Dan Mikulskis comments on defined contribution investment strategy in the wake of this years UK Budget and the effects of change to the pensions market
Things changed significantly for defined contribution (DC) pensions in the March 2014 Budget. The extra flexibility announced for savers at the points of retirement have focused further attention on DC scheme design, including the appropriate investment strategy for default arrangements. This is an issue that was already in the spotlight following the advent of auto-enrolment and the huge expansion of the UK DC marketplace.
What impact does this have on DC investment strategies?
Up to now, many DC investment strategies were set with the expectation that most members would opt for an annuity at retirement - which was consistent with experience in the pre March-2014 world. Now, retirees will have a lot more flexibility and it is hard to know how many will continue to choose to purchase an annuity (although data from Australia , where retirees have similar flexibility, shows that fewer than 8% choose to). It seems sensible then that we should allow for an investment strategy that continues through retirement. Illustratively, a typical DC member's investment 'journey' might look something like Figure 1.
Of course, in reality, investment returns will not be earned smoothly, and this is where the investment strategy comes in. In order to earn investment returns some level of risk must be taken. In turn, this can result in fluctuations (downward moves are naturally of more concern) in the member's savings account,
The starting point for setting any investment strategy is a set of objectives. While broad objectives are easy to formulate such as, "provide sufficient income in retirement", it is specific and quantitative objectives and constraints relating to both risk and return that are necessary. For example:
? To reduce to 5% or less the chance of having to work four years beyond 65 to ensure a replacement ratio of 65%
? To provide a steady level income in retirement, with the expectation of significant capital remaining for inheritance after 25 years.
Objectives are a real challenge for those setting an investment strategy for a default fund, as it is likely to contain the assets of a large and varied group of members. It seems unlikely that we can know, or even approximate, the likely requirements of each individual in a DC scheme, so fitting an overall risk level is difficult. All we can say is that, while it may be imprudent to adopt a default strategy with excessive levels of investment risk for obvious reasons, it may also be imprudent to adopt too conservative a strategy as this may give an equally high probability of not meeting members' objectives.
Today, it seems to make sense to divide the DC investment journey illustrated in Figure 1 into two significant stages, with quite different objectives, and therefore required investment strategies.
The pre-retirement phase
Investment risk is likely to be experienced (at least initially) by occasional falls in the member's pot size from one year to the next. But what level of fall could be expected, and how frequently?
In addressing the objective of year-on-year fluctuations in pot size, a key question is whether it is desirable to design a strategy that delivers a consistent level of experienced risk (at least from an asset-only perspective) or one in which the level of risk varies. The drivers of a traditional allocation to equities are likely to be relatively easy for most DC members to understand, but the level of experienced risk is variable, with infrequent but large losses in any given year. Recent history has shown, for example, that a member investing mainly in equity could see their pot decrease by multiples of their annual salary in a severe equity bear market (see Figure 2).
Risk-controlled investment strategies operate by varying the allocations to underlying assets dynamically in order to deliver a more consistent level of risk, or at least by limiting the exposures at times of highest risk. While the return over a long period may or may not be greater than for a similar static allocation, the year-on-year experience of the member will be smoother (see Figure 2). Applying risk control also gives an obvious lever to employ in reducing risk as the member approaches retirement - the level of risk targeted can simply be reduced. Another argument in favour of strategies that explicitly control risk is that the pricing of guarantees on the value of savings will be much more affordable than on strategies where risk is variable.
As the member approaches retirement, risk can be experienced as an increasing chance that the member will in fact have to work beyond the planned retirement age to generate sufficient capital to fund their retirement. Measuring risk in this way is complex, as a conservative investment strategy that moves into low-risk (and therefore low-return) assets too early before retirement can in fact show a higher level of risk on this measure, by locking in low returns. Figure 2 illustrates the shortcomings of an approach of scaling linearly into cash from 10 years out from the planned retirement age. Following the 2008 market falls this approach would indeed have run a high risk of the member having to work longer to fund the planned retirement.
The post-retirement phase
Setting an investment strategy for a fund that is managing a significant cash outflow each year is a challenge, as any mature defined benefit pension fund will know. The big issue is the path-dependency of the actual returns - the investment strategy becomes critical as the fund is sensitive to the timing of losses compared with gains. In Figure 3, a member is drawing down a DC pot in retirement. The member naturally wishes to receive a known amount of income each year, in this case a level 6% of the starting amount (which remains fixed). Some investment risk is taken in order to generate a level of returns that is expected to satisfy the requirement for income and leave capital left over after 25 years. The path illustrated by the grey line shows a constant investment return of 5.4% p.a.
The three scenarios illustrated by the other lines all produce cumulative investment returns over the whole period that are equivalent to 5.4% annualised (in fact the three scenarios all contain the same annual returns, in different orders). However in scenario 1 initial losses and low returns mean that the capital is significantly depleted such that, despite the larger positive returns that follow, the capital runs out before initially projected. In other scenarios, large returns in the early years can result in higher than projected amounts of capital remaining after 25 years.
This suggests an important role for careful modelling of the risks involved in this investment strategy in order to correctly balance the level of income paid out with the expected return of the investment strategy and the level of investment risk taken, and to ensure the risk of running out of capital is kept to a minimum. It turns out this is a much more nuanced set of constraints than in the accumulation phase, suggesting a significant role for investment strategy modelling. This also points to a role for capital guaranteed investment strategies, particularly in an environment where the desired income level cannot be easily generated by investing in liquid, income-bearing securities (as is likely to be the case now).