The Investment Challenges of Decumulation Part 3 June 2015 This document is for investment professionals only and should not be distributed to or relied upon by retail clients.
Investing in a DC world the importance of managing volatility during accumulation The UK pension reforms implemented from April 2015 provide UK pension savers with significantly greater freedom in determining how to use their accumulated assets. Unsurprisingly, the announcement has prompted a great deal of research into appropriate investment strategies for decumulation the gradual use of accumulated assets to fund retirement income. However, changing the way in which pension assets can be accessed also has profound implications for how to best accumulate these assets in the first place. The purpose of this paper is to investigate the accumulation stage of the defined contribution (DC) journey and, in particular, to show that accumulation and decumulation need to be considered as two interlinked parts of the same process. The investment challenges of DC: summary of our findings to date In previous papers, we used historic investment data and stochastic analysis to demonstrate: a decumulation strategy will require taking investment risk investment volatility is a major determinant of outcomes for DC scheme members payment systems (such as withdrawal caps and variable income) are key tools in delivering good outcomes for members living off their retirement savings equity-level returns with lower volatility, as delivered by a multi-asset growth approach, are very attractive in a decumulation world, adding significant value relative to a passive equity approach even after fees simple approaches to highlight the sustainability of drawdown levels for different types of investment. 2 Investment Insight: DC Solutions
The investment challenges of DC part 3 While our earlier analyses focused on the investment issues for an individual looking to live off pension savings in retirement, in this paper we take a more holistic view of the overall lifetime investment challenge from the perspective of the plan sponsor and/or DC trustees. As such, we take the opportunity to look at the investment challenges of accumulation strategies given the new freedoms for UK savers post-retirement. Chart 1: The evolution of the DC journey The old lifestyle model specified retirement date Savings and Growth accumulation Preservation of annuity purchasing power Drawdown plus Annuity Pre-retirement Post-retirement The Whole of Life model a phased approach based on needs & requirements Savings and Growth accumulation Decumulation (Income and Growth) Annuity We advocate that DC scheme designers should now be mindful of a whole-of-life approach. This is more appropriate for an individual DC saver than the old lifestyle model that presumed annuity purchase. With annuitisation, it was expected that investment risk would cease at the retirement date, in which case, de-risking in the run-up to retirement was appropriate. In the whole-of-life model, the pivot-point of retirement is far less important. As we have demonstrated previously, decumulation retirees will need exposure to investment risk after retirement in order to generate sustainable income. As a result, the distinction between pre- and post-retirement investment strategy is no longer clear-cut. This means the accumulation strategy of the old lifestyle model is unlikely to be appropriate for a saver choosing decumulation. Someone s sitting in the shade today because someone planted a tree a long time ago. Warren Buffett Investment Insight: DC Solutions 3
The decumulation challenge is also an accumulation problem Chart 2: Example of a traditional asset allocation model for Defined Contribution plans over time Portfolio Allocation 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% Portfolio Expected Risk Premium (right axis) Equity Traditional Lifestyle Approach 6% Cash Bonds 0% 30 29 28 27 26 25 24 23 22 21 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 0% 1 Years To Retirement / Horizon 5% 4% 3% 2% 1% Expected Return over risk free (cash) Chart 2 illustrates the traditional DC investment glidepath approach. The conventional asset allocation approach reduces exposure to growth assets around five to 15 years prior to the scheduled retirement date. Assuming that the saver takes the full allowance of tax-free cash at retirement, the investment strategy leads to an undiversified bond portfolio. This de-risking process results in a substantial reduction in the return potential of the portfolio, just when the pension pot size should be approaching its maximum size. Critically, we question the suitability of an undiversified bond portfolio as an appropriate starting point for a DC member choosing to invest and live off pension savings in retirement. Surely, if the landing site for drawdown investors is different, their glidepath during accumulation should also be different. In this sense, the choice of decumulation strategy has a crucial influence over the accumulation strategy. Choosing the right landing site is vitally important, as it can help mitigate the substantial dangers of markettiming risk. The importance of joining up the accumulation