By Alexander White, Senior Vice President, ALM & Investment Strategy at Redington
We believe that we need to challenge the way many DC investment strategies are put together, and the language used around them.
As a first step we need to ask ourselves - what is a DC pot trying to do?
Before we can decide what the right thing is, we need to decide what we’re trying to achieve. At the highest level, the aim of having a DC pot for most people is to provide “sufficient” income in retirement. But what “sufficient” means will vary from person to person, and is very difficult to quantify.
While a large DB pension fund can price its liabilities reasonably well, a DC member can’t rely on assuming they’ll be average. If you want to live as long as possible, this broadly gives you four choices:
1. Take an annuity at retirement – this is the safest way to ensure you don’t run out of money, but it doesn’t help if you want to leave an inheritance. Moreover, a nominal annuity could be a poor choice if inflation is high, while index-linked annuities are expensive enough to put off most purchasers. This also makes you very sensitive to interest rates at the point you retire.
2. Manage a portfolio whose investment returns match your cashflow needs – this essentially means living off your interest. It is great if you can do it, but very expensive, and has risks if the expected returns are not met. There are also subtler risks- e.g. if there is a big fall in value early on, and assets are sold, the strategy may fail, even if its returns over the next ten years are above expectations.
3. Slowly reduce your pot by drawing down the assets – this is a cheaper version of (2), but the same risks are more pronounced and there is less margin of error
4. Take a combination of the above – e.g. you could draw down for 10-12 years then take an annuity. For obvious reasons, annuity prices for older people offer much higher rates. This approach has all the risks of the above strategies, but in more muted form.
This is not a trivial decision, and it has consequences. The best portfolio to hold before retirement could be different if you want to stabilise an annuity price than if you’re trying to get a self-sufficient portfolio.
Having worked out what the goals are, the big investment decisions are likely to come down to a trade-off between some form of expected return and some measure of risk . The expected return may be subjective, but it is relatively clear what it means. The risk is a bit less obvious.
This brings us back to cash. The risks associated here are not as simple as pure asset losses. For example:
• Having too low an expected return, even for a very low risk portfolio, can lead to worse downside outcomes than a risky strategy with higher expected returns
• Similarly, mildly high inflation over a long period could dramatically erode the real value of a fund and do comparable damage to a big one-off loss. Cash offers no protection against inflation and no excess returns to offset the problem
• Cash offers no protection against the cost of income streams (i.e. interest rates)
Cash is an extreme example, but it makes the point. What constitutes a “safe” asset depends on what constitutes risk, and risk isn’t just about short-term losses- a seemingly safe portfolio may risk worse outcomes. This is not an easy point, and I think as an industry we could frame the debate around DC outcomes differently.
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