The defined contribution pensions market in the UK remains in long-term transition. Factors contributing to this change over the last few years include auto-enrolment, the rapid growth of master trusts as providers of DC pensions, and the dramatic fall in annuity purchase at retirement following the pension reforms.
Whilst many things are changing, certain features remain the same. One of the most notable is that the vast majority of pension savers continue to invest in one of their provider’s default funds. This makes default funds, particularly those of the largest providers, a key factor in determining the UK’s future retirement outcomes.
Most default funds follow so-called lifestyle strategies, designed to reduce risk by moving from high risk assets, such as equities, into safer assets, such as gilts and cash, as their retirement age approaches. Lifestyle strategies are supported by a rich history of research into financial markets and individuals’ behaviour when presented with risks.
Default funds are also in a transition phase, connected to the rapid decline in annuity purchases at retirement and the variety of available options for people to now access their pension pots. With annuity purchases, default strategies had an obvious asset allocation target at retirement: 25 per cent cash to provide a tax-free cash lump sum and a 75 per cent combination of gilts and potentially corporate bonds to broadly emulate how annuities are priced by life insurers, thereby reducing the uncertainty about how much income the pension pot would provide in retirement.
Many providers now offer alternative lifestyle strategies, catering for the variety of retirement options available. The biggest growth we see, post pension freedoms, are for those who wish to remain invested after retirement and draw down income from their pension pot over time. These lifestyle funds generally reduce risk as retirement approaches, but to a lesser extent than if targeting an annuity at retirement. How these strategies should then allocate after retirement is an important and nuanced question.
Gilts are undoubtedly a safe long-term investment, assuming we take safe to reflect certainty about receiving regular coupons and our principal back at maturity. However, the potential return on that investment is at a disconcertingly low level. The yield on 10-year gilts reached a nadir of 0.16 per cent in early March. Even with £100,000 to invest in gilts at retirement, with the intention to take the income, you would receive just £160 each year. Pensioners could increase this by selling some of the gilts over time, as their expected lifetime reduces, but most should plan for a retirement of more than 20 years so will want a majority of their capital remaining after those 10 years. Inflation will also exacerbate the problem.
In order to increase the expected pension, we need to look to higher returning but therefore also higher risk assets. Investment grade corporate bonds are an obvious addition but, on their own, may not offer sufficient additional pension. Riskier asset classes such as high yield bonds, emerging market debt and equities, can also add expected return, as would alternative categories such as infrastructure and property.
For such an allocation, a diversified approach is essential to avoid risk concentration and to reduce sequence-of-return risk. Some providers have opted to do this by allocating to several individual categories whilst others employ diversified growth funds, allowing a fund manager to do the allocation work, usually with a return and volatility target. Given the regular outflow requirements in retirement, the latter may be particularly interesting if there is also an income target for the manager.
How large to set the allocation to risky assets in retirement is a critical decision. In theory, it should be linked to an individual’s circumstances. In practice, this information is not always available, and the solution may have to suit a wide variety of participants. Modelling potential outcomes will be crucial to determining how much risk a certain strategy is running and its suitability for different participants. As input to this modelling, the available yield on gilts provides an important benchmark – the lower that benchmark, the more incentive to seek higher returns and potentially increase allocations to riskier assets in retirement.
Strategically, this is all a careful balancing act, but we would not be surprised to see allocations to gilts in retirement edging down. Very high allocations to gilts in retirement may well be an unaffordable luxury in the current economic environment.