It’s nice to get into conversation with Peter Robertson, who I know as the first man promoting Vanguard in the UK but many know as the doyen of Standard Life International. Peter sent me an article he’s written directed at IGCs, who are currently cogitating on the suitability of their provider’s investment pathways. I include it in full as it touches on a long and amiable meeting with the new chair of Vanguard’s IGC, my former boss – Lawrence Churchill.

The Vanguard IGC is all about investment pathways. Much as I enjoyed my conversation with the great man, it made me aware of how little I know about how we can predict where value can be had, when investing in later life.

Will IGCs find alternatives a roadblock on life’s pathway?

A decade or so ago a colleague and I ran a masterclass for a group of journalists on Target Date Funds (TDF). “Masterclass” might have been overegging it but, as few in the UK knew much about TDFs, the one-eyed man principle applied and it gave us a chance to talk about lessons from the USA that might be applicable if UK pensions legislation changed.

The TDF annuity route, or “to retirement” strategy, followed a glidepath much like that used in UK life-styling, 80+% growth assets early on ending in a 75:25 bond:cash split at retirement. The TDF method involved changing the asset allocation within the fund rather than switching between funds as in life-styling.

The drawdown or “through retirement” strategy looks the same early on but sees less de-risking, with an equity allocation of 30-40% at the target date and beyond and does not match the tax free lump sum with a cash allocation.

The unexpected introduction of Pensions Freedoms soon turned our theoretical musings into reality, re-enforced by the recent need to identify appropriate investment pathways.

IGCs need to find pathways, that offer, among other things: value for money, an appropriate investment strategy and a suitable approach to ESG, for the non-advised, particularly those entering drawdown. How the fund is legally structured may have a significant bearing on this last point.

UCITS are the gold standard in retail distribution of investment products and are limited to investing in listed equities and bonds. To make their usage more widespread in pensions they can be wrapped in a life fund (but not vice-versa).

Life funds offer scope to invest in alternatives like real estate, infrastructure and private equity. If a mutual fund holds such assets it will be classified as an Alternative Investment Fund (AIF), which ordinarily cannot be distributed directly to retail investors.

Two existing products in this sector get top marks for value for money, follow well structured, if differing, investment strategies, yet manage to fall either side of this fund structure divide: the UCITS has a higher equity content before and after retirement but, in this instance, no obvious ESG screen while the Life Fund is strong on ESG and includes real estate and infrastructure, offering lower expected volatility and potentially making a given level of income more sustainable and hence more attractive to drawdown customers.

This lower volatility is a direct consequence of the reduced liquidity of its alternative allocation and comes with an explicit risk warning around delayed repayment. Whether its gated property funds or Woodford, the last year has provided plenty of examples of liquidity risks coming to fruition.

Different arms of the FCA oversee investment pathways and mutual fund distribution so the rules could change. Nevertheless, a pathway with alternatives may see drawdown customers without income when they ask for it. So, for all their merits, does use of alternative investments present an impassable roadblock to life funds and mean IGCs can’t deem them to be appropriate?

Thanks for the heads up Peter!

There is some “new stuff” here – well “new” to me anyway. My first question is “what are the merits of illiquids that make them so attractive?”. If the major advantage is in the consistency of valuation, is that because there is no ready market for the asset, meaning it is not being re-valued by the market but by someone putting a finger in the air and giving a theoretical number? That doesn’t sound very transparent and it does sound very open to manipulation. It sounds remarkably like the black box of with-profits.

The valuation of private equity is a particular problem and this blog has featured a number of articles over the past two years , questioning the practices of private equity managers who seem to find every more exotic ways of justifying the valuations that suit their needs. The trouble is whether these valuations are realizable when cash is needed.

As Peter points out, illiquids can sit within a fund that is building up and is not needed for spending, but that’s not what an investment “life” pathway is, as people can call on some or all the money from the fund, when they choose.

Peter’s analysis suggests that Life wrappers may become a way for contract based pension providers to manipulate the marketing of investment pathways so that they are seen to be delivering the absolute returns that guard against the ravages of sequencing risk, until the proverbial hits the fan. We all know what happened the last time that life companies tried that trick and Equitable it wasn’t.

Why can’t UCITS adopt ESG?

While I am with Peter in his caution against  illiquids within a life fund, I find his distinction between a Life Fund and a UCIT approach to drawdown confusing.

Life funds can invest 100% into equities, just like UCITS, but UCITS can’t include alternatives and be used for retail investors (using investment pathways). So far so good, obviously life funds are more flexible and look like they will dominate the investment pathways targeting drawdown or an investment roll-up.

But what has this got to do with ESG? Surely the composition of an ESG factored fund depends on more than screening?

To my mind, the ESG in a fund depends on the commitment of the manager to exercising stewardship by publishing  its TCDF and  exercising direct influence (voting) and indirect influence by letting its views be known to the management of the companies in which equity or debt is held.

In which case a UCITS fund can be managed for ESG in the same way as a life fund. We’ve got to get away from a view of ESG as being something that is exclusive to one set of funds over another, and consider it desirable in all funds. Why would you want to have your fund not managed for  Environmental sustainability, Social purpose and  good Governance?

Peter here seems to be hinting that not only can investment pathways not risk investing in illiquids, but that they should be avoiding ESG factors too.

Is there an obvious reason to use life wrappers over UCITS ?

It’s very good to have Peter as a correspondent and he’s kindly agreed to answer my questions. I have a number of questions I want to ask.

1. What advantages do life funds offer life companies compared with offering UCITS directly?
2. How and who benefit from any differences in taxation?
3. Can life companies offset illiquidity of assets such as private equity (and if so – at what cost to performance)?

It strikes me that for decades, advisers have taken for granted that life companies ran GPPs and occupational pensions unbundled themselves from life companies. There is still some anti-life sentiment among trustees and a lot of misunderstanding of trust based schemes within life companies.

But investment pathways should be common to both GPPs and trust based schemes and a proper understanding of the advantages of life and UCIT structures is important if we are to get to best practice in this field. In answer to the question that heads this section, I simply don’t know enough and should do!

Time to open the debate?

We need transparency, and we also need the information to formulate opinion on what is best. We can’t allow a small band of “experts” to decide what is done and – even with regulators on the case – we need to be able to decide for ourselves (whether as advisers or informed investors).

So I’m really pleased about Peter’s offer and look forward to following up on this blog very shortly. In the meantime, I will be mugging up with Peter on answers to my questions.

I hope that in airing these issues, I will be helping the Chairs of IGCs, thinking about their impending reports, on how to assess the value for money of the impending pathways.