Gilts are not necessarily as secure as people assume, and that poses serious questions for lifestyling strategies says Paul Farrow
Gilts are deemed to be the safe haven of choice for pension funds but the past three years have proved that, like other assets, they are not immune to shocks.
Some pension scheme members could have seen their pension fund value fall by 10 per cent in a matter of weeks – even though 75 per cent of their fund was in gilts, and the rest cash. So with even the supposedly most secure of assets exposed to volatility in today’s markets, how should pension schemes deal with the transition to income, and what questions does this volatility pose to lifestyle solutions?
Richard Harwood, divisional director of financial planning at Brewin Dolphin, tells the tale of a member who almost fell foul of the volatility of gilts through a lifestyled plan. The client was due to retire in late January 2009. Early in December the fund was illustrated as being £9,657 and by Christmas Eve the fund was illustrated as £9,968.
The documents were completed to transfer and it was processed on January 16, based upon a fund of £9,855. However, had the client completed it on the normal retirement date just two weeks later at the end of January the fund value would have been in the region of £8,960 – a loss of around 10 per cent.
Yet despite this vulnerability, lifestyling towards a significant exposure to gilts remains the option of choice for many advisers. It is easy to see why. For starters, the strategy moves members out of risky shares the closer they get to retirement without the number having to to be proactive in anyway.
The basis of most systems is to switch the funds into a fund mix in the last year prior to retirement – the split typically being 25 per cent cash and 75 per cent gilt-based.
Harwood says: “There is a logic that gilt-based funds are used for 75 per cent of the fund as it is expected that an annuity will be purchased and so the theory is that movements in the value of the gilt fund will mirror movements in annuity rates, or at least the part of them based upon the underlying gilt investment. The perception is that these are “safe” investments, but are they?”
A glance at the performance of the benchmark for many lifestyle funds, the ABI-Sterling Long Bond, shows the ups and downs of the gilt market.
From August 2009 to February 2010 it fell by around 6 per cent; from February 2010 to August 2010 it increased by around 15 per cent; between July and August 2010 it increased by around 8 per cent; and over the three months to the end of November the benchmark fell by 5.1 per cent.
“Despite some concerns about sovereign debt it is clear that gilts are safer than many other investments as far as total loss of capital is concerned, but as far as many people invested in the run up to retirement are concerned volatility can be a major factor and history shows that they are more volatile than many clients would expect,” says Harwood.
“It seems clear that volatility has been greater over the past two or three years but prior to that there has still been a fair degree of movement in these “safe funds with the index falling approximately 10 per cent from October 2006 to June 2007 and then rising by approximately 10 per cent to December 2007.”
Not only are the movements greater than most people perceive but it is evident that movements in the capital value of such funds are much faster than changes in annuity rates, so the matching of risk does not seem to happen as hoped.
And there seems to be little hope of respite for the gilt market given the economy and the ramifications of QE.
Julian Webb, head of DC at Fidelity is also concerned the traditional DC lifestyle arrangements do not remove sufficient risk from the member as they approach retirement. “I suspect that most DC members believe that they have a higher degree of security than is in fact the reality.
Lifestyle funds should not be investing in shortdated stocks because the whole point of lifestyle is to invest in medium and long-dated stock to mimic annuity rates
Indeed they may also be surprised as to the amount of short-term volatility that can exist even though they are invested in cash and bonds,” he says.
DC specialists concede that gilts are not risk-free but argue that, from a risk perspective they need to be put into context.
They say that an allocation to gilts, as part of a lifestyle solution has a dual purpose: part of the rationale is to reduce investment risk, which a member has been exposed to during the growth phase; while the other is to reduce the conversion risk that the member faces, when they invariably convert their retirement pot into an income.
“Lifestyles are really only useful for people buying annuities. People that are going into drawdown are not looking for the certainty of an annuity – they are looking to outperform gilts and fixed interest,” says John Lawson at Standard Life.
The argument goes that from a DC investor’s perspective the issue is not just the absolute investment volatility of the gilts themselves, but also the protection they offer against variations in annuity rates.
This is because annuity rates are linked to gilt yields and so an investment in gilts will help maintain the purchasing power of a DC member’s pot during periods of volatile annuity rates. Stephen Bowles, head of DC at Schroders, agrees that it is the ’relative’ volatility between gilt rates and annuity rates that should be of interest to members and trustees rather than the absolute volatility of the gilts themselves.
“Lifestyle does make sensible use of the tools available and offers a reasonable compromise between delivering growth and managing both absolute investment risk and conversion risk as the member approaches retirement,” he adds.
