How can DC trustees help members cope with unpredictable markets?
Fear and uncertainty have returned to the markets in recent months. The Vix index, a measure of volatility, spiked in August and has been steadily climbing since October. In the UK, the FTSE 100 lost 10% in the first six weeks of the year, before bouncing back by the beginning of March. Other markets have seen bigger gyrations.
For DC schemes this brings the question of how to manage this volatility in their default funds. For much of a saver’s working life this volatility should, in theory at least, work in their favour but at certain points they need some protection. So when do schemes need to limit the risk of losses, and at what cost?
Not 2008, yet
The first question is just how bumpy will 2016 be? Economists have been queuing up since the turn of the year to issue dark warnings. China, for so long the motor of global growth, is slowing and facing a mounting debt problem, while Europe struggles with the threat of deflation and sovereign debt issues in peripheral economies. For the UK the uncertainty over its continuing membership of the EU adds to the instability.
Markets do not tend to be emotionally balanced – they are either delighted or terrified
But while the outlook is troubling, it is not yet terrifying according to Nico Aspinall, head of UK DC investment consulting at Willis Towers Watson. “We don’t think we’re about to go through another 2008-9 [when the FTSE dropped 30% in a year], but we could be wrong,” he says. “The problem is that markets do not tend to be emotionally balanced – they are either delighted or terrified, which doesn’t necessarily give us long-run market falls, but it does give us volatility.”
For anyone under 45, this is not necessarily a problem, according to Aspinall. “If you’re a net saver and have a medium to long time horizon, volatility is a good thing because you get the opportunity to buy cheap assets with your contributions,” he says.
There are sound reasons for trying to limit volatility for some younger members, however, and as savers get closer to retirement, trustees cannot ignore short-term fluctuations. Many DC members will now stay invested beyond retirement. At this point point their ability to make good losses through contributions or growth has all but disappeared, making the task even more urgent.
A strong foundation
NEST has carried out a lot of research into its potential members’ attitudes to loss, resulting in an unusual addition to its default strategy: the foundation stage. Over the first five years it adopts a cautious strategy, to avoid spooking members who are new to investing with heavy losses.
It doesn’t matter if you stick it all in the craziest investment in the world or you stick it all in cash. It gets dwarfed by 20 years of contributions
Head of investment policy Paul Todd believes too much attention gets paid to this part of the mastertrust’s strategy, but says it is based on sound principles. The firm’s research found savers of all ages, genders and incomes were far more averse to losses than to giving up potential growth. Younger savers and those on low incomes in particular acted with anger and said they were likely to quit the scheme.
Other research examined how members of UK occupational schemes responded at the key moments of the last financial crisis, the collapses of Lehman Brothers and Bear Stearns in August and December of 2008. It found 50% took some action, with many stopping or cutting contributions, a few putting more money in, and a general increase in fund switching, dispelling the idea that defaulters will always remain inert.
“This led to the concept of the foundation phase,” says Todd. “Because people have just started saving, the small amount of capital at risk means it doesn’t matter if you stick it all in the craziest investment in the world or you stick it all in cash. It gets dwarfed by 20 years of contributions.
“So if we’re faced with the knowledge that with a small amount of capital it doesn’t matter how much risk you take, and the knowledge that young people are reporting they are very likely to stop saving if they are presented with poor performance, the foundation phase became a no-brainer.”
But others believe it is the job of trustees to communicate with members in a way that convinces them to stay the course if investment conditions become tricky. “What I would try to keep in the mind of a DC member is that you put in 80p, the government puts in 20p for you in tax incentives, and your employer generally puts in £1,” says Aspinall. “So you’ve put got £2 in your pot, but you’ve only put in 80p. That kind of mathematics should reduce the fear of losses, but a lot of people are very focused on the £2.”
Going for growth
The next phase for a DC saver, which extends to around 20 years before their retirement, is when they should be looking to maximise returns. David Heathcock, DC product manager at Schroders explains: “In the growth phase members need to be focusing on return, and risk management is secondary.”
The charge cap has probably increased the volatility of some of the solutions
But this doesn’t mean going for broke. In Schorders’ main product for this stage the manager looks to generate an equity-like return with two-thirds of the volatility of stock markets. NEST benchmarks against inflation, looking to achieve a relatively cautious CPI +3% while limiting volatility to 12%.
Risk management in this phase is largely achieved through diversification. The emphasis on growth does mean a strong role for equities, although modern defaults aim for much a better geographic spread than most achieved in the past. There is also room for other asset classes like property, infrastructure and bonds.
For many schemes this will mean buying into a diversified growth fund (DGF). For bundled schemes, however, the 0.75% cap on member-borne charges for default funds could limit the degree to which they can afford this. Aspinall says that many schemes will have to blend half and half equities and DGFs.
