Members of defined contribution pension plans and schemes should carefully manage risk and volatility to create better predictability of investment outcomes. It is, in short, equally as important for those embarking on their retirement savings journey as it is for those reaching retirement age.
This is one of the key takeaways from new research that Standard Life Investments is preparing to publish in its latest white paper on DC investment strategies.
It is now more than two years since pension freedoms were launched. Chancellor of the Exchequer, George Osborne, announced in the 2014 budget that for the 2015/16 tax year anyone over the age of 55 was free to take their entire pension pot as a lump sum. One quarter would be tax free, the remaining figure taxed as if it were earned income.
This sounds great, liberating even, but it remains to be seen what the implications are to those who have taken their pension pots in full without thinking about the longer-term impact of risk should they want to invest those monies to deliver a sustainable income for their life after work
Which raises a second issue. Two years ago, at the time of the pension freedom announcement, UK gilts were still perniciously low yielding making them an unattractive investment. By contrast equities, thanks to the Brexit-induced devaluation of sterling, have delivered double-digit levels of returns.
“The implications that both those issues have on DC investment design are substantial,” says Andy Dickson (pictured), Investment Director, Standard Life Investments. “We’ve done research on this in terms of the importance of managing investment risk in DC plans. If we were to have a change in those market valuations (higher gilt yields, lower equity valuations), the amount of volatility that could ensue would have a huge impact on the income returns of DC investors.
“Therefore, consistency and greater predictability for members should be a key objective of any DC investment plan design.”
Member segmentation
Dickson adds that as pension freedoms are now available, SLI is starting to see patterns of behaviour where members are taking lump sums rather than income strips out of their pension plots. “We believe that given the amount of risk they face there needs to be a proper focus,” comments Dickson, stating that a ‘one size fits all’ investment strategy is impractical.
Trustees should, he says, start segmenting their membership profile and devise an investment strategy that best meets the profile of each segment, especially the ‘squeezed middle’: – that is, those members of DC plans whose pots are neither big enough to warrant utilising a financial adviser nor small enough to be taken as a one off cash pot to spend rather than invest. Some schemes have taken action but the majority have yet to do so.
“Those two factors combined – macroeconomic backdrop and pension freedoms – mean that it is, in our view, time to re-think DC default design” – and create more certainty over what the investment outcomes will be,” explains Dickson.
As an asset manager, SLI’s view is that those responsible for putting together investment designs should take stock and consider the risks that DC members are facing.
The key takeaway from the research that SLI has undertaken is how important managing risk and managing volatility is in determining those design outcomes. There has to be a consideration around cost, and the value being delivered. Cost, says Dickson, has to be considered in relation to the consistency of outcomes.
“If you are looking to manage volatility, it costs more money but could it add greater long-term value? And our answer to that is ‘Yes’. Not just for those coming to the end of contributing to their DC scheme who are looking for capital preservation, but for those at the start of their DC contributions,” says Dickson. Indeed, younger people might be put off contributing if they see the value of their investments erode because the DC plan has failed to adequately manage investment risk in their pension plans.
Consistency of returns
Dickson confirms that the analysis conducted by SLI shows that the consistency of returns has a significant bearing on investment outcomes.
The sequence of returns will vary considerably for different age groups. If one thinks about a DC plan, there are different members joining month after month. As time passes, different members receive a different sequence of returns.
“The impact that this has creates a significant divergence in the range of outcomes a member will achieve. It becomes a little bit of a lottery, in terms of how the markets move while the employee is investing; hence the importance of managing risk and volatility to create better predictability and narrow the range of outcomes for the DC member.
“Many of the designs that have been put in place don’t control volatility or risk for a significant number of years. We think it needs to be controlled for all DC members, regardless of how long they’ve been paying into it. Instead of just managing risk in the run up to retirement, what we are saying is that you should roll that back right to the start of someone paying into a scheme,” outlines Dickson.
Diversification is key
The USD64,000 question to this is: How? How does one design a DC investment strategy that can withstand whipsawing markets and volatility to produce consistent returns over the long term?
Certainly, having an investment strategy that is well diversified is key.
Equity market-like returns over a market cycle with two-thirds of equity market volatility. This is the investment proposition of Standard Life Investments’ Enhanced-Diversification Growth Fund. The key difference to other Diversified Growth Funds, however, is that SLI uses dynamic asset allocation that broadens the portfolio beyond traditional assets (such as equities, government and corporate bonds and real estate).
By focusing on a wider set of strategies, EDGF seeks out higher levels of return-seeking opportunities but not at the expense of higher risk. The result is a more highly diversified portfolio but with a growth bias (equities). It does this by incorporating a range of diversifying strategies, which it refers to as ‘enhanced-diversification’ strategies, and which it also expects to be profitable.
One can think of these as acting like shock absorbers. Rather than limit the risk budget to traditional assets SLI uses a robust risk management process to extend the range of return opportunities:- these are to be found in the world of currencies, interest rates and inflation, and relative value equities.
Taking an enhanced approach which seeks to generate returns from different assets that do not correlate to one in periods of market stress, “can help broaden the investment strategy and reduce volatility”, says Dickson.
In the context of managing risk, he adds that one very important component is political risk, which can impact markets just as much as economic risks; as referenced earlier by the impact of Brexit on the value of sterling.
“Political risk is one of the examples of investment risk that DC savers are facing and should be taken into consideration by investment managers.
“While we can’t predict the future, what we can do is hypothesize a range of economic scenarios that could emerge to stress test portfolios. If there was to be a significant drawdown in China’s growth story, for example, what impact would that have on financial markets? We might then adjust geographic exposures accordingly, depending on the scenario results,” says Dickson.
With the world looking more uncertain than ever, DC plans need to be more cognisant than ever of the need to manage risk for each DC member.
To read more about Standard Life Investment’s DC Solutions, please click on the following link: https://uk.standardlifeinvestments.com/dc/
The value of an investment is not guaranteed and can go down as well as up. An investor may get back less than they invested. EDGF makes extensive use of derivatives.
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