Andy Dickson explains how the DC pension investment strategy could be improved to better support the uncertainties facing DC members
A simple question that members of defined contribution (DC) pension schemes might ask their employer or DC provider is: “How much will I get when I retire?”
The answer could easily run on to several sentences. As those in the pension industry know, it all depends on how much is saved, the investment returns earned, future interest rates, whether inflation protection might be required and, of course, the future state of the DC member’s health.
In other words, the question might be more succinctly answered by quoting Oasis, along the lines of ‘definitely maybe…’
Trying to predict the income from a DC pension is clearly difficult. However, we may be failing to recognise a more important predicament facing the majority of DC savers in future, namely the need to defer their retirement.
For the UK’s DC pension system, adequacy is the ‘elephant in the room’. How many auto-enrolled DC members will only have contributions of 8 per cent of mid-band earnings saved - only to discover as they approach their planned retirement age that they simply cannot afford to retire.
DC default investment strategies have been specifically designed to allow members to take benefits at a pre-determined retirement age, using their fund to purchase an income – the ‘cliff edge’ approach also adopted by their defined benefit scheme predecessors. However, it might not work out quite like that.
The default investment strategy typically deploys growth assets like equities, until a de-risking phase is entered in the run-up to a pre-determined retirement age. At that point, assets are switched into bonds and cash. De-risking is, of course, important in mitigating the volatility that can occur in equity and other markets. However, by moving into defensive assets, the potential for higher investment returns is forfeited. This approach makes sense if benefits are to be taken, but what if that is not the case?
If the DC member cannot afford to retire when expected and is forced to defer taking retirement benefits, what happens to that member’s savings?
It is likely that a high proportion of those savings will be allocated to defensive assets and will remain there for a number of years until the member can finally afford to stop working. This is ironic, as the DC ‘pot’ is at its largest at this juncture and therefore potential investment returns could have a material positive impact. And yet, because it is not clear exactly when benefits will be taken, there is still a need to de-risk.
We can help improve the member’s situation by harnessing the benefits of a highly diversified asset mix. This approach should go beyond just a combination of growth assets that depend on a positive economic growth environment to deliver returns. Rather, it should provide a blend of assets and strategies that can provide genuinely enhanced diversification and return opportunities. So, even if markets are going through periods of stress, the trajectory of the DC default strategy can be expected to be much less volatile.
Crucially, by using this approach in the run-up to retirement and throughout the de-risking phase, the switching period of moving out of ‘growth’ into ‘defensive’ assets can be shortened. In this way, we can extend the opportunity to generate higher investment returns compared to the lower returns available from defensive assets.
If the member then realises they need to defer taking benefits, they can continue to have a significant portion of their savings invested for growth. This can result in a reduced period of time that retirement deferral is required.
We may still be unable to succinctly predict how much might be paid from DC pensions, due to the various factors influencing retirement outcomes. However, adopting an investment approach that accommodates a degree of flexibility around the retirement date should certainly help address the uncertainties facing DC members.
Written by Andy Dickson, investment director - UK institutional business, Standard Life Investments
