A life more rewarding
As defined contribution (DC) schemes become more popular with companies, it is increasingly important that they provide satisfactory investment and education programmes for their members to enable them to make suitable decisions about their long-term pension savings.
An appropriate long-term strategy for a DC plan differs in many ways from defined benefit (DB) for the basic reason that DC concerns the individual, and is – or at least should be – influenced by his or her future earnings power. By contrast, DB is about the most efficient way to invest a large financial asset held at arm’s length from a sponsoring employer. Because of this added human element, DC plan design is particularly challenging.
As the central difference is that investment risk is borne by members, it is paramount that trustees develop a strategy to ensure members maximise the value (future purchasing power) of their investments, while avoiding undue risk.
However, it is not as easy as it seems. There are two major hurdles that need to be overcome. What does it mean to select the correct investments whilst avoiding taking undue risk? And how, in running one pension scheme, do you take into account each individual member’s characteristics?
Unfortunately it is not the case that what suits one member will necessarily suit another. One member’s ideal solution might turn out to be completely unsuitable for another because of personal circumstances. At the very least, a member’s risk tolerance changes over time, meaning that what might be appropriate at the beginning of their career is no longer appropriate later in their life. It is also likely that individuals will differ in terms of their future contributions and their non DC pension assets.
One of the key differences between younger and older members can be termed ‘human capital’. Human capital is the wealth associated with an individual’s future salary. Of specific interest here is retirement human capital – the value of future contributions into a DC and/or DB plan.
Let’s consider a young member, maybe starting his career, and an older member, who is perhaps considering retirement in the next couple of years.
Young members will typically have high human capital, in that they have a long time to correct any short-term investment setbacks by changing their future saving habits as necessary. This implies a relatively high level of investment freedom. As a result they can adopt an aggressive investment policy in which the primary objective is to maximise returns.
Of course, this means that they are using their future human capital to underwrite the associated risk, implicitly creating some form of unwritten covenant between them and their future as a safeguard against potentially poor investment outcomes.
An older member will, on the other hand, have a low and falling human capital. Over their career, most older members will have built up considerable pension assets and will have established their consumption and spending habits. In the context of limited time and human capital to correct any shortfall caused by poor investment experience, they are likely to prefer to minimise or at least control the volatility of the value of their pension near retirement. The upshot is a defensive investment policy, in which they invest in fixed interest securities or index-linked bonds.
So if these two types of member represent the two ends of the spectrum, how do we cater for all the members who fall between these two? In other words, how do we manage the switch from an aggressive investment policy to a defensive one?
We achieve this by constructing what is known as a ‘lifecycle’ arrangement. A lifecycle arrangement offers an investment solution for members who wish to manage the investment risk in their fund so as to protect the purchasing power of their pension fund assets towards retirement. Such arrangements are frequently offered as a default investment choice by UK DC schemes.
The mechanics of a lifecycle arrangement involve altering the asset allocation as a member approaches retirement age. In the early years, a member’s fund is invested in a risky asset portfolio, which comprises real assets, such as equities, property and perhaps private equity. Hedge funds and other relatively illiquid but high returning assets may also be considered. As retirement approaches a more conservative strategy is adopted and the fund moves its investments predominantly into a lower risk portfolio comprising bonds, corporate bonds and cash, giving some protection to short-term fluctuations in equity markets.
In constructing a lifecycle arrangement, the first objective is to determine the target portfolio at retirement. This can be either annuity- based or set with reference to an income drawdown strategy. Setting an investment strategy for income drawdown is a separate and quite complex problem, involving the need to consider separating the accumulated funds into portions tailored to meet future payment periods. In this article we discuss the simpler and more common case of a lifecycle strategy targeted towards purchasing a whole life annuity at retirement. This requires a bond-based strategy at retirement, normally with a small amount of cash to provide a lump sum at retirement.
Given a clear retirement target to aim for, we can construct a series of age-dependent asset allocations that blends over time into the bond- and cash-based retirement portfolio. Figure 1 shows one such series of asset allocations, designed using a simplified world of equities, long bonds and cash, and with a particular risk aversion in mind.
The graph assumes that all of an individual’s retirement wealth is available for investment throughout the period, ie from age 20 in this example. This is naturally not the case in reality, but is a helpful first step to consider. Using generally accepted investment axioms we see that at young ages equities dominate the desired asset allocation, moving smoothly through to long bonds and cash as retirement approaches.
Future contributions are naturally not available for investment until they are actually paid, and so the above analysis does not present the whole picture.
Future contributions can be thought of as representing an ‘uninvestible’ asset belonging to the individual, the size of which generally reduces as the member ages and contributions are made. To the member, therefore, future contributions essentially represent a stream of payments not unlike a bond, whose cashflows are linked to salary growth.
Naturally, as time passes and contributions are made into the DC plan, the value of the invested assets grows with investment returns. The consequence over time is that the invested assets grow to dominate the human capital asset. Figure 2 plots the expected split between the investible and uninvestible assets over the course of an individual’s working life.
Figure 3 sets this split of investible assets to human capital asset against the desired pre-retirement asset allocation shown previously.
The area above the black line represents the proportion of the individual’s total DC assets (ie human capital asset plus invested assets) that are free to be invested. From the graph we can see that:
q In their early years, DC members wish for a higher proportion of their total retirement wealth in equities than they have to invest. The conclusion is a 100% equity for their investible funds.
q In the years immediately prior to retirement, the proportion of equities desired is less than the value of the investible portfolio, and hence a high bond content and not 100% equities is the preferred asset allocation.
q The point at which the switch starts is where the investible assets become greater than the proportion of the whole portfolio that would be ideally invested in equities. From this time a growing bond content is desired.
The conclusion is that for early ages the whole of the investible assets should be invested in equities to compensate for the fact that the majority of the individual’s total retirement wealth at this time (the human capital) has bond-like characteristics. At a later date, the proportion of investible assets intersects with the proportion desired in equities, implying some non-equities should be incorporated into the investible funds from this age onwards.
The resultant lifecycle asset allocation is depicted in figure 4.
Therefore, the most appropriate asset allocation for the investible assets is influenced by the implicit human capital bond each member possesses. The size and characteristics of each member’s human capital bond will invariably affect the lifecycle asset allocation.
Most investors should therefore adopt a reasonably aggressive fund during the majority of their working life, as a more defensive policy may impair the ultimate level of benefits. Linked to this high equity stance they should rely on an appropriate lifecycle strategy to control risk through to retirement.
We believe there is a strong case for considering lifecycle arrangements as part of the options available to DC members. They are important to help satisfy a member’s investment needs over their entire working life and help trustees apportion the budget risk on their behalf.
This is not to say that one size fits all. The size and shape of different individuals’ human capital, their non-DC assets, and their choice of both date of retirement and post-retirement draw-down options all significantly impact the course of their optimal lifecycle.
Lifecycle strategies should also be reviewed upon significant events in the member’s life to ensure they remain focussed and appropriate for their circumstances. Such major events that might force a reappraisal include a job change, significant market movements, change in personal circumstances, the performance of non-DC assets, and possible plans for early retirement. The regular assessment and discussion surrounding such lifecycle strategy setting should also have the benefit of helping to educate the membership, so they get the most out of their DC savings.
Andy Hunt is head of DC consulting at Watson Wyatt in the UK