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  • Outcome orientated investing for retirement From the DC scheme member’s perspective

    For European professional investors only

  • 2

    Contents Page

    Executive summary 4

    1 Introduction 6

    2 Literature review 10

    3 A brief history of lifestyling 13

    4 The future of lifestyling 19

    4.1 Static lifestyle with full annuitisation at age 65 21

    4.2 Static lifestyle with gradual annuitisation between ages 65 and 75 25

    4.3 Dynamic asset allocation strategies 27

    4.4 Liability driven asset allocation and ‘loss aversion’ 29

    References 34

  • 3

    We believe there is a need for more innovative alternatives to the lifestyling approaches

    that are typically employed in defined contribution (DC) pension schemes.

    As we explored everything that has worked well, and not so well, with the traditional

    lifestyling approaches, and considered the evolving role of target-date funds, we

    questioned the application and ‘fitness for purpose’ of various existing solutions.

    With this in mind, we sought the involvement and academic input of Cass Business School

    to evaluate alternative approaches which might also consider the desired outcomes for

    DC scheme members.

    The past and present solutions treat people of a like age and/or number of years before

    they retire as if they have the same income objectives in retirement. Moreover, and

    most importantly, this approach fails to consider how close individuals are to achieving

    their target retirement incomes. What this means in practice is that, in most existing

    DC arrangements, two people of the same age, with entirely different retirement income

    objectives, with one ‘on target’ and the other significantly ‘under target’, will have

    identical asset allocation profiles. This is clearly wrong.

    Much is made of the fact that DC is different from defined benefit (DB), and rightly so. DB

    schemes treat members’ assets as a single pool with corresponding liabilities, whereas

    DC schemes have historically focused solely on scheme members’ assets, with little

    consideration to their needs in retirement. In view of this, we wanted to investigate the

    extent to which aspects of the way in which DB schemes view and treat assets in the

    context of liabilities could be applied to DC schemes.

    Pension managers, trustees and their advisors will, we hope, find this paper to be both

    interesting and challenging. We propose some highly original theories and approaches,

    to which the asset management industry should now respond with workable products,

    solutions and technology. We believe that these approaches would require the industry

    to rethink how it engages with scheme members, and challenge assumptions on the key

    inputs for future product developments.

    David Calfo Group head of DC strategy

    BNY Mellon

    david.calfo@bnymellon.com

    Outcome orientated investing for retirement From the DC scheme member’s perspective

  • 4

    Few now dispute that the future of

    pension provision, not just in the UK

    but in other developed countries too,

    seems to be the DC model1. In moving,

    albeit gradually, from a DB to a DC world,

    the burden of risk is also shifting from

    employers and their shareholders, to

    individuals.

    However, unlike under DB arrangements,

    under DC provision employers will not

    be obliged to make up any pension

    shortfalls, meaning that this risk is borne

    by the member. Given this significant

    shift to a scenario in which scheme

    members must bear the risk that their

    retirement income will not be at the

    desired level, it is right to ask whether

    the investment approach taken to DC

    pension provision is appropriate.

    The key findings from this paper include:

    • ‘Traditional’ DC lifestyling approaches

    are producing ever-lower eventual

    pensions.

    • This paper proposes a ‘dynamic’

    investment strategy that is outcome-

    driven (targeting the generation of an

    income in retirement that will offer

    a minimum acceptable replacement

    ratio relative to the income earned

    during employment), recognises

    investors’ attitudes to risk and takes a

    flexible approach to the decumulation

    phase.

    • We show that a more dynamic

    investment and annuitisation strategy

    produces a less uncertain outcome

    with regard to the final DC-related

    retirement income replacement ratio,

    thereby helping greatly to reduce the

    risk of future DC pension shortfalls.

    Executive summary

    1 Indeed, the National Employment Savings Trust (NEST), which is due to launch next year and which has been designed to provide pensions for potentially millions of low paid UK workers, has a DC structure, and within a few years is likely to become one of the largest DC pension schemes in the world.

  • 5

    The vast majority of DC members invest

    their precious pension pots in the default

    fund provided by the scheme. Given

    that saving for a pension is a long-term

    investment commitment for most people,

    most (if not all) DC funds are heavily

    weighted to equities, on the assumption

    that, in the long-run, equities will out-

    perform all other asset classes.

    A second feature of a traditional default

    DC investment strategy, is the lifestyling

    that takes place, usually over the 10

    years leading up to retirement and full

    annuitisation, when investors’ pots

    are automatically and mechanistically

    switched out of equities and into

    government bonds, with little reference

    to the risk preferences of the member,

    to the size of the investment fund

    accumulated over this period, or, indeed,

    to financial market developments.

    In this paper we address some of

    the shortcomings of the current DC

    framework. In keeping with other studies

    our empirical work shows the typical

    approach to de-risking, or to lifestyling,

    and how this mechanical strategy

    has produced ever-lower eventual

    pensions for a typical DC member over

    the past 20 years. With annuity rates

    at such depressed levels currently, it is

    imperative that investment strategy is

    more enlightened.

    To examine these substantial investment

    challenges we develop a model that

    incorporates three important elements.

    First, the asset allocation strategy is

    dynamic and, crucially, it is driven

    by the target replacement rate of the

    representative DC member. The strategy

    is not to generate the largest DC pot

    possible, but, instead, to minimise the

    likelihood of not achieving the target

    replacement ratio.

    The second feature of the model is that

    we do not impose a constraint that forces

    DC members to annuitise at the normal

    retirement age – although we do impose

    the constraint that they should be fully

    annuitised by age 75. A crucial feature

    of any dynamic DC investment strategy

    should be the ability to bring forward or

    delay the annuitisation process, or to

    annuitise partially over time.

    Finally, we adopt the framework

    first proposed by Blake, Wright and

    Zhang (2011) and suggest that the risk

    preferences of each DC member should

    be recognised and in particular the

    notion that most individuals are actually

    ‘loss averse’, meaning that they are

    generally more distressed about a loss

    of a given amount, than they are happy

    about a gain of the same amount.

    Using this framework, it can be seen

    that when compared with the traditional

    approach to DC investment strategy,

    the dynamic, outcome-oriented strategy

    increases the probability of achieving

    the desired pension significantly, while

    greatly reducing the probability of

    the replacement ratio falling below a

    minimum ‘acceptable’ level.

    In keeping with other studies our empirical work shows the typical approach to de-risking, or to lifestyling, and how this mechanical strategy has produced ever-lower eventual pensions for a typical DC member over the past 20 years.

  • 6

    IntroductionSection 1

    The UK’s private sector pension

    landscape has been dominated for many

    years by the DB model. Until the early

    part of this century, the amount of risk

    that DB plan sponsors were assuming

    was not widely appreciated. However, a

    prolonged bear market in equities has

    had a significant impact upon DB asset

    portfolios over the past decade or so.

    But DB balance sheets have also come

    under pressure from continuing (and

    recognised) improvements in longevity

    and the move to marked-to-market

    accounting practices at a time when the

    discount rate used to market DB liabilities

    to market, have fallen substantially.

    Upwardly revised estimates of longevity

    and lo