Developing and delivering NEST’s investment approach

A companion document to the Statement of Investment Principles

Contents

Purpose of this documentPage 01

Member researchPage 02

Delivering suitable investment funds for our membersPage 04

NEST Retirement Date FundsPage 05

Other fund choicesPage 11

Delivering our investment objectives – investment beliefsPage 12

Risk management and asset allocationPage 13

Responsible and active ownershipPage 14

Appendix 1Page 15

01

NEST has published its first Statement of Investment Principles (SIP), a document that all occupational pension schemes must have by law. Developing and delivering NEST’s investment approach sets out the thinking behind the SIP, in particular how we as Trustee Members have developed our investment approach and plan to deliver it.

Purpose of this document

02

Member research01

1.1 We have conducted a significant amount of research into the characteristics, circumstances and attitudes of the target group of likely future members of NEST. Our interpretation of this research has a number of implications for the investment approach for NEST. The focus of this research has been on members’ capacity and desire to take investment risk. We know that members will need to take investment risk in order to accumulate enough savings to generate a retirement income but our research shows that their desire and capacity to take such risk is lower than those currently saving for a pension.

1.2 This research is explained in the Member Research Brief, which is available at www.nestpensions.org.uk. The key conclusions for the investment approach from the research are:

• That we will need to strike a careful balance between taking sufficient risk to deliver an acceptable investment return and not taking so much risk (for members with lower risk appetite and capacity) that short-term volatility and losses discourage persistency of contributions.

• In particular a lower-risk start for younger members is likely to encourage persistency.

• That the majority of our members will not want or feel qualified to make investment decisions and so a well designed default fund will be extremely important for them.

• That a focused choice of other funds to meet different members needs should also be provided.

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Summary of Member research• Due mainly to the target group having lower median earnings and lower existing savings than that of

people currently saving in a pension, their risk capacity is substantially lower.

• The target group is split between those who are actively risk seeking and those who are risk averse. On balance the target group is more risk averse than risk seeking.

• The target group is largely loss averse and exploratory research suggests that responses to investment loss are likely to be negative and strongly emotional. Some of the strongest reactions to investment loss were observed among the younger participants.

• Automatic enrolment makes default funds much more important than they otherwise would be. Unless spurred into action, majorities (between approximately 70 and 90 per cent) of those automatically enrolled into DC pension schemes in the US, Sweden and Chile invest in the default fund.

• In common with the general population, some in the target group are likely to be unfamiliar with investment material and concepts. As a consequence they may find making investment decisions, for instance selecting appropriate funds, challenging.

• Qualitative research suggests that, unless prompted, many in the target group do not consider particular risks, notably inflation risk.

04

Delivering suitable investment funds for our members02

2.1 Based on our understanding of the diverse needs of our target group, we have aimed to develop an approach to investment that offers:

• A well constructed default strategy – the NEST Retirement Date Funds1 – with clear return objectives and a carefully managed risk profile.

• A selection of fund choices for those who want a different level of risk or an approach which matches their beliefs or faith.

1 Referred to as ‘default investment funds’ in the NEST scheme order.

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NEST Retirement Date Funds03

3.1 There will be over 45 NEST Retirement Date Funds, a series of yearly target date funds, through which we will invest members’ contributions. Members will be enrolled into the fund that targets the year we expect them to want to take their money out of NEST. We have assumed members will retire when they reach State Pension age but if an individual wants to retire at a different date they just have to select a different NEST Retirement Date Fund.

3.2 The objective for the NEST Retirement Date Funds is:

To target investment returns in excess of inflation after all charges over the long term.

Our chosen measure of inflation is the Consumer Price Index (CPI).

3.3 We believe that using an inflation benchmark is crucial to allow us to focus on protecting the real value of members’ contributions, particularly as the target group appears to underestimate the long-term impact of inflation on the real value of their savings.

3.4 There are various measures of inflation that we could have chosen as a benchmark but the two main and recognised options are the CPI and the Retail Price Index (RPI). The CPI measures change in prices for a basket of goods that is similar to the RPI basket with a few key exceptions. The biggest difference is that mortgage interest costs are not included in the CPI. We believe CPI better reflects the potential impact of inflation on our members.

