Do they really know the risks?

The massive falls in value seen across a range of asset classes over the past year has undoubtedly left many DC members disillusioned with the performance of their pensions and re-evaluating their attitude to risk.

Individuals with large equity exposure were obviously the worst hit after the FTSE 100 plunged by 31 per cent last year, while many other markets – including Europe, Japan and the US – fell even further.

Indeed, the economic downturn has only served to highlight the gulf between the realities of investment risk and scheme members’ understanding of it, says Towers Perrin principal David Bird.

“We are seeing the mismatch between how DC members perceive risk and how professionals do. People say that they can accept some volatility, but really they do not expect funds to behave like they have,” he says.

The problem is compounded by the fact that members’ attitude to risk does not take into account the whole life of their pension fund, which may be 20 to 30 years out, and therefore gives the scope to overcome short-term falls even when they are severe, he adds.

So, how does this reflect on the risk-profiling exercises that members generally go through at outset, given that these are designed to ensure individuals enter a fund that matches their attitudes to risk?

It is certainly an inexact science, particularly when a scheme may have several thousand members who have no access to individual advice.

As Phil Duly, an associate at Barnett Waddingham, notes: “Risk-profiling tools are approximate by their very nature and a lot of the questions are aimed at general financial matters and not specifically pensions because of the different individual circumstances of their employees.”

Although the questions have a certain generic quality, the wording of them and the way in which they are phrased can have a significant impact on the effectiveness of the exercise.

Simon Pearse, a senior associate in Mercer’s investment consulting arm, points to the wealth of behavioural finance research that has helped shape risk-profiling questionnaires by documenting individuals’ at times asymmetric attitudes to risk. (See box below)

He says that it is important to strike a balance between how much information people are given and the tools they have to help interpret this in relation to their own individual circumstances.

“People find it difficult to interpret too much information at the same time, so simplifying the questions or breaking them up into smaller, more manageable pieces can help them make progressive decisions more easily,” he says.

Lee French, DC proposition director at Alexander Forbes Financial Services, says that his firm uses psychometric profiling, boiled down into around ten questions asked in face-to-face sessions.

He admits that the way that this is carried out will influence individuals’ responses. To counter this, AFFS asks similar questions in different ways to make it more difficult for people to second-guess how they will be categorised, and only offers four choices of answer to prevent them sitting in the middle.

“We have found that by sitting down with each member and discovering what retirement they want we get much better engagement, and only 25 per cent of our clients’ scheme members end up in default funds,” he says.

French adds that even during the downturn, 80 per cent of contributions are still going into risk-profiled funds, effectively “turning the industry average on its head”. Although these may have performed worse than the default fund, the measure of success is really judged by how many members opt out of the default and into a tailored fund, which should ultimately better meet their needs, he says.

Although consensus suggests that risk-profiling does not need a radical rethink in light of the credit crunch, one of the key things the economic downturn has thrown up is the importance of including all possible investment outcomes, including so-called ‘black swan’ events. These are defined by economist Nassim Nicholas Taleb as hard-to-predict, large impact events that are beyond the boundaries of normal expectation, such as 9/11 and, arguably, the current banking crisis.

Mark Smith, senior consultant at Lane Clark & Peacock, stresses that stochastic modelling will throw up a large number of scenarios, so it is therefore up to the corporate adviser to show the best and worst potential outcomes and provide their best estimate on the most likely event.

“It does mean you get a wide range of outcomes, but it is good in that in some ways it shows the extremes,” he says. “Chopping off the outliers is a very significant decision to make.”

Pearse says the advances in technology make factoring in black swan events more straightforward and better enables trustees in particular to prepare ways to mitigate them beforehand, for example by building in much greater diversification.

With members, however, the trade-off is between scaring them away by highlighting the worst case scenario, and managing expectations.

In all likelihood, Duly admits, many investors’ attitudes to risk will have changed during the economic downturn, as they have seen the losses marked on their pension statements.

Pearse points to research in the US by Vanguard and economists Richard Thaler and Shlomo Benartzi, showing that during the 2000-2003 stockmarket crash most individuals left their allocation to equities but allocated new contributions to bonds.

“History suggests that members actually see equities as more risky after an event than before and treat past contributions and new contributions differently,” he says.

He stresses the importance of communication, particularly around the benefits of pound cost averaging, after such steep falls in the equity markets. The Pensions Regulator highlighted the need for trustees and sponsoring employees to provide guidance to members in a recent missive.

