18/12/2009
By Colin Tipping
Colin Tipping on what the financial crisis has meant for defined contribution (DC) schemes and members
As the year-end approaches, the investment world typically gazes into the metaphorical crystal ball to forecast the following 12 months. Many pundits often start by taking a backward-looking view, assessing the lessons we have learned from the recent (and not so recent) past – in effect telling us what we already knew.
While recent events in world markets are now well documented, what is less clear is what lessons have been learned when connecting market events to the pensions environment. As we move inexorably towards a DC landscape, the impact that markets can have has been brought into sharp and often painful focus for those in both the accumulation and the decumulation phase of their pensions journey.
The economic volatility experienced through the financial crisis has brought into sharp focus the challenge that all types of pensions investors face. This is especially true of those DC participants whose actions strongly shape their future income in retirement. The confidence level among scheme members has been battered by the recent crisis with many struggling to understand what action, if any, they might expect to take as a result.
Have DC plans stood up to the test of market volatility?
Helping plan sponsors understand participant concerns and making use of that information was the objective of a US survey conducted by BlackRock in association with Boston Consulting Group (BCG) earlier this year. The key findings of the survey pointed to a strong corollary influence of retirement confidence upon member attitudes and behaviours. The findings also signal a strong desire among 401(k) participants’ for access to guaranteed retirement income.
Although the losses experienced have weakened their confidence, DC participants are not abandoning their plans - rather they are reviewing what they want their plans to provide. Notably, the survey indicates that participants give equal importance to guaranteed retirement income as they do to covering their health care costs. Importantly, regardless of their current confidence level, almost half (46%), feel their 401(k) plan has become more important to them during the recent economic turmoil and that the default investment design is critical.
Default funds
With many UK scheme default funds based solely on equities, the hot topic across the UK market – diversification – has been brought into sharp focus by the credit crisis. Equity portfolios have suffered of course, but Multi Asset or Diversified Growth strategies have not necessarily proven to be the investment panacea that many scheme trustees thought they were. Certainly when one considers the way asset classes behaved at the peak (or trough) of the crisis it looked as if diversification had failed investors with most asset class returns heading in the same direction – down. With the exception of government bonds, no asset class – including alternatives – appeared to have protected investors from the credit crisis.
On the surface, while the flight to quality and extreme liquidity demand permeated all asset classes the lesson has been that although these conditions may have explained returns, they have not led to the end of diversification. The conventional wisdom is that diversification is achieved by investing in different asset classes. However the recent past has challenged this to a certain extent and taught us that the asset class mix should not be looked at in isolation. Each investment decision exposes members to various systematic risks and it became clear that asset classes are not the only fundamental building blocks of investing. If they were, then private and public equity would have performed very differently from real estate or emerging market bonds and commodities throughout the crisis. What became clear is that they all appear to be linked by something more fundamental – a mix of systematic risk factors like interest rate risk, economic risk, inflation risk, liquidity risk, and the like. It is exposure to these risks that drives the returns of asset classes.
This is important for DC members as it has brought a further dimension into the debate around how default funds should be designed and delivered.
Re-thinking retirement income
Although there is a heavy focus on the accumulation phase – quite rightly – a further lesson learned from the crisis has been the need to rethink the retirement income problem. Given that over the next 20 years the UK will experience a 60 per cent increase in the over 65 population, if we do not apply the hard-learned lessons from the recent crisis we face the real danger of a “pensioner underclass”.
Whilst quantitative easing may well be a necessary response to deal with the crisis, the knock-on effect for annuity rates has left many retirees in a precarious situation. As lifestyle and target date funds gain further traction in the accumulation phase, the way we as an industry deal with de-risking towards a retirement fund with an annuity-like asset mix needs a radical re-think.
Given the longevity challenge – with members outliving the purchasing power of their annuity and/or other income - the question of whether equities or other “risky assets“ should remain a component in the mix at retirement is a critical point to consider. Insurance-based retirement income products may remain the most accessible for retirees but the inefficiencies in the transfer mechanism – where the member’s individual fund is passed over to the life company which then effectively matches it against an almost identical asset mix - clearly needs to be reviewed. One key outcome has been the development of a more sophisticated approach to the income crisis e.g. unallocated annuity pools or deferred income funds. Hedging out the risk of buying an annuity at a single (wrong) point in time has been brought to the fore during the crisis and remains a key challenge for product providers.
So is it back to the future?
The typical DC investor may of course suffer from a short memory – the way markets have snapped back in 2009 has helped recover some (but not, we suspect, all) of the lost ground. However we must not ignore the lessons of the recent past and as an industry we need to pursue the development of innovative and far-reaching solutions to both the investment and the income problem.
Colin Tipping is head of institutional wholesale for BlackRock
