By Alex White, Head of ALM Research at Redington
This article builds on the debate around what risk means in DC, particularly looking at building an appropriate investment portfolio.
A Different perspective on the assets
Assuming you have worked out how you want your portfolio to behave, you can then set about building it. But, this should not be done in isolation as it’s important to also account for all the other relevant factors. If we take the essentials, you have 4 components you can view as assets.
1. Your pot of invested assets.
2. The state pension- this is a government-backed income stream with inflation linkage; in asset terms this is a lot like a long-dated index-linked annuity.
3. Your future contributions – this is a difficult asset to capture, as it will depend on contribution rates, wage increases and periods of unemployment. It will have some broad sensitivity to the economy and to inflation, but is likely to behave more like a stepped series of bonds than like other assets. While complicated, this will often be the most significant “asset” young members have.
4. Other income streams (e.g. DB pensions). Where this is significant, managing the DC pot is obviously less significant to the member’s welfare, hence we focus on the first three.
It is worth thinking in these terms because the pot of invested assets can often be the smallest source of a member’s retirement income. Therefore, when viewed in isolation, a strategy might seem very risky or concentrated, but when in the context of the other “assets”, it may seem completely different. Say we have an old member close to retirement with a small pot - if 70% of their income on retirement is likely to come from the state pension, we can think of them as having 70% of their assets in index-linked gilts. From that perspective, a 100% equity pot would really be a 30% equity/70% indexed annuity portfolio. Clearly, we can (and do) go one better and put everything into an integrated risk model, but this is a more intuitive way of understanding how a portfolio can affect member outcomes. The point is you can have a very different perspective on what risk means - and therefore make very different decisions -, by considering all parts of the portfolio, rather than each in isolation.
Can we quantify this?
For simplicity, let’s assume you are targeting maximizing your pot while keeping a high chance of meeting a minimum size. All things being equal, you would not want your final pot to hinge on the success or failure of the strategy over one year - so DC schemes tend to lifestyle. If you can’t predict the future, you would want to spread your risk evenly over every year.
Unfortunately, you can’t do this. What happens to your pot at 21 is not going to make as big a difference as what happens to your pot at 61, when there’s (hopefully) some money in it. But it gives us a guide as to what your investments should be doing over that period. We can take a simple, deterministic plan and calculate how much difference a shock makes in each year to your final pot.
This means we can compare, say, a 6% loss at age 61 with a 50% loss at age 21, and say which is bigger. That defines how much risk you can run.
If you do that, you’ll get a smooth, concave function that starts very high and curves downwards. So under this framework you’d want to gear up in the early years if you could, but start de-risking potentially 25-30 years before retirement. This is meaningfully different from taking a moderate level of direct investment risk for many years and lifestyling only in the final few, but gives a better spread of risks.
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