and decumulation approaches We revisit an earlier study, where we illustrated the significant differences between retirement outcomes for three investors whose retirement date differed by only one year. We assume their pension fund at retirement is invested 100% in global equities, with 6% of the retirement sum drawn down as annual income and payments inflation-protected over time. We graph the passage of the remaining fund over time, as payments and investment returns take effect (Chart 3). As Chart 3 demonstrates, the outcome for the saver retiring in 1982 is decidedly better than that experienced by the 1984 retiree, whose pension fund runs out after 25 years. Why this difference? Looking at historical equity market performance data, it is clear that the 1982 member benefited from very strong equity returns in the first two years of drawdown. The 1984 retiree missed out on this good fortune. Chart 3: Sustainability of drawdown payments Fund value 4 Investment Insight: DC Solutions 500,000 450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 0 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 Number of years of payment 1982 1983 1984
However, the 1984 retiree would only miss out on this windfall if the investment strategy had de-risked, as the old lifestyle model recommends. Had investment risk been maintained through late stage accumulation and into retirement, then a different outcome would have been achieved.to show this, Chart 4 considers the outcomes for these retirees using a whole-of-life approach. The investment strategy again, global equities remains constant through both working life and retirement. Chart 4: Fund values over 30 years accumulation and 30 years decumulation 1, 800,000 Fund value throughout accumulation and decumulation 1, 600,000 1, 400,000 1, 200,000 1, 000,000 800,000 600,000 400,000 200,000 0 0 5 10 15 20 25 30 35 40 45 50 55 30 years of accumulation followed by 30 years of decumulation 1952 1953 1954 We have assumed that our DC savers invest 20% of their pay each year, with pay increasing by inflation. After 30 years, they start taking a pension income of 50% of their salary at that time. Thereafter, the pension payments increase in line with inflation. This can be thought of as similar to a defined benefit pension plan that accumulates a pension using an accrual rate of 1/60 per year (i.e. 30/60th of pension is accumulated at retirement). The chart demonstrates that the variability of payment longevity is now much reduced; all three pensions last in excess of 30 years. Why is this? Chart 3 showed that the 1984 decumulation retiree (equivalent to the 1954 saver in Chart 4) ran out of money on account of missing the strong returns of 1982 and 1983. That problem has now been mitigated. By maintaining a constant investment strategy, the 1984 retiree now enjoys the benefit of these returns in latestage accumulation. As a result, the starting-pot size for a member retiring in 1984 is bigger than that of a 1982 retiree. This reduces the negative impact of weaker returns in early retirement. Avoiding reinvestment/market-timing risk helps to decrease the variation in outcome for DC members; clearly, having a joined-up approach to accumulation and decumulation is of huge significance in determining retirement outcomes. This should be taken into account when planning an accumulation strategy. Moreover, our findings suggest that the decision to decumulate ought to be taken many years prior to retirement. So, what is an appropriate investment strategy for both accumulation and decumulation? In previous papers, we demonstrated conclusively the role of a reduced-volatility, multi-asset growth strategy in decumulation. How might that work during accumulation? Growth assets lower cost versus reduced volatility In Charts 3 and 4, we used equities as a proxy for growth assets. However, as history has amply demonstrated, equity markets are subject to sharp corrections from time to time. Therefore, it is intuitively appealing to reduce the volatility of the pension pot closer to the end of the accumulation phase, albeit not at the expense of losing investment returns. Many DC saving plans use equity-only investments (usually passive plans because of their low costs) in the early stages of accumulation and then switch to a lower-risk profile. In some cases, this involves a higher-fee multiasset growth strategy. Investment Insight: DC Solutions 5
Much has been written and argued on the benefits of active equity management (and higher fees) compared with passive equity investment. However, there has been less of a focus on the advantages offered by a multi-asset growth strategy in seeking to deliver the same level of return as a passive equity approach but with markedly lower volatility. To investigate this, we carried out a stochastic analysis to answer the question, At what phase of the accumulation cycle is it more beneficial to invest in a higher-cost, actively managed multi-asset growth strategy versus a lower-cost (and higher volatility) passive equity strategy?. We considered accumulation periods up to 40 years in length and carried out 10,000 projections. Our assumption was that the multi-asset growth strategy