4 minute read
A solution for the decumulation challenge Why protected equities are a natural fit for DC members
By Philipp Loehrhoff - Berenberg
In the UK’s DC market, the lifecycle model has always played a crucial role. This model dictates that the closer investors get to retirement, the more conservative their asset allocation becomes, typically shifting towards bonds and away from equities. Due to the generally young age of DC scheme members, the focus has been on the early stages of this journey, often with little regard to what comes next. Now with investment pots growing and members getting older, more assets are moving towards the later stages (mid-growth and decumulation) of the lifecycle which is causing fundamental changes within the DC market.
In one sense the conservative approach in the later stages is a prudent one. Investors naturally become more risk-averse the closer they are to receiving their pension pot. However, looking at the broader picture across someone’s whole investment lifecycle and not just until retirement, this approach is too conservative. What happens all too often is that these later stages of the lifecycle witness an overallocation to low-risk bonds and money market funds. This approach results in low equity allocations, which is problematic considering a retiree's remaining life expectancy has been steadily rising. Currently, a man aged 65 is expected to live for a further 20 years (for women this figure is even higher).
This makes it even more important that pension funds should have higher growth asset exposure, given the high risk that conservative strategies will not give investors sufficient pension pots. In our new world of higher inflation, high bond allocations also pose a significant risk, as inflation could potentially erode the real value of the assets, particularly in the later stages of the lifecycle. This new market environment necessitates a focus on investments that generate positive real returns, another reason why investors later in the lifecycle should invest more in equities.
One challenge here lies in the fact that many investors nearing retirement are unable or unwilling to take on the volatility associated with a more aggressive portfolio, necessitating a solution that balances risk and return. Up to now, not enough has been done to address this, especially as the number of DC members along with their pots keep growing and the age of the average member is increasing.
To develop a solution to this problem, schemes need to understand that investors towards the end of the pension lifecycle want their investments to follow four key principles: n
Risk Mitigation: Many DC investors want a solution that can provide a buffer against losses during market downturns.
Growth Potential: Although many DC investors are more defensive, they still want to participate in the growth of equity markets to ensure their savings last throughout retirement.
Flexibility: There are broad similarities between DC investors at this stage of the lifecycle, but schemes must be able to cater to various risk tolerances and investment horizons. n
Inflation Protection: DC investors want their solutions to provide some form of protection against inflation.
Unfortunately, there are not many solutions out there to address this challenge. However, recently some progress has been made and it comes from a familiar quarter.
There’s a solution that has stood the test of time and that has become available to DC investors quite recently: Protected Equities.
A Protected Equity strategy is an approach that has been used by many institutional investors over the last few decades. It works by combining equity investments with a protective element. The equity component gives investors growth potential and a hedge against inflation, while the protection component guards investors to some extent from the full brunt of potential losses during periods of market downturns. It offers investors in the mid-growth phase as well as those nearing retirement a way to maintain or even increase their equity exposure without increasing their risk profile substantially. If one wants to generate better returns without jeopardising savings, protected equity can provide the flexibility to achieve this.
Our Protected Equity Strategy has only recently become accessible within the DC space in a way that fulfils the essential requirements for investors within the DC market by offering high liquidity and transparency, low cost, attractive value for money and ease of access via various platforms. It is also very complementary to other developments in the DC market such as private market investments and can offer a natural alternative to bonds and DGFs, many of which have often fallen short of expectations.
