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.