Many investors nearing retirement are unable or unwilling to take on the volatility associated with a more aggressive portfolio

The UK’s defined contribution (DC) pension market is on the brink of a substantial transformation. Over the past decade, membership in DC schemes has experienced a meteoric rise, surging from approximately one million individuals in 2012 to an impressive tally of 26 million as of March 2023¹.

In this market the lifecycle model has always played a crucial role. This model dictates that the closer investors get to retirement, the more conservative their asset allocation becomes, typically shifting towards bonds and away from equities. Due to the generally young age of DC scheme members, the focus has been on the early stages of this journey, often with little regard to what comes next.

Now with investment pots growing and members getting older, more assets are moving towards the later stages (mid-growth and decumulation) of the lifecycle, which is causing fundamental changes within the DC market.

In one sense the conservative approach in the later stages is a prudent one. Investors naturally become more risk-averse the closer they are to receiving their pension pot.

However, looking at the broader picture across someone’s whole investment lifecycle and not just until retirement, this approach is too conservative. What happens all too often is that these later stages of the lifecycle witness an over-allocation to low-risk bonds and money market funds.

This approach results in low equity allocations, which is problematic, considering a retiree’s remaining life expectancy has been steadily rising. Currently, a man aged 65 is expected to live for a further 20 years, but 13% can expect to survive until 95 years old (for women this figure rises to 20%)².

This makes it even more important that pension funds should have higher growth asset exposure, given the high risk that conservative strategies will not give investors sufficient pension pots.

Philipp Loehrhoff at Berenberg

Philipp Loehrhoff at Berenberg

In our new world of higher inflation, high bond allocations also pose a significant risk, as inflation could potentially erode the real value of the assets, particularly in the later stages of the lifecycle. This new market environment necessitates a focus on investments that generate positive real returns, another reason why investors later in the lifecycle should invest more in equities.

So why has this problem not been fixed? One challenge here lies in the fact that many investors nearing retirement are unable or unwilling to take on the volatility associated with a more aggressive portfolio, necessitating a solution that balances risk and return.

Up to now, not enough has been done to address this, especially as the number of DC members along with their pots keep growing and the age of the average member is increasing.

To develop a solution to this problem, schemes need to understand that investors towards the end of the pension lifecycle want their investments to follow four key principles:

  1. Risk mitigation: Many DC investors want a solution that can provide a buffer against losses during market downturns, especially in one of the most volatile macroeconomic environments in living memory.
  2. Growth potential: Although many DC investors are more defensive, they still want to participate in the growth of equity markets to ensure their savings last throughout retirement.
  3. Flexibility: There are broad similarities between DC investors at this stage of the lifecycle, but schemes must be able to cater to various risk tolerances and investment horizons.
  4. Inflation protection: Given this has dominated the headlines over the past 12 months, it is understandable that DC investors will want their solutions to provide some form of protection against inflation.

Unfortunately, there are not many solutions to address this challenge. However, recently some progress has been made and it comes from a familiar quarter.

There is a solution that has stood the test of time and has become available to DC investors quite recently – protected equities.

A protected equity strategy is an approach that has been used by many institutional investors over the past few decades. It works by combining equity investments with a protective element.

The equity component gives investors growth potential and a hedge against inflation, while the protection component protects investors to some extent from the full brunt of potential losses during periods of market downturns.

The strategy offers investors in the mid-growth phase as well as those nearing retirement a way to maintain or even increase their equity exposure without increasing their risk profile substantially. If one wants to generate better returns without jeopardising savings, protected equity can provide the flexibility to achieve this.

Protected equity has only recently become accessible within the DC space in a way that fulfils the essential requirements for investors in the DC market by offering high liquidity and transparency, low cost, attractive value for money and ease of access via various platforms.

It is also complementary to other developments in the DC market such as private market investments and can offer an alternative to bonds and diversified growth funds, many of which have often fallen short of expectations.

It feels like we are on the cusp of a period of substantial change in the UK DC pension market. Given the radical changes in the structure of the market we should be seeing even more solutions on offer.

DC schemes, consultants and trustees need to think carefully about how to manage the challenges of the later stages and increase their exposure to growth assets without substantially increasing the risk of the portfolio in ways other than relying on diversification, which frequently lets investors down as the lessons of 2022 have shown.



Philipp Loehrhoff is head of multi-asset solutions at Berenberg