3.5 We aim to deliver this objective over the lifetime of saving through three phases: Foundation, Growth and Consolidation.

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Foundation phase3.6 There will be a lower risk start for younger

members. This is the Foundation phase. It is expected to last for around five years for a member joining at age 22. The investment objective will be to match inflation. At this age, development of a savings habit and avoidance of the negative reactions to volatility – which research shows may be prevalent – are key to retirement income prospects. Equally, the size of members’ pots will be relatively small and therefore the amount of investment risk taken has limited impact on the final size of the accumulated pension pot. We aim to encourage persistency in making contributions and help develop the habit of saving for a pension that will be ongoing for the member’s working life.

Growth phase3.7 As members get older, their NEST Retirement

Date Funds will transition out of the Foundation phase and seek returns in excess of inflation throughout the Growth phase. Lifetime savers with NEST will spend the majority of time in the Growth phase. The specific objective will be to outperform inflation by 3 per cent over the long term. This is the longest phase where we will look to maximise investment performance whilst avoiding extreme shocks. This is the main opportunity for members to benefit from global economic growth through exposure to, primarily, return seeking assets.

3.8 CPI + 3 per cent has been chosen as a target because we believe that this is the optimal balance between members taking sufficient risk to generate an acceptable retirement income for our members and not taking so much investment risk as to expose members to excessive volatility or lead to unacceptable dispersion of outcomes between members in different cohorts.

NEST’s investment approach • NEST Retirement Date Funds

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Consolidation phase3.9 As members move closer to retirement, pension

conversion risk becomes increasingly important. The objective in the Consolidation phase will be to gradually reduce exposure to more volatile return seeking assets and invest in a way that best matches members’ planned method of taking retirement benefits. For members retiring in the early years of the scheme this is likely to be taking a cash lump sum and so the consolidation phase will target cash in this period2. In the long term, however, members are expected to buy a retirement income in combination with taking a tax free cash lump sum.

3.10 Figure 1 shows the lifecycle of a typical target date fund illustrating the varying risk profile and the shifting asset allocation.

Managing the funds3.11 Each NEST Retirement Date Fund will operate as

a fund of building block funds and have an asset allocation appropriate to its target date. We will blend:

• return seeking asset funds – currently a global developed equities fund and a diversified beta fund3

• income seeking asset funds – currently a gilts fund, an index linked gilts fund and a liquidity (money market) fund.

This enables us to manage the risk profile of each fund.

3.12 See Figure 2 for the initial range of building block funds for all NEST Retirement Funds.

3 A fund that invests in a diversified range of asset classes such as emerging market equities and debt, property and corporate bonds. The underlying asset classes are passively managed.

2 In the early years if a member wishes to target a retirement income they can select the NEST Pre-retirement Fund which is designed for this purpose.

08 NEST’s investment approach • NEST Retirement Date Funds

Figure 1

22 27 32 37 42 47 52 57 62

Risk

pro

file

Income seeking assets

Annuity-tracking assets

Illustrative lifecycle of 2058 Retirement Fund

Return seeking assets

Foundation Growth Consolidation

Minimum Reference glide path Maximum

Figure 2

Building block fund range

Fund Investment approach Benchmark/target Fund manager

Global Equity Fund Passive FTSE All World Developed Index UBS

UK Gilts Fund Passive FTSE Actuaries All Stocks Index SSgA

UK Index Linked Gilt Fund Passive FTSE Acturaries Index Linked Gilts over 5 years Index SSgA

Low-risk Liquidity Fund Active 7-day LIBID BlackRock

Diversified Beta Fund Mostly passive UK Risk Free Rate +2% - +4% BlackRock

Global Ethical Equity Fund Active MSCI World F&C

Sharia Compliant Global Equity Fund Passive Dow Jones Islamic Titans 100 HSBC

Sterling Bonds Active iBoxx Sterling Non-Gilt All Maturities Index RLAM

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Managing the transition between phases3.13 The transition between the Foundation, Growth

and Consolidation phases will be managed dynamically on the basis of what is happening in financial markets and the economy as well as our understanding of different member cohort characteristics. For example, a member joining the scheme at age 22 will be fully in the Foundation phase portfolio for at least three years while by the age of 30, the member will have fully transitioned into the Growth phase portfolio. Typically this will mean he or she is in the Foundation phase for around five years and the transitional period (moving from Foundation to Growth portfolios) will occur during the years that a member is between 25 and 29. The length and timing of that transition will be subject to our expertise.

