Research (Professional Only)
Mr Micawber's illuminated guide to DC pensions and property
The value of defined contribution (DC) pension schemes in the UK is set to rise sharply as employers close traditional defined benefit (DB) schemes to new members and as auto-enrolment extends private pensions to a further nine million employees.
8 December 2013
The value of defined contribution (DC) pension schemes in the UK is set to rise sharply as employers close traditional defined benefit (DB) schemes to new members and as auto-enrolment extends private pensions to a further nine million employees. Spence Johnson estimate that the total value of DC pensions will triple
from around £276 billion in 2012 to approximately £825 billion in 2022.1
This article looks at two key risks for an individual with a DC pension. First, the risk of poor investment returns in the decade prior to retirement. Second, the risk that their pension is insufficient to meet their needs in retirement. In both cases, we consider how investing a proportion of a DC pension scheme in property might help mitigate these risks. Along the way we catch up with our old fictional friend Mr Micawber who started life in Charles Dickens’ David Copperfield2, but now has a second career as an unauthorised financial consultant.
DC pensions and the importance of investment returns close to retirement
A major but often-overlooked feature of DC pension savings is that the final value of the pension pot - used to buy an annuity or a drawdown product - is highly dependent upon investment returns in the final 10 or 15 years before retirement. The simple reason for this is that, unlike in a traditional collective DB pension scheme, an individual’s DC pension pot starts at zero and then builds up over time, hopefully reaching a maximum at the point of retirement. While investment returns in the early years of the scheme will have some impact on the final value of the pot, it will be relatively modest because the value of the accumulated contributions is initially quite small. By contrast, the impact of investment returns in the decade prior to retirement is critical, because at that point the returns are acting on a much larger sum of money.
Figure 1 highlights the sensitivity to this ‘sequencing risk’. The Actual experience line shows the value of a hypothetical pension pot for someone who took out a DC personal pension on 1 January 1973 and retired forty years later on 31 December 2012. We have assumed for the sake of simplicity that the individual had average earnings, that they routinely saved 10% of their income, and that they maintained a constant 60:40 allocation between equities and gilts. By the time they retired they had a pension pot of almost £470,000, equal to 13 times their annual salary in 2012 and their pension contributions had an effective money-weighted internal rate of return (‘IRR’) of 10.3% per annum.
The orange line shows an alternative scenario of what might have happened had there been a bull market in equities and gilts in the critical period leading up to retirement. We created the alternative scenario by simply switching the relatively poor returns of the 2000s with the relatively strong returns of the 1980s. The switch has no impact on compound annual total returns over 40 years measured on a time-weighted basis, because they ignore the amount of capital invested (as in DB pension funds). However, the switch has a major impact on the final value of the hypothetical DC pension pot, because the strong returns in the final decade before retirement were acting on a much larger sum of money. In the alternative scenario the final value of the pot is nearly £1,000,000 - equal to 27 times the individual’s salary in 2012 and the money-weighted IRR on their contributions is 13.6% per annum. In short, therefore, the final value of a DC pension pot is very dependent on the path taken.
Can property help people saving in DC pensions?
How should individuals saving for a DC pension try to deal with this sequencing risk? It is easy to look back and assess its effects, but much harder to predict due to the time horizons involved. When we look at the main cause of sequencing risk we find it is the volatility of equity markets, in particular, which savers should be wary of. When we discussed the issue with Mr Micawber his advice was to cross fingers and hope for an equity bull market in the ten years before retirement. As Mr Micawber likes to say, “something will turn up”.
A second approach, which we think savers should seriously consider, is to further diversify their portfolio by investing in other assets, such as property. The main attractions of property are that returns tend to follow a slightly different cycle than equities and are less volatile. Traditionally, property has been a good diversifier of equity risk. This is because capital values and total returns have been driven by rental values and the current state of the economy, rather than by expectations of future economic growth.
In figure 2 we compare a portfolio containing only equities and gilts to one with a 10% allocation to property, consistent with our example above. Using forward looking return expectations and historical volatility we find that an allocation of 10% to property provides two major benefits: lower expected volatility for a marginal reduction in expected return, and a reduction of risk concentration in equities.
There is a trade-off for achieving this lower volatility, and hence less sequencing risk exposure. Property investments are inherently less liquid than financial assets and long-term total returns have lagged behind those of equities. Thus, if our hypothetical saver had invested for 40 years in a portfolio with 50% in equities, 40% in gilts and 10% in UK property their pension pot would have increased more smoothly than in the base case, but its final value in 2012 would have been around 5% lower.
1. Broad Brush, Spence Johnson. December 2012.
2. David Copperfield, Charles Dickens, 1849-1850.
For professional investors and advisors only. This document is not suitable for retail clients.
The views and opinions contained herein are those of Schroder Property Investment Management Limited and Schroders’ Global Strategic Solutions team and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Property Investment Management Limited (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. The hypothetical results shown above must be considered as no more than an approximate representation of a portfolios’ performance, not as indicative of how it would have performed in the past. It is the result of statistical modelling, based on a number of assumptions and there are a number of material limitations on the retroactive reconstruction of any performance results from performance records.For example, it does not take into account any dealing costs or liquidity issues which would have affected a real investment's performance. This data is provided to you for information purposes only and should not be relied on to predict possible future performance.Any forecasts in this document should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. We accept no responsibility for any errors of fact or opinion and assume no obligation to provide you with any changes to our assumptions or forecasts. Forecasts and assumptions may be affected by external economic or other factors.Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them can go down as well as up and investors may not get back the amount originally invested.
Issued by Schroder Property Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registration No. 1188240 England.Authorised and regulated by the Financial Conduct Authority. For your security, communications may be taped or monitored. W940860
Important Information: This communication is marketing material. The views and opinions contained herein are those of the author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. It is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a reliable indicator of future results. The value of an investment can go down as well as up and is not guaranteed. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Schroders has to its customers under any regulatory system. Regions/ sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this material include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change. To the extent that you are in North America, this content is issued by Schroder Investment Management North America Inc., an indirect wholly owned subsidiary of Schroders plc and SEC registered adviser providing asset management products and services to clients in the US and Canada. For all other users, this content is issued by Schroder Investment Management Limited, 31 Gresham Street, London, EC2V 7QA. Registered No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.