In many respects in the UK, however, the problem is more around countering the risk of people stopping contributions than switching their asset allocation, such is the dominance of default fundsIndeed, Chris McWilliam, a senior consultant at Aon Consulting, believes that default funds are the issue rather than risk-profiling techniques, and the recent performance of many funds will spark debate about their effectiveness going forward.

“With 80-90 per cent of members tending to go into default funds, it is much more important for the employer to be reviewing the risk profile of that default fund to ensure it is appropriate for the majority of its workforce,” he says.

Certainly with the Personal Accounts Delivery Authority set to consult on the shape of personal accounts’ default fund in the Spring, the topic is likely to become something of a hot potato. Whatever shape it takes it will set the benchmark for all other default funds and, regardless of which funds a company’s risk-profiling exercise channels them into, it is likely that anyone in an underperforming fund will feel short-changed even if, stochastically speaking, it is viewed as a better fit for their long-term aspirations.

How we respond to risk and uncertainty

Economists Daniel Kahneman and Amos Tversky rose to prominence through their studies of how people respond to risk and uncertainty, and their Prospect Theory was developed over a 30 year period. In 2002, Kahneman took the Nobel Prize in Economics for his work, but sadly Tversky had died by then and missed out.

Their research highlights the contradictions in human behaviour, with subjects at times displaying risk aversion when offered a choice formulated in one way but then exhibiting risk-seeking behaviour when essentially the same choice is communicated in a different way.

One of Kahneman and Tversky’s key findings was that individuals’ attitudes towards risk around gains can be very different to their attitudes toward risk when it comes to losses.

In one experiment, for example, they found that when people are offered a certain $1,000 or a 50 per cent chance of getting $2,500, they are likely to display risk-aversion and favour the certain $1,000, even though the mathematical expectation of the uncertain option is $1,250. However, when offered a certain loss of $1,000 or a 50/50 chance of no loss or a $2,500 loss, the same people often choose the second, risk-seeking option.

As a further example, Thayer Watkins, head of the San José State University Economics Department, cites an experiment carried out by renowned economist and behavioural finance expert Richard Thaler.

When Thaler told a class of students to assume they had just won $30 and then offered them a coin-flip upon which they would win or lose $9, 70 per cent of students agreed. When other students were offered $30 for certain and offered the same coin-flip, only 43 per cent agreed.

Watkins notes: “This is not necessarily irrational but it is important for analysts to recognise the asymmetry of human choices.”

Different risk at different ages

The Pensions Regulator advised trustees and sponsoring employees of defined contribution schemes to look at the risk profiles of their members in light of the market downturn, at the end of last year.

It highlighted the importance of segmenting members to determine which tranches may be at particular risk and in need of reviewing their arrangements.

Chris McWilliam, a senior consultant at Aon Consulting, agrees that a blanket approach is inadequate and points to those closer to retirement as being most in need of targeted communications.

He says: “We have been recommending that companies carry out specific communications, particularly to members within 10 years from retirement. It is important to explain lifestyling and give them food for thought by explaining the options and the fact that it might not be the best option for them, especially if they are going to be selling out of equities.”

Younger members face different risks but their needs should not be overlooked, adds Lee French, DC proposition director at Alexander Forbes.

He says: “Younger members need reassuring that equities are still expected to outperform over the longer-term and it is important to communicate the benefits of pound cost averaging.”

Pada acknowledges the design of its default fund is ‘critical’

The Personal Accounts Delivery Authority is expected to launch a consultation into the design of its default fund in the next two months and admits it is “critical” that it gets it right.

Speaking at the National Association of Pension Funds conference last month, Pada investment director Matthew Fawcett said that given the industry average, it has to be a fund that meets the needs of 80 per cent of its members.

He said the target audience is predominantly risk-averse, which means it is unlikely to be 100 per cent equities, while the charging structure will guarantee at least a proportion of the fund is passively managed.

Fawcett also suggested it will not adopt conventional lifestyling, in part over fears about persistency. “We need to manage the glide path less mechanistically and more intelligently over time,” he added.

Towers Perrin principal David Bird says that designing the personal accounts default fund will be a difficult balancing act between the traditional managed approach and a safe harbour fund.

“It will be interesting to see which way they go because it will have a massive influence on other companies. The Pada fund may have 5 to 10 million people in it and how it does will be newsworthy and people in company schemes will benchmark the performance of their own funds against it,” he says.

Barnett Waddingham associate Phil Duly adds: “Pada will be faced with all of the problems pension providers have now around engaging members and perhaps even more so if Personal Accounts are not going to be supported by advisers.”