Majority of DC Plans Should Choose Passive Management

UK, October 14, 2009 -- The majority of Defined Contribution (DC) pension plans would benefit from the significant use of passive management because of its cost effectiveness and alignment with the governance capability of most plan fiduciaries, according to Watson Wyatt. In a new UK report entitled Investment Governance: enhancing the value chain, the firm recommends that plan fiduciaries should focus their time, expertise and resources on asset allocation decisions rather than trying to select the best active managers.

Gary Smith, senior consultant at Watson Wyatt, said: “Even where precious governance time is allocated to seeking skilled active managers, this effort is best focused on including active management within the default fund. This is particularly relevant for diversified growth investing, where most members are likely to be invested, rather than on self-select options where only a handful of members invest.”

According to the firm, higher governance plans that want to use active management should ensure that they have sufficient controls and processes, such that they are able to quickly replace managers when appropriate. This is usually achieved through flexible white-labelled fund structures rather than via proprietary products, in the firm’s view.

Gary Smith said: “It is pleasing to note the increasing levels of investment governance that are beginning to be applied to DC plans, but a lack of time in particular remains a significant barrier. Plan fiduciaries need to be clear on where they wish to add value and how they spend their time. While we believe that active management can add value, the evidence is that it is difficult and time-consuming. With a number of key areas to focus on like member engagement, at-retirement support for members and managing an effective investment choice and default framework, spending time searching for active management skill should not be a priority for most plan fiduciaries.

In the Defined Benefit (DB) world there is now a pleasing polarisation among pension fund investment strategies, with those that have high governance capabilities opting for strategies that use active management and those with lower governance opting for simpler strategies where passive management dominates. While this trend started before the economic crisis it has certainly accelerated since and should kick start a similar trend in the DC world.”

In the paper, the firm suggests that plan fiduciaries can add significant value by prioritising the design and management of more efficient lifecycle strategies, more engaging choice structures and more advanced management of asset allocation. In addition to a strain on governance, the fee levels associated with active management should also be taken into consideration when designing an investment strategy. The firm advises that transactions costs associated with changing active managers and headline management charges should be areas of priority.

Gary Smith said: “The alignment of a plan’s investment strategy to its governance capability is critical to maximising value for members; a misalignment will, at best, be wasted effort and, at worst, destroy value.”

According to the firm, this process of aligning governance and investment strategies should revolve around balancing three primary drivers:

• Risk management: ensuring that the plan complies with relevant legislation and regulation as well as not exposing the sponsor, member or fiduciary to undue risk
• Maximising the impact for the sponsor: ensuring that the plan sponsor gets a reasonable level of return on its pension spend. This focuses primarily on ensuring the employee or member gets a positive experience of the plan
• Maximising member outcome: ensuring the member gets the best possible outcome from the plan net of fees. Effective governance can significantly increase the level of a member’s retirement income.

Gary Smith said: “Balancing member and sponsor needs while managing risk is about effectively addressing tensions inherent in the pensions deal. While challenging, the task is made substantially easier when the plan’s governance is focused on clear, realistically achievable objectives and not stretched beyond its limits.”

About Watson Wyatt Investment Consulting

Watson Wyatt Investment Consulting, a division of Watson Wyatt, is focused on creating financial value for institutional investors through independent, best-in-class investment advice. We are specialist investment professionals who provide co-ordinated investment strategy advice based on expertise in risk assessment, strategic asset allocation, and investment manager selection. Watson Wyatt Investment Consulting provides investment advice to some of the world’s largest pension funds and institutional investors, and has over 550 associates in Europe, the Americas and Asia.

In the US investment advisory and investment consulting services are provided by Watson Wyatt Investment Consulting, Inc., which is a subsidiary of Watson Wyatt Worldwide Inc. Watson Wyatt Investment Consulting, Inc., is a registered investment adviser with the Securities and Exchange Commission.

Watson Wyatt (NYSE, NASDAQ: WW) is the trusted business partner to the world’s leading organisations on people and financial issues. The firm’s global services include: managing the cost and effectiveness of employee benefit programs; developing attraction, retention and reward strategies; advising pension plan sponsors and other institutions on optimal investment strategies; providing strategic and financial advice to insurance and financial services companies; and delivering related technology, outsourcing and data services. Watson Wyatt has 7,700 associates in 33 countries and is located on the Web at www.watsonwyatt.com.

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