3.14 Similarly the Consolidation phase is expected to start 10 years before a member is to take his or her retirement benefits but this could vary between five and 15 years and we will review the timing for each fund as it approaches the Consolidation phase.

3.15 In the early years of the scheme, large numbers of people will be automatically enrolled at a variety of ages. Figure 3 indicates which phase we expect people to join (assuming they are in the fund that aligns with their State Pension age) as well as the expected glide path for members of different ages.

10 NEST’s investment approach • NEST Retirement Date Funds

Figure 3

22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 62 64

0

5

10

15

20

25

30

35

45

40

8 years

5 years

3 years

10 years

15 years

5 years

Consolidation phaseGrowth phaseFoundation phase

Year

s in

eac

h ph

ase

Age on joining scheme

Time spent in and transition between different phases for NEST members

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Other fund choices04

4.1 We expect up to 90 per cent of our members will invest in the NEST Retirement Date Funds, either through choice or as the result of not making a fund choice. However our member research identifies that some members will have specific needs that we believe should be met through offering a focused range of additional fund choices. Specifically we will initially make available:

• NEST Ethical Fund aims to achieve similar above inflation returns as the NEST Retirement Date Funds, over a whole savings career, while investing in companies that meet ethical criteria. It will be delivered through an ethical global equity fund along with the income seeking asset funds used for the NEST Retirement Date Funds. The fund is likely to be more volatile than the Retirement Date Funds but we will look to manage risk throughout a member’s savings career.

• NEST Sharia Fund will invest in a portfolio of global equities, compliant with Sharia principles.

• NEST Higher Risk Fund which seeks high returns through investing in a diversified portfolio of return seeking assets with high volatility. This is designed to meet the needs of those members who have high risk appetite.

• NEST Lower Growth Fund aims to preserve the nominal value of capital invested and to grow that money in line with low risk money-market investments.

• NEST Pre-retirement Fund aims to meet the needs of members retiring in the early years of NEST who expect to buy a retirement income. It invests 75 per cent in UK gilts and sterling bond funds and 25 per cent in the liquidity fund. This matches the combination of retirement income and cash lump sum we expect these members will take.

4.2 The key characteristics of all the funds are presented in the table in Annex 1. More details on all the NEST Retirement Funds will be available in the fund fact sheets.

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Delivering our investment objectives – investment beliefs05

5.1 We have established a set of seven evidence based investment beliefs as guiding principles to provide a transparent framework for consistent decision making.

Investment beliefs1. That understanding scheme member

characteristics, circumstances and attitudes is essential to developing and maintaining an appropriate investment strategy.

2. That as long-term investors, incorporating environmental, social and governance (ESG) factors within the investment process is in the interests of our members.

3. That taking investment risk is usually rewarded in the long term.

4. That diversification is the key tool for managing risk and return.

5. That risk-derived asset allocation is the biggest determinant of long-term performance.

6. That analysis of both economic conditions and market regimes should be used to drive strategic decisions.

7. That passive management - where available - generally delivers better value for money than active security selection.

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Risk management and asset allocation06

6.1 NEST views risk management as a strategic function. We will have a large and diverse membership, and we will have to manage their risks all along their lifecycle in a holistic way. This has led us to three main design characteristics:

• The use of three phases in accumulation (Foundation, Growth and Consolidation) to recognise that members’ needs are different at different ages. For the default fund there will be annual target date funds so that each member is in a fund that focuses on his or her expected retirement date.

• We will manage risk through diversification – spreading money, wherever possible, across a wide variety of assets to spread the risk and smooth the returns – this will help us navigate through many different economic and market environments.

