Understanding the route to retirement

Transcription

1 March 2012 Understanding the route to retirement Lauren Juliff, UK Institutional Business Development, Schroders Jonathan Smith, UK Strategic Solutions, Schroders In the UK, Defined Contribution (DC) pensions are a much newer phenomenon than Defined Benefit (DB) pensions. As a consequence, DC members have been considered as younger and much of the focus of DC design so far has been on encouraging members to join and accumulate assets. Despite some recent innovation, investment default design has lagged the sophistication of the DB market. For younger members this is less of an issue, as retirement pots are small and losses can be made up over time. However with a significant wave of early DC members now approaching middle age and the crucial later stages of accumulation, we re reaching a tipping point. As members age, investment strategy design becomes the key determinant of retirement outcomes. Traditional lifestyling strategies only partially improve potential outcomes and by the nature of their systematic de-risking approach they usually deprive members of growth when they stand to benefit from it the most. Furthermore, lifestyling alone does not necessarily provide the level of risk reduction that members require in their 40s and early 50s, when losses can do considerable damage to retirement outcomes. In this paper we discuss the importance of understanding the different stages of a member s route to retirement and the investment risks that they are exposed to, particularly in the later stages of accumulation. The timing of investment returns achieving growth As a member saves for retirement their pot is expected to grow as they accumulate assets through contributions. However, the process by which our industry models, measures and reports investment returns is based on time-weighted returns (i.e. a traditional geometric return) which assumes the capital value is static. Time-weighted returns are useful for measuring the performance of a particular strategy over time; however they are less useful for assessing retirement outcomes. This is because individual members earn money-weighted returns, so the timing of returns can be as important as the size. Consider the example of a fund that earns a return of 30% in year one, 0% in year two and minus 10% in year three. This would usually be represented as an annualised return of 5.4% per annum. If we now think of an individual who had 100 in the fund at the start of year one and contributed another 100 in year two and another 100 in year three, the end value is 297.

2 Understandi ng the route to retirement However had this orderr of returns been reversed, the end value would be 3777 a very different outcome, even though the annualised return remains the same at 5.4% per annum. Therefore the order in which returns are earned is key. As another illustration, consider Chart 1 whichh shows the effect of contributionss and investment returns in the first 20 years and second 20 years of a member s working life. Inn the first 20 years a 1% increasee in the annual contribution rate will have broadly the same effect ass a 1% increase in the annual investment return. However, in the last 20 years the situationn is considerably different, showing us the value of holding a meaningful allocation to growth assets in thiss period. Chart 1: Impact of contributions and investment returns as members age Return % 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% First 20 years Second 20 years 1% increase in contribution ratee 1% increase in investment returns Another important implication here for members is that increasing contributions later in life has much less impact than saving in the early years. This shows us that in order to achieve a good outcome for members, schemes should focus their efforts on encouraging them to save in the early years but place much more emphasis on their investment risks and potential for growth in the later l years. Source: Schroders, for illustration only. 40 year contributions at base rate of 10% of o salary. Salary increases assumed to be 3% pa. Starting salary is 25,000. Base annual investment returns are estimated expected returns of a lifestyling strategy switching from equities to bonds and cash in the 10 years prior to retirement. It is clear from these two examples that achieving asset growth through investment returns in the later years has a significant impact on the outcome for the member.. This is duee to the amount of capital invested, or larger pot size, at this later stage. This has important implications forr DC defaultt design the longer members m can have access to investment growth at older ages the better. However most traditional default designs automatically reduce growth allocations for olderr members via lifestyling. The timing of investment lossess achieving stability For a DC investor the timing of losses can bee as important as the size of thosee losses a large fall in pot value can have more material consequences for an older member than a younger member. This has led most investment default strategies to lifestyle into bonds and cash as members approach etirement. We have already discussed one limitation of lifestyling it can deprive members of investment growth when they might benefit from it the most. Given recent changes to annuity purchase requirements we also question whether the traditional solution (lifestyling) offers enough flexibility for members who may want w to retiree or annuitise later. In order to achieve that flexibility and maintain exposure to growth for longer whilee still achieving some bond-like interest rate sensitivity for annuity matching we can learn lessons fromm more capital efficient LDI techniques employed in defined benefit schemes. 2

3 A further drawback of lifestyling is that investment losses experienced at the ages just before lifestyling begins, or during the early stages of lifestyling, can still do considerable damage to a member s retirement outcome. This is illustrated in Chart 2. In both scenarios we assume the same starting salary, contribution rate and average investment return, except that in Scenario A a 30% loss occurs at age 30, compared to at age 50 in Scenario B. The final pot in Scenario A is some 22% higher. Chart 2: The importance of the timing of losses Pot 700, , , ,000 30% loss at age 50 Pot in Scenario A is approximately 22% higher 300, , , % loss at age Age Scenario A Scenario B Source: Schroders, for illustration only. Starting salary of member is 25,000. Salary growth is 3% pa. Contributions are 10% pa. Both strategies assume ten year lifestyling strategy (starting at age 50) switching from equities, to bonds and cash. This analysis has clear implications for DC investors equity lifestyling may not be enough. Losses in the years before lifestyling begins (i.e. before the pre-retirement phase) can have significant consequences for members. Members could begin to reduce risk sooner; however as we saw in the previous section having access to growth at older ages can be as important as protecting against losses. This suggests that schemes should pay even greater attention to the type of risks they are taking at older ages; achieving growth through investment returns is important but the stability of those returns is vital. Taking another look at default design Our analysis suggests that the accumulation phase would be better thought of in two stages early accumulation and stable growth. In the early accumulation phase members can afford to take more investment risk. An increase in investment returns has a valuable effect but an increase in contributions is easier for the member to control and is therefore arguably more valuable. 3 In the stable growth phase investment returns, and investment risk, become the dominant factor in achieving the right outcome. Choosing a more diversified growth strategy over a purely equity based strategy can have dramatic effects for older members, as illustrated in Chart 3.