However, Bowles says the two issues that trustees need to be aware of when considering traditional lifestyle solutions are the imperfect hedge offered by gilts in the first place and the limitations placed on when you can initiate the risk management due to the inherent compromise between the objectives of growth and protection.
“If you implement risk management too early you reduce your growth potential, while a delayed implementation leaves the member exposed to significant risks, with no conversion risk protection being provided at all outside of the lifestyling period.”
It is a very blunt tool, adds Brian Henderson at Mercer, but on the whole it does work. “You only have to go back to 2008 when shares fell by 30 per cent – people in lifestyle arrangements would have been better off.”
The biggest problem DC arrangements have is with the de-accumulation investment strategy, not the accumulation strategy – and lifestyle is not an exact science.
So what are the alternatives to traditional lifestyling? A great deal of emphasis is put on building a pension pot and finding the right asset mix to get members to a point where they can be happy with their lot. But the exit strategy is just as crucial and no one has discovered the Holy Grail yet.
Mike Turner, head of global strategy & asset allocation at Aberdeen, says: “The biggest problem DC arrangements have is with the de-accumulation investment strategy not the accumulation strategy – and lifestyle is not an exact science.”
Providers and consultants are acutely aware of the limitations of lifestyle strategies and are constantly looking at ways to get the balance right.
David Hutchins, UK head of research and investment design at AllianceBernstein reckons that target date funds tend to be more robust because they can manage dynamically the risk of a members investments against their retirement options. “By way of example, over the same period our funds for members reaching retirement, despite holding some equities, which fell by 30 per cent, would have lost less than 5 per cent in value,” he says.
The National Employment Savings Trust (Nest) has already said it will offer more than 50 target date return funds at launch with savers placed into a fund timed to meet their designated retirement age.
Mark Fawcett, chief investment officer at Nest, expects as schemes modernise they will move away from rigid mechanistic lifestyling strategies to target date funds and that will see an improvement in the situation. “While there is general awareness of the problem, outside of target date funds it is extremely difficult to manage these risks appropriately,” he says.
In a lifestyle default fund, there are usually three underlying sub-funds: equities, bonds and cash. In a target-date default, instead of three sub-funds, there might be as many as 40, investing in anything the manager chooses.
The likes of Axa and Friends Provident have introduced target date funds into their default fund ranges, but not everyone agrees that target date provides the answer. A target date fund can either switch mechanistically just like a lifestyle or the fund manager can apply their judgment.
For example, rather than switch to gilts, the fund manager can make a call as to whether they think equities may do better, so they could stay in equities longer or switch to fixed interest quicker.
“A lot of target date funds in the US managed the fund on this basis and this ended in disaster for many when the financial crisis hit. The managers didn’t get out of equities quickly enough and the funds fell a long way just as many of the participants were due to reach retirement,” says Lawson. “Unlike lifestyle, equities are not a natural hedge against annuity rates, so annuity rates were also falling resulting in a double whammy. The concept of target date is overplayed. It is really a marketing tool rather than anything fundamentally different to lifestyle.”
Other providers are trying to smooth the path to gilts, re-assessing the alignment of the investments on a more frequent basis – typically monthly. This, they argue has the beneficial effect of reducing the risk of being exposed to extreme market events that can occur between rebalancing points.
Fidelity adopts this approach and also focuses on matching the cost of annuities with the underlying investments in bonds. It reckons that there is fundamentality a duration mismatch between long-dated gilts and annuity costs which gives raise to volatility and not being able to achieve optimum buying power.
“Unlike most lifestyle products, which end up with a portfolio invested in long-dated gilts we gradually move DC members to a portfolio of sterling corporate bonds, overseas bonds and long-dated bonds. By the time retirement is reached this blend of bonds acts to match the duration of an annuity, and through it the ’annuity buying power’ that the DC member will require at retirement.”
The strategy that is being pushed is liability driven investment. Fawcett notes that at least one provider has launched a product which uses Liability Driven Investment (LDI) strategies in order to have a pre-retirement fund that better tracks annuity prices and is less volatile than gilts.
“We would expect more providers to develop products along these lines and we will look very closely to see if these funds are suitable for our members.”
It is a strategy that Schroders seems to prefer. Bowles says that it is possible to transfer the investment methodologies used in LDI for DB pension schemes into DC and create new investment solutions that can be implemented as part of a lifestyle type solution.
“Rather than switching into gilts as you approach retirement it is now possible to use interest rate and inflation swaps. The characteristics of these investment tools mean that annuity rate hedging can be implemented much earlier, with a significantly reduced impact on the overall portfolio’s ability to deliver growth.
“It is possible to dial down the compromise and offer member a better hedge,” he concludes.