Defined contribution lifetime income strategies: time for new thinking
By Euan Munro | February 11, 2013 11:10 am
Defined contribution plan executives are grappling with a wide variety of issues today as they confront the problem of poor investment returns and demographic trends that make it clear millions of people could be placed in the position where they outlive their retirement savings.
Not that long ago, the solution would simply have been to generate a sufficiently sizable fund to procure a reasonable level of income at the point of retirement. But then interest rates sank to levels that make squeezing a living level of income from even a very sizable investment fund difficult to expect.
The problem, and challenge, for DC plan executives is not just to devise an investment proposition that gives participants a realistic prospect of a living income in retirement. The challenge also is acknowledging, and then acting on, the radical change of thinking that will be required during both the accumulation and the drawdown phases of the plan.
The most radical of these changes is breaking the dogged adherence to some of the doctrines of efficient market theory. Specifically, looking at this challenge in terms of the conventional “risk/return” framework, where there is assumed to be an axiomatic link between higher risk and higher return. That is not going to work. We would argue that historically it never helped much and, in the face of the present challenge, it is rapidly losing whatever utility it once had.
The idea that by taking more risk in the plan's portfolio you will automatically increase return is simplistic and potentially misleading. It is therefore quite unhelpful for an investor to decide on a strategy simply on the basis of risk alone. The question should not be “how much risk are you willing to take?” but “what outcomes are you seeking?”
A focus on outcomes drives the discussion to what the portfolio is expected to actually deliver. This takes us beyond the easy to achieve but unhelpful creation of plans with the “right level” of market volatility, toward a more nuanced but more beneficial discussion about what the portfolio is expected to actually deliver. And that leads to a focus on the levels of skill dependence, or liquidity and risk premium dependence that are needed for successful delivery of that desired outcome.
Such an approach goes beyond trying to create funds with the “right level” of market volatility. It will result in the relentless elimination of risk that militates against the safe delivery of the agreed outcome. Most importantly, our experience is that it is possible to achieve consistent and steady progress toward important client goals even amid major market disruptions.
Focus on outcomes
In our conversations with investors we find the outcomes that are important to them rarely can be described in terms of the metrics that are usually set as targets for their fund manager. For example, when a participant is trying to accumulate a savings to fund retirement, they do not express this as a desire for a return of 3% above the return on the S&P 500. It is the asset management industry that sets these benchmark comparisons. Left to their own devices participants may express their needs as a percentage return in absolute terms, e.g. 8% per annum or as a desired return above inflation.
Likewise, defined contribution plan participants who are close to retirement cease to think about return at all. Instead, they start to express a desire for a certain level of income. This might be an expectation for a fixed level of income or one that rises over time. Quite clearly the investment strategy for the former would need to be different from the latter.
We believe that a successful DC solution should take members on a journey where the success of the plan is assessed at regular intervals against the outcomes that are important to them. The winners will be those plan executives who can design a plan that makes this journey as smooth and stress free as it can be.
The limits of balanced strategies
There is a great deal of activity surrounding the design of “graduate to grave” DC plans. The various solutions to address the full span of beneficiary participation include special customized funds, or funds of funds, low-cost index funds and even stretching into alternative asset classes such as hedge funds, real estate and private equity. There will typically be a life-styling or target-date element, where the risk is perhaps reduced to protect capital as the member approaches retirement.
Most of those solutions appear to us to be slightly disguised, but still recognizable, balanced fund strategies. This is not revolutionary. The market volatility of recent years has demonstrated quite elegantly that balanced fund strategies are an inadequate provider of true diversification — especially during times of extreme market disruption. It is an asset allocation approach without the needed shock absorbers.
The balanced approach embeds the efficient market theory's axiomatic link between risk and return. As such, it knows only one source of sustainable return: the systematic reward for taking economic risk primarily via the credit or equity markets.
A typical approach to setting the strategic asset allocation for a balanced fund will create a model where it is expected that the equity market will deliver a return of 5% more than cash investments and with 20% volatility, and that credit markets will deliver a return of 2% more than cash with 9% volatility. A model that accepts these inputs when combined with some expected correlations between the key asset classes will of course produce an output that says taking more risk will increase return.
There are three big problems with such a model. First, it only recognizes risk in terms of day to day price volatility, ignoring risks such as illiquidity; second, it ignores the fact that some core asset classes may fully correlate as they did during the financial crisis; and third, it gives no place to investment skill in the selection of rewarding risks and risk management skill in the construction of well-balanced and diversified portfolios. Importantly, it is unlikely to get DC plan beneficiaries to their desired outcomes.
A new approach
An approach based solely on conventional asset allocation thinking where the only inputs are expected return, risk and correlation will run into severe difficulty with investment conditions as they are today. Many participants are still hoping they can achieve returns of above 7% to 8% on a sustained basis in order to achieve their desired level of affluence in retirement.
Participants need to be told that this level of return is not achievable without access to the right level of investment management skill, leverage and possibly also a higher tolerance for asset illiquidity. Of course these three factors do not feature in the standard approach.
In our view the most reliable way to meet participants' expectations is to create solutions where every risk is selected to address the objective of the fund and is expected to generate a reward. Moreover, every asset class must be considered within the scope of the strategy and leverage must be permitted as long as it's subject to overriding risk management restrictions.
This will mean greater reliance on the skill and judgment of the asset manager to select and array into the portfolio the right opportunities across global markets, and to actively manage the risk to reduce volatility.
The alternative is simply a slightly disguised bet on risk premium, especially on equity markets, with a measurably higher risk of failing to achieve the client outcome.
We think participants will be left with a stark choice: If you want some comfort that you will have some level of affluence in retirement, either increase your contributions now or find a more radical savings solution.
Euan Munro is head of multiasset investing and fixed income at Standard Life Investments.