4 Chart 3 shows how the amount a member can expect to lose in a bad year 1 grows as they age. At younger ages, the amount is small as the pot size is small, however it grows rapidly as the member approaches the pre-retirement phase, when their pot size is large and the investment risk is high. Introducing a diversified growth strategy reduces the amount at risk significantly in the all important pre-retirement phase years. Chart 3: Pot at risk throughout the lifestyle Pot at risk (1 in 20 risk) 140, , ,000 Pot is large and growth allocation is high, so growth risk management is key at these ages 80,000 60,000 40,000 20,000 - Pot is large, however allocation to growth is small Equity lifestyle lifetstyle strategy Diversified lifestyle strategy Age Source: Schroders, for illustration only. Assumes pot grows at same rate for both strategies, however potential losses are based on the historic volatility of equities and a diversified strategy with assumed volatility of 2/3rds that of equities. Starting salary of member is 25,000. Salary growth is 3% pa. Contributions are 10% pa. Both strategies assume ten year lifestyling strategy switching to bonds and cash. The hidden benefits of diversification Diversification is often referred to as the only free lunch in investment. This is because, by diversifying their assets, an investor can potentially reduce risk without sacrificing expected return. In fact, there is an additional hidden benefit to diversification for long-term investors. Following a less volatile strategy can actually increase long term returns. Consider the following two sets of fund returns: Year 1 Year 2 Year 3 Year 4 Average annual return Total compound return Fund A 10% -10% 5% -5% 0% -1% Fund B 20% -20% 10% -10% 0% -5% An investor in Fund A would have a better outcome after four years than an investor in Fund B, even though both have the same average annual return. This is because a 10% fall in returns requires an 11% gain the following year to break even; however a 20% fall requires a 25% gain the following year to break even. The bigger the fall, the larger the required relative gain hence over the longer term, a more volatile strategy tends to underperform a steadier strategy. 1 bad year is defined as a 1 in 20 outcome 4

5 This has important implications for DC investors. Chart 4 shows the spread of potential outcomes for two members, with the same starting age, salary progression and contributions. Both follow a traditional 10 year lifestyle strategy, however one follows an equity only strategy in the growth/accumulation phase, whereas the other follows a more diversified strategy. We have assumed that the diversified strategy has the same annual expected return as the equity strategy but with 1/3 less volatility. Using Schroders in-house model, 25% of the potential outcomes at retirement would be better than the blue bars and 50% would be better than the orange bars (the median); however 25% would be worse than the red bars and 5% would be worse than the green bars. Hence the orange bars represent average outcomes for the strategies and the red and green bars represent downside scenarios. Not only is the spread of outcomes and downside risk lower for the diversified strategy, as we would expect, but interestingly the median outcome is also higher. The higher median outcome for the diversified member is a consequence of the hidden return benefit of a less volatile strategy. Chart 4: Spread of retirement pots for an equity only and diversified growth strategy Pot at retirement 900, , , , , , , , ,000 - Equity lifestyle Diversified lifestyle Source: Schroders, for illustration only. Starting age is 20 years, retiring at 60. Starting salary is 25,000, increasing at 3% pa. Contributions are 10% pa. Summary Best 25% Median Worst 25% Worst 5% Focusing on the timing of potential investment gains and losses, as well as the size can help schemes better understand potential retirement outcomes. In particular it highlights how, as DC schemes mature, investment default design becomes even more important - the effect of losses for older members can be devastating but this has to be balanced with the need for growth. However most lifestyling strategies deprive members of growth when they stand to benefit from it the most. They also often fail to protect members in their 40s and early 50s when losses can do the most damage. This means that schemes may wish to look again at their default. In order to achieve good member outcomes we need to understand the journey of a DC member and develop default investment strategies that will allow them to achieve the growth they need while keeping an eye on the risks they are exposed to at each step along the route to retirement. 5

6 To discuss the themes in this article further, please contact: Lauren Juliff UK Institutional Business Development Tel: +44 (0) Jonathan Smith UK Strategic Solutions Tel: +44 (0) Important Information The views and opinions contained herein are those of Lauren Juliff, UK Institutional Business Development and Jonathan Smith, UK Strategic Solutions at Schroders, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.. This document is not suitable for retail clients. 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 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. Past performance is not a guide to future returns. The value of investments can fall as well as rise as a result of market movements. Exchange rate changes may cause the value of overseas investments to rise or fall. Less developed markets are generally less well regulated than the UK, they may be less liquid and may have less reliable custody arrangements. Investors should be aware that investments in emerging markets involve a high degree of risk and should be seen as long term in nature. The risk of default is higher with non-investment grade bonds than with investment grade bonds. Higher yielding bonds may also have an increased potential to erode your capital sum than lower yielding bonds. Forecast Risk Warning The forecasts stated in the article are the result of statistical modelling, based on a number of assumptions and should be seen as objectives only. There is no assurance or guarantee that these results will be achieved and they should not be considered as predictions of actual results which may be realised in the future. Forecasts are subject to a high level of uncertainty regarding future economic and market factors that may affect actual future performance. The forecasts are provided to you for information purposes as at today's date. Our assumptions may change materially with changes in underlying assumptions that may occur, among other things, as economic and market conditions change. We assume no obligation to provide you with updates or changes to this data as assumptions, economic and market conditions, models or other matters change. Hypothetical Modelling Results The hypothetical results shown in this article 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 of 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. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registration No England. Authorised and regulated by the Financial Services Authority. For your security, communications may be recorded or monitored. 6