March 2012
For professional investors and advisers only
Understanding the
route to retirement
Lauren Juliff, UK Institutional Business Development, Schroders
Jonathan Smith, UK Strategic Solutions, Schroders
In the UK, Defined Contribution (DC) pensions are a much newer phenomenon than Defined Benefit
(DB) pensions. As a consequence, DC members have been considered as younger and much of the
focus of DC design so far has been on encouraging members to join and accumulate assets.
Despite some recent innovation, investment default design has lagged the sophistication of the DB
market. For younger members this is less of an issue, as retirement pots are small and losses can
be made up over time.
However with a significant wave of early DC members now approaching ‘middle age’ and the crucial
later stages of accumulation, we’re reaching a tipping point. As members age, investment strategy
design becomes the key determinant of retirement outcomes.
Traditional lifestyling strategies only partially improve potential outcomes and by the nature of their
systematic ‘de-risking’ approach they usually deprive members of growth when they stand to benefit
from it the most. Furthermore, lifestyling alone does not necessarily provide the level of risk
reduction that members require in their 40s and early 50s, when losses can do considerable
damage to retirement outcomes.
In this paper we discuss the importance of understanding the different stages of a member’s route to
retirement and the investment risks that they are exposed to, particularly in the later stages of
accumulation.
The timing of investment returns – achieving growth
As a member saves for retirement their pot is expected to grow as they accumulate assets through
contributions. However, the process by which our industry models, measures and reports investment
returns is based on time-weighted returns (i.e. a traditional geometric return) which assumes the
capital value is static.
Time-weighted returns are useful for measuring the performance of a particular strategy over time;
however they are less useful for assessing retirement outcomes. This is because individual
members earn money-weighted returns, so the timing of returns can be as important as the size.
Consider the example of a fund that ‘earns’ a return of 30% in year one, 0% in year two and minus
10% in year three. This would usually be represented as an annualised return of 5.4% per annum. If
we now think of an individual who had £100 in the fund at the start of year one and contributed
another £100 in year two and another £100 in year three, the end value is £297.
For pro
ofessional invvestors and advisers onlyy
Understandi
U
ng the route
e to retireme
ent
However
H
ha
ad this orderr of returns been revers
rsed, the end value wou
uld be £3777 – a very different
outcome,
o
evven though the annualised return rremains the
e same at 5.4% per an num. There
efore the
order
o
in whicch returns are
a earned is key.
As
A another iillustration, consider Ch
hart 1 which
h shows the
e effect of contributionss and investment
re
eturns in the first 20 ye
ears and se
econd 20 ye
ears of a me
ember’s worrking life. Inn the first 20
0 years a
1% increase
e in the annual contribu
ution rate w
will have broadly the same effect ass a 1% incrrease in the
e
annual
a
invesstment return. Howeve
er, in the lasst 20 years the
t situation
n is consideerably differrent,
showing
s
us the value of holding a meaningful allocation to
t growth assets in thiss period.
Chart
C
1: Imp
pact of contrributions and investmen
nt returns as
a members age
Return
R
%
20%
2
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
First 20 yyears
S
Second 20 ye
ears
1% in
ncrease in contribution rate
e
1% increa
ase in investm
ment returns
Anoth
her important implication
n
here ffor members
s is that
increaasing contrib
butions laterr
in life has much le
ess impact
e early years.
than ssaving in the
This sshows us tha
at in order to
o
achievve a good ou
utcome for
memb
bers, scheme
es should
focus their efforts
s on
uraging them
m to save in
encou
the eaarly years bu
ut place
much more emphasis on theirr
a potentia
al
investtment risks and
for gro
owth in the later
l
years.
Source:
S
Schrod
ders, for illustrration only. 40
0 year contribu
utions at base rate of 10% of
o salary. Salaary increases assumed
a
to
be
b 3% pa. Starrting salary is £25,000. Base annual invesstment returns
s are estimate
ed expected reeturns of a lifestyling
strategy switch
hing from equities to bonds and cash in th
he 10 years prrior to retireme
ent.
Itt is clear fro
om these tw
wo examples
s that achie
eving asset growth thro
ough investm
ment returns in the
la
ater years h
has a signifiicant impact on the outtcome for th
he member.. This is duee to the amo
ount of
capital
c
invessted, or larg
ger ‘pot size
e’, at this late
er stage.
This
T
has imp
portant implications forr DC defaultt design – the longer members
m
caan have acc
cess to
in
nvestment g
growth at ollder ages th
he better. H owever most traditiona
al default deesigns automatically
reduce
r
grow
wth allocatio
ons for olderr members via lifestylin
ng.
The
T timing of investm
ment losses
s – achievin
ng stability
y
For
F a DC invvestor the tiiming of los
sses can be
e as importa
ant as the size of thosee losses – a large fall
in
n pot value can have more
m
material consequ ences for an
a older mem
mber than a younger member.
m
This
T
has led
d most invesstment defa
ault strategie
es to ‘lifesty
yle’ into bon
nds and cassh as memb
bers
approach
a
re
etirement.
