DAN MIKULSKIS is
co-head of ALM & investment strategy at Redington
Phase
Cash flow into pot
Investment objectives
Preretirement
Positive
■
Capital growth
■
Year on year falls in pot size
■
Controlled investment risk taking
■
■
Capital preservation closer to retirement
Chance of having to work beyond desired retirement age to generate sufficient capital
■
Manage drawdown of capital
■
Risk of partial or full loss of capital
■
Maintain flexibility/liquidity
■
■
Generate income
Failure to generate expected income
Postretirement
Negative
example, that a member investing mainly in equity could see their pot decrease by multiples of their annual salary in a severe equity bear market (see Figure 2, left). Risk-controlled investment strategies operate by varying the allocations to underlying assets dynamically in order to deliver a more consistent level of risk, or at least by limiting the exposures at times of highest risk. While the return over a long period may or may not be greater than for a similar static allocation, the year-on-year experience of the member will be smoother (see Figure 2). Applying risk control also gives an obvious lever to employ in reducing risk as the member approaches retirement – the level
GETTY
p21_23_june_DC_investment_FINAL•CT.indd 23
Risk measured by
of risk targeted can simply be reduced. Another argument in favour of strategies that explicitly control risk is that the pricing of guarantees on the value of savings will be much more affordable than on strategies where risk is variable. As the member approaches retirement, risk can be experienced as an increasing chance that the member will in fact have to work beyond the planned retirement age to generate sufficient capital to fund their retirement. Measuring risk in this way is complex, as a conservative investment strategy that moves into low-risk (and therefore low-return) assets too early before retirement can in fact show a higher level of risk on this measure, by locking
in low returns. Figure 2 illustrates the shortcomings of an approach of scaling linearly into cash from 10 years out from the planned retirement age. Following the 2008 market falls this approach would indeed have run a high risk of the member having to work longer to fund the planned retirement.
The post-retirement phase Setting an investment strategy for a fund that is managing a significant cash outflow each year is a challenge, as any mature defined benefit pension fund will know. The big issue is the path-dependency of the actual returns – the investment strategy becomes critical as the fund is sensitive to the timing of losses compared with gains. In Figure 3, a member is drawing down a DC pot in retirement. The member naturally wishes to receive a known amount of income each year, in this case a level 6% of the starting amount (which remains fixed). Some investment risk is taken in order to generate a level of returns that is expected to satisfy the requirement for income and leave capital left over after 25 years. The path illustrated by the grey line shows a constant investment return of 5.4% p.a. The three scenarios illustrated by the other lines all produce cumulative investment returns over the whole period that are equivalent to 5.4% annualised (in fact the three scenarios all contain the same annual returns, in different orders). However in scenario 1 initial losses and low returns mean that the capital is significantly depleted such that, despite the larger positive returns that follow, the capital runs out before initially projected. In other scenarios, large returns in the early years can result in higher than projected amounts of capital remaining after 25 years. This suggests an important role for careful modelling of the risks involved in this investment strategy in order to correctly balance the level of income paid out with the expected return of the investment strategy and the level of investment risk taken, and to ensure the risk of running out of capital is kept to a minimum. It turns out this is a much more nuanced set of constraints than in the accumulation phase, suggesting a significant role for investment strategy modelling. This also points to a role for capital guaranteed investment strategies, particularly in an environment where the desired income level cannot be easily generated by investing in liquid, income-bearing securities (as is likely to be the case now). a
June 2014 • THE ACTUARY www.theactuary.com
23
27/05/2014 17:24