Manage the risk of not achieving income rather than targeting absolute returns says Paul Farrell, vice-president and head of UK institutional clients at Dimensional Fund Advisors
What’s the biggest mistake people make with their DC pension? Do they buy the wrong funds? Take too much investment risk; or too little? Is it that they underestimate how much they need to save?
All of the above are problems, but for many people, the biggest mistake is actually made before any of them are really considered; the mistake they make is to fail to set the right goal from the outset.
As a result, they risk living though their retirement with an income below their expectations or running out of money too soon.
A pension, unlike many investment goals which are about reaching a cash target, is all about achieving a stream of income at the end.
Yes, you need the capital sum to buy a retirement income, but the pot of money is the means to the end, not the end in itself. Unfortunately, this mistake is made by pension fund members as well as many plan sponsors and their advisers.
The importance of setting the right end goal cannot be overstated. Not only, by guiding the investment strategy, does it have a direct influence on the outcome, it sets the tone for member communications and ultimately member engagement.
A pension used to promise a member a retirement income; now, in too many cases, it offers little more than anxiety, uncertainty and the means to buy an unknown level of income in retirement.
Ask a DB pension fund member what their pension is worth and they will reply with an income figure – “two thirds of my salary” they might say. Ask a DC fund member the same question and you are likely to get a cash figure in reply along with a sorry story about what it would be worth were it not for the financial crisis.
The uncertainty the typical DC member experiences is enough to put some people off pensions altogether and is precisely what the pensions minister is hoping to overcome with his Reinvigorating Workplace Pensions paper.
But how can simply focusing on the income goal provide reassurance to members about the eventual outcome of their pension account? After all, whatever the goal, the aim is to build assets to buy an income.
They key is that with the focus on the end rather than the means, an investment strategy can be set that does not seek to increase absolute returns, but instead manages the risk of not achieving the income.
So instead of chasing straight performance and capital gain, the investment strategy can consider the impact of interest rates, inflation and longevity – the forces that influence the price today of an income tomorrow.
For years, defined benefit schemes have been managing their investments in this way. This is relatively easy at a group level where the whole DB scheme can look at its whole liabilities and manage assets to meet them. But conventional individual DC plan structures have found it difficult to apply the framework of LDI to DC default funds that are owned by individual members with individual liabilities. Elements of LDI have crept into some DC default funds, but they are far from the pure concept of an LDI strategy made for individual members.
Today’s technology makes it possible for schemes to adopt just that – a customised LDI strategy for each and every member. Schemes that do this build a member-specific balance sheet which incorporates current and future pension assets and liabilities. This creates a complete picture of the member’s financial and human capital and can be used as a meaningful base from which to manage assets.
Significantly, with future income as the goal, those assets are managed not to build a big pot of gold, but to deliver the right shape and size of assets for the member to buy an annuity at retirement.
The benefits of adopting an LDI framework for individual DC members are numerous and significant. At the heart of them is avoiding the one big mistake and focusing on the real goal – the retirement income.
Adopting this approach means that members understand how the decisions they make today will affect their life tomorrow and asset managers can take a more measured and focused approach to delivering what members expect.