We
W have alrready discussed one lim
mitation of llifestyling – it can deprive membe rs of investment
growth
g
when
n they migh
ht benefit fro
om it the mo
ost.
Given
G
recent changes to
o annuity pu
urchase req
quirements we
w also que
estion wheth
her the tradiitional
solution
s
(life
estyling) offe
ers enough flexibility fo
or members
s who may want
w
to retire
re or annuitise later. In
order
o
to achieve that fle
exibility and maintain ex
xposure to growth
g
for longer whilee still achiev
ving some
bond-like
b
intterest rate sensitivity
s
fo
or annuity m
matching we
e can learn lessons from
m more capital efficientt
LDI
L techniqu
ues employe
ed in defined benefit sc
chemes.
2
For professional investors and advisers only
Understanding the route to retirement
A further drawback of lifestyling is that investment losses experienced at the ages just before
lifestyling begins, or during the early stages of lifestyling, can still do considerable damage to a
member’s retirement outcome.
This is illustrated in Chart 2. In both scenarios we assume the same starting salary, contribution rate
and average investment return, except that in Scenario A a 30% loss occurs at age 30, compared to
at age 50 in Scenario B. The final pot in Scenario A is some 22% higher.
Chart 2: The importance of the timing of losses
Pot £
700,000
Pot in Scenario A
is approximately
22% higher
600,000
500,000
30% loss at
age 50
400,000
300,000
200,000
100,000
30% loss at
age 30
0
20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60
Age
Scenario A
Scenario B
Source: Schroders, for illustration only. Starting salary of member is £25,000. Salary growth is 3% pa. Contributions are
10% pa. Both strategies assume ten year lifestyling strategy (starting at age 50) switching from equities, to bonds and
cash.
This analysis has clear implications for DC investors – equity lifestyling may not be enough. Losses
in the years before lifestyling begins (i.e. before the ‘pre-retirement’ phase) can have significant
consequences for members. Members could begin to reduce risk sooner; however as we saw in the
previous section having access to growth at older ages can be as important as protecting against
losses.
This suggests that schemes should pay even greater attention to the type of risks they are taking at
older ages; achieving growth through investment returns is important but the stability of those
returns is vital.
Taking another look at default design
Our analysis suggests that the accumulation phase would be better thought of in two stages –
‘early accumulation’ and ‘stable growth’.
— In the ‘early accumulation’ phase members can afford to take more investment risk. An
increase in investment returns has a valuable effect but an increase in contributions is easier
for the member to control and is therefore arguably more valuable.
— In the ‘stable growth’ phase investment returns, and investment risk, become the dominant
factor in achieving the right outcome. Choosing a more diversified growth strategy over a
purely equity based strategy can have dramatic effects for older members, as illustrated in
Chart 3.
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For professional investors and advisers only
Understanding the route to retirement
Chart 3 shows how the amount a member can expect to lose in a ‘bad year’1 grows as they age. At
younger ages, the amount is small as the pot size is small, however it grows rapidly as the member
approaches the pre-retirement phase, when their pot size is large and the investment risk is high.
Introducing a diversified growth strategy reduces the amount at risk significantly in the all important
pre-retirement phase years.
Chart 3: Pot at risk throughout the lifestyle
Pot at risk £ (1 in 20 risk)
140,000
Pot is large and
growth allocation
is high, so growth
risk management
is key at these
ages
120,000
100,000
80,000
60,000
Pot is large,
however
allocation to
growth is small
40,000
20,000
20
25
30
35
40
45
50
55
60
Age
Equity lifestyle
lifetstylestrategy
strategy
Diversified lifestyle strategy
Source: Schroders, for illustration only. Assumes pot grows at same rate for both strategies, however potential losses are
based on the historic volatility of equities and a diversified strategy with assumed volatility of 2/3rds that of equities.
Starting salary of member is £25,000. Salary growth is 3% pa. Contributions are 10% pa. Both strategies assume ten year
lifestyling strategy switching to bonds and cash.
The ‘hidden’ benefits of diversification
Diversification is often referred to as the ‘only free lunch in investment’. This is because, by
diversifying their assets, an investor can potentially reduce risk without sacrificing expected return.
In fact, there is an additional ‘hidden’ benefit to diversification for long-term investors. Following a
less volatile strategy can actually increase long term returns.
Consider the following two sets of fund returns:
Year 1
Year 2
Year 3
Year 4
Average
annual return
Total compound
return
Fund A
10%
-10%
5%
-5%
0%
-1%
Fund B
20%
-20%
10%
-10%
0%
-5%
An investor in Fund A would have a better outcome after four years than an investor in Fund B, even
though both have the same average annual return. This is because a 10% fall in returns requires an
11% gain the following year to break even; however a 20% fall requires a 25% gain the following
year to break even. The bigger the fall, the larger the required relative gain – hence over the longer
term, a more volatile strategy tends to underperform a steadier strategy.
