Defined benefit (DB) schemes are traditionally the big users of transition management services in the pension world, due to their typically enormous pools of assets. However, the shift to defined contribution (DC) schemes over the last decade or more, made to reduce costs for employers, means that DC pools are now large and growing rapidly, enough to soon be big users of TM services.

The US and Australia, where the DC model is more mature and therefore has greater scale, have been the leading users of TM services. To date, transition management has had relatively little impact on the European DC pension market but this is likely to change in the coming years.

DC schemes will also expand as a result of government initiatives designed to alleviate pressure on the state from aging populations. In the UK, the auto-enrolment reform has required employers to set up workplace schemes for their employees or use the government-created Nest, with a legal obligation to boost both employer and member contributions over the next few years (following Australia’s lead).

In the UK, many schemes are also reconsidering their current DC default fund structures in the light of the new freedom and choice regulations. Lifestyle funds, which automatically switch members into fixed income and cash at the normal retirement date, are almost universal but are no longer appropriate. Tighter regulatory oversight of UK DC funds – yet another DC Code was issued by the Pensions Regulator in August – will also encourage trustees to reshape their default funds with more diversified and sophisticated assets that allow market growth during the retirement phase, but with more limited volatility.

“Some transition management providers have created DC specialists but growth is slow,” says Chris Adolph, head of transition management EMEA at Russell Investments. “In other regions, DC plans are larger – we don’t have the megafunds of Australia where transition managers are used proactively. In the UK there are many individual DC plans. Use of transition managers will increase as schemes gain mass, but it will take a while to get to that sea-change.”

DC complexity

Some scheme sponsors that are accustomed to using transition managers for their DB funds have begun to sound out transition managers for the complex challenges involved in DC arrangements. It may not be transition management in the traditional sense – of physically holding the assets during a transition – and may perhaps be more akin to project management.

This nascent activity is not limited to the largest schemes. Smaller DB schemes have also used managers to help with their increasingly sophisticated portfolios as asset allocations have generally become more global in nature and in particular for fixed income, which has expanded to include illiquid instruments and complex derivatives.

“For smaller employers that now need to buy and sell units in funds, transition managers can co-ordinate disinvestment and reinvestment in the new target structure, advising and managing the exercise, and managing out of market risk,” explains Adolph.

Default funds

“Larger pension schemes may well be sitting on multiple pooled funds, creating a need for co-ordinated redemption and subscriptions. While the default fund can be just one fund, such as a global absolute return strategies (GARS), for large pension schemes there can be a variety of default funds, which increases complexity.

“Transition managers have experience of the market consequences and potential difficulties with trading such funds and the alternative strategies available if a trade does not match up. For DC plans there are also a lot more stakeholders on the administration side to co-ordinate and communicate with, not just the custodian and investment performance areas typical of a DB transition.”

Ben Jenkins, global head of transition management at Northern Trust, based in Chicago, believes demand for transition management in the European DC market will grow in line with the US.

“We are starting to see DC plans switching their default fund allocation,” he says. “We’ve had a handful of clients considering DC transitions approach us in the last 12 to 18 months. The majority are still at the planning stage. Usually they will have used Northern Trust transition managers on their DB scheme or our custody services and will therefore have a strong comfort level with us and feel secure about walking us through what they are trying to do. Next year will be much more telling, in my view. Uncertainty over Brexit did lead some clients to delay their plans.”

Arguably, transition management could become a greater imperative in DC than in DB owing to the sheer number of moving parts and the need to deal with payroll, benefits distributions, participants changing funds and transparency. Each of these factors impact at various points in an event, giving rise to a host of internal reporting requirements.

Project management

“Transitions in DC schemes are more labour-intensive than in a typical DB structure, and require more oversight,” suggests Jenkins. “Project management is needed to line everything up such as notification and pre-notification dates and blackout dates for the record-keeper but also for the participants. Some schemes will want to rebalance their asset allocations simultaneously and will ask: ‘how do I manage everything at the same time?’”

Transparency in a DC scheme is critical. Each individual member’s assets must be earmarked and preserved, and all the activity, costs and valuations affecting member accounts throughout the process must be monitored and viewable by the scheme members.

Although most mainstream fund platform providers offer a degree of transition management, today DC transitions are rarely a simple switch from one fund to another. Over 90% of a scheme’s assets will usually be in its default fund and because these funds are often trying to be all things to all members, and are also subject to changing regulatory diktats, they will typically consist of a number of underlying funds. This increases the challenge across the range of risks, and is exacerbated by the number of participants in the DC process.

The ability for members to select and switch their own fund allocations presents particular issues. “Liquidity sleeves are important for clients to consider,” explains Jenkins. “DC scheme participants can switch whenever they want so the transition needs to be done quickly. Funds can generally deal with participant switches by dealing with the rebalances internally, but that may be challenging if there are many participant redemptions. On the date of the re-allocation, you have to monitor the fund flows and the participant flows and exposures. What happens, for example, if participants pull out more money than anticipated?”

In one recent case, involving a global company with a DC scheme in multiple regions migrating to a lifestyle structure, scheme members were given 21 days to make a decision on where to invest their pots. In the event, a large band of participants voted to migrate early on in the period, and then for a while there was almost no activity, and finally on the last few days there was another surge as the last-minute group switched. Such a process is hard to manage and requires daily engagement with the record-keeper, and possible modification of the strategy every day throughout the process.

One significant factor is out-of-market risk. “There is a risk of divesting a fund on one day and not being able to reinvest the proceeds until the cash has settled – getting back the cash can take four days and all that time you are out of the market,” adds Adolph. “Markets can move 4-5% in that period, so you could lose a large proportion of your expected annual return in a couple of days.”

When pension schemes buy these funds, the potential complexities and costs upon redemption are often underestimated. Trustees may well focus on the level of fees rather than how flexible they will be in terms of redemption. Many funds have single pricing, which can sometimes involve prohibitive and opaque redemption costs.

A structural shift back to segregated mandates is also evident. “Instead of the traditional fund structure, some DC schemes are switching to segregated funds and more diversified holdings,” explains Jenkins. “It may be that they think the fund can’t accommodate the large amount they hold in it and they need a structure that is more appropriate to their scale. They may have 30 pooled funds but want to consolidate this to, say, 15 to 20, but not with a co-mingled pool structure but instead with segregated funds. They need support and expertise, including setting up an operational structure that works for them, and matching allocations to the right managers.”

Scheme managers may need to discuss and plan their strategy six to nine months ahead of a DC transition. “That will involve talking to everyone, notifications, where it will happen, when it will happen and who will be impacted,” adds Jenkins. “There may be a US silo, a European silo and a UK silo and that requires mapping and the development of a timeline and looking at how each transition may impact another.”

Recently, Northern Trust conducted a transition for a DB plan that had similarities to a DC transition. It involved 16 fund manager pieces over two and a half months, but the planning took three months, owing to the different time-frames and the complexities of lining it all up, including providing hedging to cover out of the market risk.