NEST Corp. recently lifted the veil on the investment structure of the new U.K. nationwide defined contribution plan that is estimated to grow to as much as £200 billion ($320 billion) by 2040.
Plan officials will use tactical asset allocation to limit risk and boost returns in target-date default strategies; limit investment risk in young workers' investments; and seek diversification across asset classes and geographies, making a point to avoid home-country bias, said Mark Fawcett, chief investment officer at the National Employment Savings Trust, London.
Paul Macro, Manchester, England-based senior investment consultant at Towers Watson & Co., said the plan likely will set the standard in the U.K. on defined contribution governance and customization when the nationwide plan goes live next spring, after officials spent years determining best practices and what would be best for NEST members, expected to be low- to middle-income people who aren't already saving for retirement.
“It's been heavily trialed,” Mr. Macro, a DC specialist not associated with NEST, said. “The key to all of (NEST's investment structure) is a recognition ... that their membership is — in the main — going to be really quite different from the population of the majority of existing (DC) schemes.”
For example, NEST officials have thought a lot about how to keep members participating, and decided to limit the amount of investment risk in the early years of someone's career. Returns matter in the early stage of one's career, but make up just a tiny fraction of the total savings pot at retirement. Plus, volatility or a severe loss — as experienced in 2008 — could easily put off young workers saving for retirement, especially those not familiar with saving, let alone investing.
“We've arrived at this because we've thought about the needs of our members,” Mr. Fawcett said.
That thinking also led NEST officials to seek a well-diversified portfolio for its default fund, into which 90% or more of members are expected to be automatically enrolled. NEST members already will be exposed to the U.K. economy through their jobs, Mr. Fawcett said, so “why would you give them a whole load more U.K. economic risk” through retirement investments? Both DC and defined benefit plans in the U.K. traditionally have held substantial home-country bias.
NEST also will strive for diversification across asset classes. Mr. Fawcett expects NEST to add exposure to real estate, credit (both investment-grade and high-yield), emerging markets (equities and bonds), infrastructure, hedge fund replication and commodities over time.
“You need a certain amount of size before you can commit to something like an infrastructure fund,” he said.
Because NEST is expected to have a substantial default fund and positive cash flows, liquidity is less of an issue than it might be for some DC plans, Mr. Fawcett said. However, officials are grappling with finding a way to accurately and fairly value these investments to ensure individual member purchases and sales are made at the correct prices.
“The investment management industry is beginning to think about these problems,” Mr. Fawcett said.
Although NEST will put into practice leading thinking on many DC investment and governance issues, the fund has the advantage of starting with a clean slate, Mr. Macro noted.
Still, trustees at other DC funds should view NEST as a “comparator, not a benchmark,” Mr. Macro said; the key is to mimic NEST's processes in determining what's best for their members, not just copying the decisions NEST has made.
One element Mr. Macro hopes DC trustees will take a close look at is tactical asset allocation within default funds, a tool he said “not many” plans in the U.K. now use.
Mr. Fawcett said NEST officials believe in TAA, but it “needs to be on a long-term view.” Officials will try to take advantage of major market trends or dislocations, but not minor ones. One example NEST might have taken advantage of was the severe swing in corporate bond spreads in recent years, having sunk to almost nothing in 2007, then shooting up to nearly Depression-era levels in 2008, Mr. Fawcett noted.
“In practice, we probably are not seeing enough of (TAA),” Mr. Macro said, adding that NEST's example “might give other trustees the confidence to do that themselves.”