Good pensions are as much about risk as about return
2 November 2016
It’s common to see risk as the threat of loss, whether it be of money, of life or of happiness. But there is a wider meaning, encapsulated in the international standard for risk management, ISO 31000. It states that risk is the “effect of uncertainty on objectives”, explaining that an effect is “a deviation from the expected – positive and/or negative.” The point here is that risks are not just about loss, but also about the absence of gain, which is not a bad starting point for looking at defined contribution (DC) pensions.
The objective of such a pension is to have a pot of money at retirement that will meet the needs of a saver when work income stops. There are many risks that could imperil that objective, but only two that need concern us here from an investment point of view. Either the saver loses money which they cannot recover in time before retirement – too much risk – or that their savings fail to grow fast enough to reach their goal – too little risk.
Whether they have got the balance right between the two is something the member will only know for sure when they are about to retire (or not, as the case may be). However, our research amongst DC pension members who are further from retirement is clear: they are much more worried about taking too much risk than failing to take enough. Many would be willing to swap some potential gains for more certainty, even if they seem less keen to pay for an explicit guarantee.
So can the pensions industry reconcile these competing needs and desires?
We think it can, but only if it recognises that the risk-return balance shifts as the DC member makes their savings journey. At the beginning, it makes sense for members to take more investment risk. Not only can it boost what is likely to be a small pool of savings, but the saver should also have plenty of time to make up for losses.
As the years go by, however, and there is less time to recover from loss, the balance shifts towards taking less investment risk. This “de-risking” phase when the member reaches their 50s sees many switch their investment portfolio gradually into bonds, traditionally seen as lower risk. The question is: could we provide the same level of risk, but a better return to help them through 20 years of retirement or more?
We put it to the test. We modelled the savings pots that two savers might expect at 65 if they followed different de-risking strategies from the age of 55. In the first case, we assumed they gradually switched from a portfolio of equities into gilts. In the second, they switched into a risk-controlled mix of equities and bonds.
This strategy combined a diversified portfolio of assets to provide growth, safety and inflation protection, with a systematic process for swapping growth assets into cash as losses started to rise. The aim here was to limit any loss to no more than 8% of the portfolio.
The chart shows the range of retirement pots our model suggested would result from these two approaches. As can be seen, the smallest pots from both approaches were very similar, but there was a much higher likelihood of achieving something larger with the risk-controlled strategy all the way up the rest of the scale.
We would argue that such a strategy achieves a much better balance than bonds between the two risks we outlined at the outset: minimising the threat of loss, while maximising the possible opportunities. In doing so, it helps meet the demand of DC members for low-cost risk protection, yet also provides them with the element of growth they need even at this late stage in their savings journey if they are to meet their objective.
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