Building guarantees into DC products
The wild card in the defined contribution pack is the level of investment risk to which individual members are exposed and it is here that derivatives can play an important role in protecting investors from unwelcome volatility, particularly in the years preceding retirement.
Derivative-based guaranteed funds are not a universal panacea for DC investment risk, however, and those responsible for product design should consider how this type of fund can be used in conjunction with other risk management techniques, such as with profits contracts, within a lifestyle asset allocation strategy. The lifestyle approach determines the asset mix for each member according primarily to age and the number of years to retirement.
But before tackling risk it is important to set clear objectives. The two most obvious risks for DC scheme members are that they will invest in the wrong type of assets and that their fund will be decimated by a market crash just before retirement. With- profits and guaranteed funds provide different levels of protection against market volatility whereas lifestyle is an overall structure and is used to direct investors into appropriate asset classes throughout the investment term. Whether used separately or in conjunction, these three approaches to risk management share a common aim, namely to enable investors to benefit from the growth associated with exposure to real assets but at the same time to protect them from the full impact of a severe fall in the markets.
For product designers it is important to appreciate that although the choice of funds offered is critical, there is no single solution to protect investors both from their own follies and from the whims and inconsistencies of world markets. A lifestyle strategy that incorporates a guaranteed fund for those close to retirement may prove practical but the with-profits should not be ruled out for medium- to long- term investment. Indeed, the UK government recently bowed to expert opinion and agreed to include with- profits in the fund choice for its industry-wide or stakeholder schemes, due to be launched in April 2001.
The government took this decision because it recognised that the conventional wisdom that younger people should invest virtually 100% in equities may be sound in theory, but in practice many people of all ages cannot tolerate the associated level of volatility. The structure of with-profits funds suits the medium- to long- term investor, while derivative-based guaranteed funds are not generally considered appropriate for this purpose due to the limits on the total return (these funds usually do not benefit from reinvested dividends) and the cost of derivative contracts.
The majority of guaranteed equity funds are actually cash-based but use a derivative contract (a call option) to provide the link to the stockmarket index. With a cash/call fund the bulk of the individual’s money is held in a deposit or fixed interest account. This provides the guaranteed return of the original capital. Typically about 4% of the fund is used to buy the option contract, which provides a hedge against the value of the selected index or indices. If the index rises over a specified period, the contract is exercised to realise a profit. If the index remains level or falls the contract expires. In this case all the investor gets back is his or her original capital, less charges.
Since these funds are not actively managed, the performance record of the provider is not an issue but the cost of the derivative contract and the restrictions in the index growth most definitely are. After all, a guarantee of 120% of the FTSE 100 growth (without reinvested dividends) after five years is no great shakes.
So what is the cost of this limited growth? Given the link to an index, a good comparison in the UK might be an All Share or FTSE 100-tracker fund that typically would carry an annual management charge of between 0.5–1%. Some of the popular insurance company guaranteed funds carry a 1% annual management charge plus an additional 1.5% per annum for the guarantee.
Protected funds from institutional managers who operate in the retail market through mutual funds can be cheaper. These companies argue this is partly because they have more experience in buying derivatives and partly because the commission to advisers is a lot lower than the 7–8% typically paid on an insurance company bond.
One of the features of the more flexible funds is the quarterly ‘ratchet’. This raises the unit price to take account of any capital growth. In theory, by adjusting the guaranteed unit price on a quarterly basis the investor can gain from potentially greater capital growth than if the guarantee is based on the level of the index on a specific date either one, three or five years after the initial investment. The ratcheting mechanism is considered particularly valuable if the markets are volatile.
Regular adjustment of the unit price is a valuable feature but it is also vital to consider the actual link with the stock market index. Over the past few years the index links have become more complicated and while some funds still offer an explicit link to the performance of a single index, more commonly the fund performance will depend on the movement of two or three indices - for example, the FTSE 100, S&P 500 and the Nikkei 225.
This added layer of complexity has been skillfully marketed as a broadening of performance potential. The truth may be somewhat different. In recent years the price of derivatives in the London market in particular has increased, so explicit guarantees are more expensive to provide. Multiple index links are one way of confusing the nature of the guarantee – and the investor. Mike Wadsworth, partner with the consultant Watson Wyatt, says, “These ‘magic box’ guarantees depend on such a complicated series of interactions between indices that, although in theory the risk/reward profile can be extrapolated, in practice investors cannot assess the balance of probability and so cannot attach any real meaning to the guarantee.”
With-profits funds are designed to provide a reasonable degree of security together with good potential for long-term capital growth. The downside is that charges are opaque and the investor can be penalised for early termination.
The asset allocation of a UK with- profits fund, for example, is similar to a managed mutual fund and invests mainly in domestic and international equities, gilts and fixed interest securities and property. The annual return is distributed in the form of bonuses which, once allocated, cannot be taken away.
These annual bonuses are ‘smoothed’ to provide a relatively consistent return. To do this the life office holds back some of the profits in good years to boost returns in lean years. In this way the plans aim to avoid the volatility associated with most mutual funds where the unit price is directly linked to the fluctuating value of the underlying securities. On top of the annual bonuses there is a final or ‘terminal’ bonus which is discretionary and tends to reflect actual performance over the past 12 months.
It is important to recognise that there are few if any solid guarantees with this type of contract, particularly since the introduction of the controversial ‘market value adjuster’ (MVA) which allows a company to reduce the value of units if an investor pulls out early. The MVA is not applied at retirement or on death but at all other times it undermines the image of security the product seeks to convey.
The lifestyle strategy is used by many DC schemes and plans as a default option. Typically it would direct all contributions into an equities fund until the investor is about 10 years from retirement. From this point new contributions and the fund itself are gradually switched from equities to a guaranteed fund or to gilts and cash.
Most experts agree that the lifestyle structure is the best default programme for investors who do not want to make their own asset allocation decisions or who might otherwise put too much into cash and bonds at an early age. There are drawbacks, however. Some advisers argue that to start pulling out of equities 10 years before retirement takes the investor out of real assets too soon and at a time when regular premium plans in particular tend to benefit from the greatest growth. A five-year phased switch out of equities might be preferable.
But perhaps the biggest problem is that standard lifestyle programmes do not cope well with a variable retirement date. Few employees these days make it to the company retirement age. Many go early either voluntarily or through a redundancy/early retirement programme. A decision to postpone retirement can be equally problematic for the lifestyle structure.
The success of new DC schemes in Europe will depend to a great extent on how well the provider designs the product for individual schemes and markets. However, risk management techniques for DC products are still in their infancy and vary considerably.
For these strategies to work, it is essential that the plan sponsor and the fund provider make sure investors understand that four-letter word, risk, and the difference between risk from inflation, risk to capital and the risk involved in pension conversion.
Finally, DC providers would do well to recognise that investment risk management is not just about protecting the scheme member. In the US, members of DC schemes have taken plan sponsors to court where they felt they had failed to discharge their investment responsibilities satisfactorily. The implications for European trustees, foundation boards and other types of plan sponsor are very worrying. Safety, it seems, lies in offering an appropriate fund choice and in educating members to use it wisely.