• We will set and operate within a risk budget. We will seek to take the appropriate risk at the appropriate time in order to achieve the long-term objectives efficiently.

6.2 Intrinsically linked with our risk management process, is our process for understanding the market and economic regimes under which we operate and setting appropriate strategic asset allocations.

6.3 The strategic asset allocations for the NEST Retirement Date Funds, the NEST Higher Risk Fund and the NEST Ethical Fund are set through widely used modelling techniques, using well researched inputs and assumptions from one of our investment advisers4. The underlying data will provide a long-term perspective as is appropriate for a pension fund but also must recognise current market conditions. These asset allocations will be adjusted dynamically in order to manage risk and to create circumstances in which there is a good chance that both short and long-term market expectations are appropriately reflected within portfolios.

4 The NEST Lower Growth Fund, NEST Pre-retirement Fund and NEST Sharia Fund have fixed allocations into the underlying funds.

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Responsible and active ownership07

7.1 We believe it is important for NEST to act as a responsible and vigilant asset owner and market participant across our range of retirement funds. It is our view that responsible investing will help deliver long-term value to our members. We will however take a proportionate approach to our activities when assets under management are modest.

7.2 Initially, we will implement our responsible ownership approach through:

• considered voting of all the shares we own where practical

• engagement with companies

• collaboration with other institutional asset owners

• engagement and dialogue with regulators and industry bodies around the globe

• becoming a signatory to the Financial Reporting Council’s Stewardship Code and the UN Principles of Responsible Investment (UN PRI) and using their best practice principles to benchmark the NEST approach to responsible investing.

7.3 Our approach to responsible ownership is one element of our overall approach to managing environmental, social and governance (ESG) risks. Integrating ESG factors into our investment process is an important element of our approach to managing investment risks.

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NEST Higher Risk

Primary objective

To target high returns through taking more risk

To preserve the nominal value of capital and to grow in line with low risk money-market investments

CPI CPI +3% To manage conversion risk by progressively switching from growth phase portfolio into annuity-tracking and cash matching assets

Invest in annuity-tracking and cash matching assets

Ethically invested. Inflation + for members 22-55. Prepare for annuity 56+ with reducing exposure to ethical equity

To invest in a portfolio of Sharia compliant global equities

Purpose To provide a fund to meet the needs of those members with a high risk appetite

To take very little investment risk

To establish a savings habit and start building a pension pot. Preserve capital in real terms and reduce probability of severe shocks

To maximize return at an acceptable level of risk. To reduce probability of severe shocks

To transition the pot from the growth phase and secure the value of a retirement income. Reduce probability of severe losses close to retirement

To meet the needs of people who expect to buy an annuity in the near future

To provide a fund with similar characteristics to the NEST Retirement Date Funds invested in line with ethical principles

To provide for members who want to invest in accordance with Sharia law

Health warning

Higher chances of loss

The value of contributions may not keep up with inflation

These funds have been designed to meet the needs and characteristics of the majority of our future members. Individuals should check that these meet their needs or whether one of the other fund choices would be more appropriate

Value of the fund will be very sensitive to changes in interest rates

Likely to be more volatile than the NEST Retirement Date Funds due to less diversification

Likely to be highly volatile

Lifecycling Yes - switches into NEST Retirement Date Fund ten years before member’s retirement date

None Retirement Date Funds are dynamically lifecycled throughout a member’s savings career

None Yes No – working with the market to develop products to support lifecycling

NEST Retirement FundsA1

NEST Lower Growth

Foundation phase Growth phaseConsolidation

phase

NEST Pre-retirement

NEST Ethical NEST ShariaNEST Retirement Date Funds

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Notes

© NEST Corporation 2012. This document has been created by National Employment Savings Trust Corporation,the trustee of the National Employment Savings Trust (NEST). This is not and is not intended to be financial or other professional advice.The information contained in this document is correct at the time of its publication.

NC012 INVAPR 04/12

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NEST CorporationSt Dunstan’s House201–211 Borough High StreetLondonSE1 1JA

Contact us:Public enquiries: 020 7940 8519Email: support@nestpensions.org.uk

Visit our website:www.nestpensions.org.uk