1
4
bad year is defined as a 1 in 20 outcome
For professional investors and advisers only
Understanding the route to retirement
This has important implications for DC investors. Chart 4 shows the spread of potential outcomes for
two members, with the same starting age, salary progression and contributions. Both follow a
traditional 10 year lifestyle strategy, however one follows an equity only strategy in the
growth/accumulation phase, whereas the other follows a more diversified strategy. We have
assumed that the diversified strategy has the same annual expected return as the equity strategy
but with 1/3 less volatility.
Using Schroders’ in-house model, 25% of the potential outcomes at retirement would be better than
the blue bars and 50% would be better than the orange bars (the median); however 25% would be
worse than the red bars and 5% would be worse than the green bars. Hence the orange bars
represent ‘average’ outcomes for the strategies and the red and green bars represent downside
scenarios.
Not only is the spread of outcomes and downside risk lower for the diversified strategy, as we would
expect, but interestingly the median outcome is also higher. The higher median outcome for the
diversified member is a consequence of the hidden return benefit of a less volatile strategy.
Chart 4: Spread of retirement pots for an equity only and diversified growth strategy
Pot at retirement £
900,000
800,000
700,000
600,000
500,000
400,000
300,000
200,000
100,000
-
Equity lifestyle
Best 25%
Median
Diversified lifestyle
Worst 25%
Worst 5%
Source: Schroders, for illustration only. Starting age is 20 years, retiring at 60. Starting salary is £25,000, increasing at 3%
pa. Contributions are 10% pa.
Summary
Focusing on the timing of potential investment gains and losses, as well as the size can help
schemes better understand potential retirement outcomes. In particular it highlights how, as DC
schemes mature, investment default design becomes even more important - the effect of losses for
older members can be devastating but this has to be balanced with the need for growth.
However most lifestyling strategies deprive members of growth when they stand to benefit from it the
most. They also often fail to protect members in their 40s and early 50s when losses can do the
most damage.
This means that schemes may wish to look again at their default. In order to achieve good member
outcomes we need to understand the journey of a DC member and develop default investment
strategies that will allow them to achieve the growth they need while keeping an eye on the risks
they are exposed to at each step along the route to retirement.
5
For professional investors and advisers only
Understanding the route to retirement
To discuss the themes in this article further, please contact:
Jonathan Smith
UK Strategic Solutions
Tel: +44 (0) 20 7658 6877
Email: jonathan.smith@schroders.com
Lauren Juliff
UK Institutional Business Development
Tel: +44 (0) 20 7658 4366
Email: lauren.juliff@schroders.com
www.schroders.com/definedcontribution
Important Information
The views and opinions contained herein are those of Lauren Juliff, UK Institutional Business Development
and Jonathan Smith, UK Strategic Solutions at Schroders, and may not necessarily represent views
expressed or reflected in other Schroders communications, strategies or funds.
For professional investors and advisers only. This document is not suitable for retail clients.
This document is intended to be for information purposes only and it is not intended as promotional material in any
respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument.
The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or
investment recommendations. Information herein is believed to be reliable but Schroder Investment Management
Limited (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of
fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the
Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders
has expressed its own views and opinions in this document and these may change. Reliance should not be placed
on the views and information in the document when taking individual investment and/or strategic decisions.
Past performance is not a guide to future returns. The value of investments can fall as well as rise as a result of
market movements. Exchange rate changes may cause the value of overseas investments to rise or fall. Less
developed markets are generally less well regulated than the UK, they may be less liquid and may have less reliable
custody arrangements. Investors should be aware that investments in emerging markets involve a high degree of
risk and should be seen as long term in nature. The risk of default is higher with non-investment grade bonds than
with investment grade bonds. Higher yielding bonds may also have an increased potential to erode your capital sum
than lower yielding bonds.
Forecast Risk Warning
The forecasts stated in the article are the result of statistical modelling, based on a number of assumptions and
should be seen as objectives only. There is no assurance or guarantee that these results will be achieved and they
should not be considered as predictions of actual results which may be realised in the future. Forecasts are subject
to a high level of uncertainty regarding future economic and market factors that may affect actual future
performance. The forecasts are provided to you for information purposes as at today's date. Our assumptions may
change materially with changes in underlying assumptions that may occur, among other things, as economic and
market conditions change. We assume no obligation to provide you with updates or changes to this data as
assumptions, economic and market conditions, models or other matters change.
Hypothetical Modelling Results
The hypothetical results shown in this article must be considered as no more than an approximate representation of
a portfolios’ performance, not as indicative of how it would have performed in the past. It is the result of statistical
modelling, based on a number of assumptions and there are a number of material limitations of the retroactive
reconstruction of any performance results from performance records. For example, it does not take into account any
dealing costs or liquidity issues which would have affected a real investment’s performance.
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Registration No. 1893220 England.
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