years ago. At that point, most people saving in a workplace pension were among a lucky minority with an open and active scheme in place. They were generally in a defined benefit scheme and were typically earning more than the UK average.

Fast forward to today, nearly 10 million people are now saving in a workplace pension, representing nearly three quarters of the working population. The vast majority of members are in defined contribution (DC) schemes. They represent a broad cross-section of workers, typically those on average incomes.

That’s a pretty big, and pretty quick, shift. The DC market is only just beginning to wake up to the reality that it’s now the biggest show in town. What does that mean for pension scheme design, in particular the investment strategies they offer?

Back in 2005, most DC savers were invested in traditional ‘lifestyle’ funds. These involved a set asset allocation that was switched automatically over time, according to a fixed schedule in the run-up to retirement. However, this can be an expensive and inflexible option, particularly if pot sizes are small and memberships large.

The aim of NEST was to design a scheme that meets the needs of the new auto enrolment generation. We wanted to create an optimum solution based on where we knew the market was headed. We looked overseas, at pension models in Australia for example, to see what other, more mature DC marketplaces had done to provide robust options for members. By being bigger, providers could focus on cost and best value for members. They were able to diversify and adapt the asset allocation dynamically. We took this information and used it to develop our default fund strategy.

Our default funds alone are spread across 11 different asset classes. We aim to identify the needs of our members at different stages in their savings journey and tailor the asset allocation accordingly. We research and pick the best fund manager for each of the asset classes we invest members’ money in, to generate the strongest return with the least investment risk. Each quarter, we review progress and assess how relative risks in different asset classes may be developing. We think about how markets are likely to evolve in the future and act with this in mind.

At NEST, we simply can’t stand still because we’re growing so rapidly. We currently have approximately £4 billion in assets invested, which is expected to double in the next year and again the year after as a result of increased pension contribution rates. As we grow, we expect to be able to do more by virtue of our size. Negotiating costs is no exception, as the bigger you grow, the more aggressively you can negotiate deals in lucrative areas, such as property and infrastructure.

NEST is sometimes seen as the backup solution, classed as simply ‘good enough’. This view was particularly common in the early days. However, it isn’t the case and we’re on a par with and often outperform our leading competitors. We’re particularly efficient at turning investment risk into investment return. Over five years, for every unit of investment risk we’ve taken, we’ve generated three units of investment return. Looking over three years, the numbers are very similar. We can demonstrate consistency of positive outcomes, which is most important to members in the long run.

We get good results without taking bigger risks partly because our approach is a thoughtful, responsible one. Responsible investment is embedded within the whole system at NEST. That means managing a range of environmental, social and governance (ESG) risks and opportunities, among other things. We set objectives for this and manage members’ money against them. For example, climate change is one of the biggest systemic risks facing the global economy over the coming decades. In February, we increased the allocation across our default strategy to our climate aware fund and we’re likely to do so again as the global economy transitions further away from fossil fuels. By investing in a climate-aware way, we’re getting ahead of those long-term trends while also supporting global sustainability.

So, investment management success relies upon diversification, understanding long term trends and understanding where risks will be sufficiently rewarded. This is a strategy that NEST adopts and that we hope will allow us to continue delivering strong, smooth returns for members for many decades to come