Risk: This time it’s personal

Estimated reading time: 5 minutes

The DC industry has come a long way in the last five years.  We are seeing improvements across the board: better communications, better governance and a greater focus on reducing unnecessarily high costs.

How we talk to members about investment strategies has also evolved and it is now commonplace to see schemes offering a choice of strategies designed with different member objectives in mind, whether someone is expecting to cash in all in one go, in instalments, or would prefer the security of purchasing an annuity.  This means we are asking members to make choices they can relate to (’how do you plan to retire?’) rather than choices they are not in general equipped to make (‘how much do you want to invest in Japanese equities?’).  For the majority who do not make a choice, there is a much greater focus on the design and monitoring of the default strategy.

So far so good.  However, it is not yet time to sit on our laurels.  While the objectives of DC investment strategies are becoming better aligned with members’ needs, one area which is still largely neglected is risk.

We are familiar with lifestyle strategies that reduce risk in the run up to retirement, but when we talk about risk, we commonly mean investment volatility or the risk of sudden large losses.

In this area we haven’t yet made that mind shift to look at this from a member’s point of view.  What does that investment risk actually mean for the member?  The real impact of a sudden investment loss for a member close to retirement is, in practice, going to translate into changing retirement plans.  Either in the form of a lower pension or pushing back retirement. 

As a result, we should be framing our investment risk and asking: ‘how far would the member need to delay retirement by to make up this loss?’ Or alternatively, ‘how big a cut in income, would the member have to accept following this loss?’

For a member further away from retirement, perhaps this impact is more likely to be felt in terms of having to increase future contributions, so we should measure instead: ‘how far would the member need to increase contributions by to make this loss back?’

How can we measure this?

Let’s take a look at an example. 

Meet Ada: she’s aged 40 and is just now starting to contribute £1,200 pa.  She intends to use this fund to take drawdown from age 65 to 75. (Let’s assume for a minute that Ada also has a separate pension pot with which she intends to buy an annuity from age 75.)

First, we can project what income she’s likely to receive at retirement using “best estimate” assumptions (i.e. assumptions intended to be roughly equally likely to over as underestimate). This is in much the same way as we currently calculate projections for members annually for SMPI statements.  So in this example, her projected pot at age 65 is £48,000 which, based on projected market conditions at the time, is expected to fund income of £5,100 pa.

If we were to move forward one year.

Suppose Ada’s investments have returned -5% pa over the year.  Market conditions have also changed future return expectations, meaning that we now expect her to have £45,000 at age 65 which would now fund an income of £4,700 pa.

So what does this mean for Ada?

We can then run this calculation on thousands of different scenarios for what happens in the next year.  We then find the 1 in 20 worst outcome (for each 1,000 scenarios modelled, 50 cases performed worse and 950 cases), performed better than the point we considered.  This gives a measure of the impact that Ada would be facing in a ‘bad’ outcome for the next year.

In our example, a ‘bad’ outcome for Ada would mean:

• Impact on retirement date: push back by 1 year 4 months
• Impact on contributions - contribute £290 pa more
• Impact on retirement income -  accept income £940 pa lower

How can this help?

By re-framing how we look at the risks faced by DC members, we can:

1. Better understand the risks posed by different strategies and so make sure that the strategies are aligned to members’ needs.
2. Monitor these risks over time, to ensure that they remain within reasonable bounds.
3. Communicate the risks to members in a way which is more meaningful to them.

Conclusion

Managing the risks is just as important in DC as it is in DB – if not more so because, members are even less well placed to absorb risk than employers are.

By using the right kind of risk measures, we can shift the conversation to focus investment strategies on the end goals that actually matter to the people who matter.