Building default investment options for defined contribution (DC) members is really the art of creating a process that will allow asset allocations to change over time, reflecting the changing needs of members as they age. Put another way, it is goals-based investing where you predict how the goal will change over time.
For years – until the introduction of pensions freedoms – the goal of the journey was clear cut: buy an annuity at retirement age. In other words, we knew that the goal was going to move, but we also knew where on the pitch it would end up.
In the immediate aftermath of pensions freedoms, defaults changed to reflect the new needs and goals of members. Most of the work focused on the need to extend the investment journey through and beyond retirement to accommodate the needs of members who might treat their pensions savings like a bank account rather than secure a known income for life. Principally this meant including equity in portfolios well into retirement, which is sensible – many members will have retirements lasting 20 or 30 years. With that kind of investment horizon, you do have time to hold on to risk that you might not have needed or wanted in a pre-freedoms environment.
And while extending the investment horizon was easy to do, there has been a bit of head scratching about how to deal with improving the certainty of income being taken now. If a member has decided to take £100 of income regularly, how do we make sure that, irrespective of markets, that member can continue to rely on being able to spend £100 and not see their spending power eroded by the markets or their own continued drawdown?
We believe crash barriers are needed. Our approach is to have a goals-based investment philosophy underpinning our defaults. Our more conservative, or stability-focused funds, are designed for investors who have shorter investment time horizons and require more stability, such as our member that wants to rely on the regular £100 now and into their future. These funds are included in our defaults for members closer to or in retirement.
The crash barriers allow us to manage a fund’s losses to a maximum of 10 per cent from the peak to the trough of the market. The asset allocation is robust enough to withstand most market shocks, but in extreme circumstances we may actively intervene in the portfolio, derisking it to minimise the chance of it breaching its loss target threshold. We do this to keep members invested but also to build in a failsafe. If markets are falling, at some point a falling fund value will start to impact the likelihood of maintaining the member’s income for life or will need a downward adjustment to income now. For a member that is not used to making complicated predictions about markets or their own mortality, I very much doubt that they would understand the impact of either and nor should they; that’s our job to do for them.
Some will argue that derisking in falling markets is crystallising losses, and that’s a valid argument if you are looking at the future of a member with a 30-year investment view, but we’re not. We’re looking at protecting the income of members in retirement now and the sustainability of their income for the future. It’s about recognising that a member doesn’t care about crystallising losses or academic research, they care about the £100 and when they will receive it; not having to worry about if they will receive it.
Our approach isn’t a 100 per cent-into-cash move once a loss target threshold is reached, but rather an actively managed derisking process. We begin to derisk the portfolio as it approaches its maximum loss target but retain some exposure to risk assets. As markets, and the portfolio, begin to recover we rerisk the portfolio back to the original asset allocation. We do this to keep members invested, which ensures they have the best chance of reaching their goals.
For those who still argue that this is crystallising losses in a fund, I would much prefer to be able to look a member in the eye and say yes, you can continue to draw your £100 as you planned because we took an action to protect your savings, rather than explain that they need to reduce their income because we didn’t take an action.