Andy Dickson explains why many defined contribution schemes have to do more to manage risk
A lot of attention has been paid recently to the level of risk within the defined benefit system. This is understandable, given what DB failures can do to sponsoring companies and the wider economy.
But are we overlooking problems in the defined contribution system where this risk is borne by individual members, who are generally less able to manage it? Given the growing unpredictability of global politics, and historically high valuations in many asset classes, it’s a question worth asking.
The impact the political climate has on markets can’t have escaped anyone’s attention
Andy Dickson, investment director – UK institutional business at Standard Life, believes many schemes could be doing more. “The impact the political climate has on markets can’t have escaped anyone’s attention and nor can the heights that markets have reached in traditional asset classes,” he says. “So trustees should be thinking about what impact that will have.”
It is one of the key duties of trustees – or other DC fiduciaries – to regularly review default investment strategies to make sure they are appropriate. And Dickson argues that the macro-economic and geo-political climate makes this task particularly important for schemes that have taken a ‘set and forget’ approach in the past.
He believes schemes that are relying heavily on market beta in the accumulation stage should re-examine their approaches. But even schemes that have taken steps to manage investment risk need to understand exactly how their strategies work.
We know that those types of assets – like real estate and commodities – can correlate with equities
“If you’ve implemented a blend of diversified growth funds, it’s worth checking exactly what those assets are,” says Dickson. “Do they have a growth bias? Because we know that those types of assets – like real estate and commodities – can correlate with equities.”
For schemes that have not updated their pre-retirement investment strategies, they may well be exposing their members to increasing levels of risk at exactly the point they believe they are de-risking. Many funds still move members into a portfolio of long-dated bonds on the assumption they will buy an annuity on retirement – the price of which is linked strongly to the bond market.
But since the relaxing of regulation in 2015 the number of members annuitising has shrunk, with many opting to cash in their pot or go into drawdown.
For those members you have absolute concentration risk by being in one single asset class
“For those members you have absolute concentration risk by being in one single asset class,” says Dickson. “That’s not what members want – they want to de-risk as they approach the point where they will want to use their savings to support their retirement.”
So how can DC trustees manage risk at this stage in the cycle? Dickson says the key is to find strategies that are negatively correlated. This can mean getting into markets that have not traditionally played much of a role in growth strategies. For example, schemes could take positions in the currency market that would give them a cushion against a downturn in equities, or on global interest rates to mitigate a cooling in commodity markets.
Dickson says: “Then if there is an unexpected market stress event – or even an anticipated one – you can have some confidence that the overall impact that would have will be mitigated.”
But it’s important that schemes think very carefully about how they communicate risk management to members.
You do run the danger of putting members off if you start talking about risk
“You do run the danger of putting members off if you start talking about risk,” says Dickson. “Definitely don’t use phrases like ‘uncorrelated return-seeking strategies’, but you can use analogies like having a smoother savings journey, or preserving your savings, or getting more predictable results.
“If you have a headline that says ‘there’s a lot of risk’ that could have a detrimental effect, but it is a responsibility of trustees to manage those risks, and to communicate that effectively.”