could deliver similar returns (gross of fees) to passive equity, but with a higher annual charge of 0.5%, versus 0.1% for passive equity. Crucially, we assumed multi-asset growth could deliver its return with just two-thirds of the volatility associated with equity investment (Chart 5). Chart 5: Stochastic analysis of Multi-Asset Growth outcomes versus passive equity over time % probability of Multi-Asset Growth exceeding passive equity growth over time 64 62 60 58 56 54 52 Multi-Asset Growth versus Passive equity 50 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 Time horizon of accumulation (years) Chart 5 indicates the probability of multiasset growth outperforming passive equity over time. The same contribution history (with contributions increasing by inflation every year) is used in all examples. We can see that, in the early years, there is little to choose between multi-asset growth and passive equity. In other words, there is as much chance of relative outperformance as relative underperformance. However, as we extend the time horizon to encompass periods of strong and weak market growth, it is clear that the lower-volatility multi-asset growth portfolio can deliver a better outcome than passive equities. individual investor outcomes may vary greatly owing to market-timing risk. By contrast, the multi-asset growth approach delivers good investment outcomes more consistently. Plan sponsors, who need to consider an investment strategy that can provide good investment outcomes more reliably for different generations of DC savers, may consider that the value of consistency as offered by multi-asset growth is of greater benefit than a lower-cost passive approach which is more likely to deliver a much wider spread of outcomes, both better and worse. While the highest investment sums may be accumulated under a passive equity approach, this will depend on market conditions, and 6 Investment Insight: DC Solutions
Lifestyling comparison between the old model and using multi-asset growth It is also worthwhile looking at a multi-asset growth approach for accumulation and comparing that with the traditional lifestyle outcome. Chart 6 shows the range of portfolio outcomes for our projections analysis, for DC savings accumulated over a 35-year period. The traditional lifestyling model assumes de-risking into bonds over the final 10 years and providing tax-free cash at retirement. The multi-asset growth approach assumes some derisking is done over the final 10 years into cash in order to fund a 25% tax-free cash sum. Our findings show that the median multi-asset growth portfolio is 11% bigger with reduced probability of a bad outcome. At the 10th and 25th percentiles, the multi-asset growth portfolio is 12% bigger and delivers greater commonality of accumulation outcomes. Both of these projections allowed for the provision of tax-free cash. This may be ideal for many savers who want to spend their tax-free cash (on holidays, cars, etc.) on retirement. However, for those who want to invest these monies (since their DC pot is their main source of retirement income), the issue of markettiming risk will again come to the fore. As discussed earlier, the decision on whether a saver does or does not want to take tax-free cash at retirement should be made before any de-risking adjustment is undertaken. Chart 6: Distribution of portfolio value outcomes for a regular saver over a 35-year period Accumulated fund after 35 years of saving 1,880,000 1,680,000 1,480,000 1,280,000 1,080,000 880,000 680,000 480,000 280,000 80,000 0 200 400 600 800 1000 1200 1400 1600 1800 Multi-Asset Growth Lifestyle Count of projections Assumes 10% pension contribution from a 30,000 salary, escalating at 3.50% p.a. Returns take account of 0.5% fees for multi-asset growth and 0.1% for lifestyle. Conclusions, discussion and future work Decumulation raises important issues for existing DC default investment glidepath approaches. Regarding the question of whether or not to live off pension savings in retirement, it is important that savers make this decision before any de-risking within a glidepath approach is undertaken, in order to mitigate market-timing risk. It is imperative to control investment risk. A lower-volatility growth asset approach (such as multi-asset growth) would be very attractive through the entire accumulation cycle, compared with the lower-fee benefit and higher-risk drawback of a passive equity approach. It is essential to reduce the existing variability in retirement outcomes. Thus, the core issue in DC investment design is managing investment volatility effectively, rather than focusing solely on lower fees. We now ask if there is still room for annuities in the drawdown phase, as implied earlier in our whole-of-life model (Chart 1). In the next phase of our work, we aim to assess at what point in the drawdown cycle it might become more compelling to buy an annuity. Closely linked to this is analysis to help savers establish the likelihood they will outlive their savings at different drawdown levels of income. We shall seek to explore these topics in future papers. Investment Insight: DC Solutions 7
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