There is also the option of low cost DGFs that don’t employ any active management. These funds will likely see losses in tricky conditions like the back end of 2015, but falls should be cushioned, and lower charges should result in similar returns in the long-run.
“So the charge cap has probably increased the volatility of some of the solutions, but for the medium-term saver there probably isn’t too much of an issue,” says Aspinall.
For big DC schemes, there is also the possibility of effectively building a DGF in-house. The cutting out of a layer of fees should allow them to access more expensive asset classes, like property, or to look for the most skilled managers in areas like equities.
As members approach retirement, the balance begins to shift and risk management gradually becomes the most important factor. Members do not have the time horizons or contributions to make up any losses.
Traditional glide paths have seen funds begin to move into bonds ten years before retirement, but Heathcock believes this period should be extended. Schroders’ stable growth fund, intended for members who are one or two decades from retirement looks to reduce volatility to a half to two-thirds of equities.
More significantly, big shifts in the DC landscape mean that this traditional glide path – which looks to track annuity prices with a bit of cash in the mix – is inappropriate. This was a sensible strategy when almost all members bought an annuity at retirement and took a 25% lump sum. Now that they have the option of annuitising, cashing out, going into drawdown or blending all three, it makes less sense.
Heathcock explains: “There is this misconception that people held bonds because they were low risk. That’s not the case – they were held to hedge annuity prices. But those bonds are only useful if you’re hedging the changes in annuity prices, otherwise you are taking a very risky bet on what will happen to the value of bonds”
So schemes could try to find out what their members intend to do at retirement and design separate default pathways. Those that are likely to annuitise would get the old-fashioned glide path, those that want to cash out would move into cash, and those that intend to stay invested could switch to a low-risk portfolio that mirrors a drawdown fund.
There is a very clear trend that periods of high volatility are often followed by a large market correction
But this risks putting members into an inappropriate strategy if they change their mind about when they retire, or what choice they will make when they get there. Heathcock believes a one-size-fits-all approach is most appropriate, given the lack of engagement most members show throughout the rest of the accumulation period.
The fund Schroders has developed for this looks to beat inflation to make sure members’ pots don’t shrink (it targets CPI +2% compared to RPI +5% and CPI plus 4% in earlier phases), while limiting losses to no more than 8% over any time period.
It does this by starting with a fairly conservative asset allocation, with 40% in growth assets such as equities, 40% in assets that do well when economies contract like bonds, and 20% in assets that perform when inflation kicks in like index-linked gilts and commodities.
The fund is also derisked into cash if volatility spikes higher than the 5-6% expected for the portfolio in normal market conditions. So if volatility hits 8%, 25% of the growth portfolio is converted to cash. A similar mechanism kicks in if the growth portfolio starts to experience losses. The core strategy targets inflation +2.5% while the risk management overlay adds a drag of about 2.5%.
Critics of this method say this cost of being out of the market is too high, but Heathcock believes the rationale is sound.
“If you look over time there is a very clear trend that periods of high volatility are often followed by a large market correction,” he says. “So if you can limit your exposure to those periods, you can miss out on the very worst of those downsides.”
Many funds are still recalibrating the pre-retirement phase of their defaults. NEST has changed from annuity price hedging to a strategy that moves towards inflation matching. But Todd says: “At the moment, the only way we are doing that is through asset allocation. In the longer term we may look at more specific volatility management strategies, but we are some way away from that at the moment.”
In the retirement phase, members really can’t tolerate volatility. Those that remain invested and have to sell off assets on the cheap to give them an income during a slump will never see those losses fully recovered.
If you’re trying to reduce volatility, you’re also probably reducing returns – that’s just a fundamental pact
This is why the development of default decumulation options is so important. NEST’s retirement blueprint explores blending drawdown with deferred annuities to give people the flexibility they want with the security they need. Other providers are exploring similar offerings.
The fact that the FTSE has fallen by around 15% since the introduction of freedom and choice highlights the fact that these products cannot arrive soon enough. Anyone who took their cash and invested in an inappropriately racy fund will now be counting the cost.
But what will a retirement income default look like? It will have to be well diversified, and cautious. It would do well to use active management to limit losses, without high fees, and it will have to include an element of actual insurance like the NEST plan.
“Assets will never enable individuals to protect themselves against extreme risk,” explains Aspinall. “The only way you can do that is by pooling that risk.”
But across the whole piece, savers are going to have to get more comfortable than they currently are with balancing risk and return.
“You can’t get returns without risk, and the nature of the DC deal is that the individual takes that risk,” says Aspinall. “That is the DC deal, and the job of the trustee is to communicate it. At the moment, when it’s volatile and going upwards we love it and when it’s volatile and going down we hate it. If you’re trying to reduce volatility, you’re also probably reducing returns – that’s just a fundamental pact.”