Schroders Meeting the Budget challenge: offering DC members choice with security

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December 2014 For professional investors and advisers only. Not suitable for retail clients.

Schroders

Meeting the Budget challenge: offering

DC members choice with security

Stephen Bowles,

Head of UK

Institutional Defined

Contribution,

Schroders

The Budget in March has opened up a new world of choice for retirees. But for trustees and sponsors of defined contribution

(DC) pension schemes, it is forcing a radical rethink of what they offer members in the years running up to retirement. To ensure that savers are well placed to take advantage of the new opportunities, schemes will need a default investment approach that aims to combine inflation-beating growth with a safety net that attempts to protect against big losses.

That’s why we have launched our Flexible Retirement Fund. Its target is to generate an annual return equivalent to 2% more than the Consumer Price Index. What is a little bit revolutionary is that it will also seek to prevent any loss of more than 8% over any investment period. Our aim is to provide members with solid reassurance that their savings will be protected against the sort of debilitating market falls that can represent an irretrievable loss for them late in their careers.

The revolutionary bit is that it will aim to put a floor under any such losses, which should allow the member to be much more confident that they will avoid big falls and lock-in gains. The result should be savings that ratchet up over time (see chart) and give them the confidence to keep contributing.

Preserving members’ wealth: protecting the downside, locking-in growth

%

125

120

115

110

105

100

95

90

Fund Net Asset Value

Source: Schroders, for illustration only .

8% Loss Target Ratchets Up Over Time

Maximum Loss Target

So what are the new choices now opening up for members that need to be accommodated by schemes? One at least will be very familiar. We think it’s quite likely that, even though the elements of compulsion have gone, some members may still elect to purchase an annuity on retirement.

These more conservative savers may still need to be directed towards a portfolio of long-dated government bonds (gilts) that provides some match with the sort of annuity they will eventually buy.

Schroders: Meeting the Budget challenge: offering DC members choice with security

However, we think many more members will want to take advantage of the new flexibility to, for instance, move into drawdown or cash-in their savings when they give up work. For these savers in the years running up to (and potentially through) retirement, the typical gilt-laden default designed as a precursor to annuity purchase is not just inappropriate, we think it’s potentially dangerous. Gilt yields are artificially depressed right now, something that looks set to end once interest rates start to rise. In such circumstances, a default fund tied to gilts is almost guaranteed to shrink as rates increase.

Instead we think a new and very different type of default fund will be required. It will need an element of growth to combat the ravages of inflation, but the overriding priority is that it should protect against those potentially disastrous market falls. And, of course, it must also allow the member freedom in the use of their capital to match the freedom they now have when they retire.

The growth, we believe, can be provided using a multi-asset portfolio. This should provide a range of assets that captures different sources of growth, as well as enough diversification to minimise volatility. We calculate that such a portfolio could give the pre-retiree a healthy all-in return of 2% over and above inflation. And, of course, such a fund will allow the member to cash it in at any time without penalty, giving them the freedom to keep their options open up to – and, if desired, beyond – their retirement date.

The bigger question is how to provide the sort of protection against loss that will give members the comfort to stay invested in growth assets so late in their savings journey. It would be possible to provide some form of portfolio insurance policy. However, the higher costs and/or lower performance involved are likely to make this an unattractive route to follow. A better approach, we think, is to build in a ‘floor’ using a systematic process which aims to limit any loss to no more than

8% over any period, effectively allowing gains to ratchet up over time. It will be even better if it can be provided while still keeping the fund’s annual cost well within the government’s 0.75% charge cap – indeed, the all-in charge will be just 0.3% at launch.

Our process starts with the more modest aim of limiting volatility. Big upward spikes in volatility typically herald big falls in value. So, we will monitor the portfolio’s volatility and when it hits a predetermined level (or ‘cap’), our exposure to risk assets will be reduced until volatility returns to more normal levels. If, however, losses continue to mount, an even higher level of protection will kick in. As the portfolio value drops, the volatility cap will automatically tighten, accelerating the move out of risk assets until the portfolio stabilises. Once the market starts to recover, the cap will be gradually lifted back to its original level, allowing the portfolio to participate in the recovery. This makes it possible to set our objective of trying to limit any loss to no more than 8% of the portfolio value over any period.

We think such a fund could provide the sort of flexibility we expect most DC pension members will want to retain right up until retirement. Indeed, we think that a pre-retirement default fund that aims to limit losses to 8% while locking-in annual gains of 2% over inflation, for an all-in cost of just 0.3%, should be compelling for many savers and their schemes.

To discuss the themes in this article further, please contact Stephen Bowles, Head of

UK Institutional Defined Contribution at Schroders, on +44 (0)20 7658 4916 or email ukpensions@schroders.com.

www.schroders.com/definedcontribution

Important information: The views and opinions contained herein are those of Stephen Bowles, Head of UK Institutional Defined Contribution 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. Specific Risk Factors: The maximum loss target is an investment objective only and does not constitute a guarantee. The Fund targets specific outcomes and as a result its performance may differ significantly from that of equity markets. The Fund is not benchmarked and investors need to understand that during certain market environments (e.g. volatile upward trending markets) the Fund may underperform equity markets. To effectively run the strategy Schroders may rely on information generated internally or sourced externally, used separately or in combination. There is a risk of errors arising directly or indirectly from erroneous data. Schroders will not be liable for errors arising directly or indirectly from erroneous data. Internal and/or external providers may be used to deliver index tracking equity returns. There is a risk of differential performance between the index and portfolio or pooled vehicle. Schroders will not be liable for differential performance between the index and the portfolio and pooled vehicle. 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. The strategy can use derivatives for investment purposes and may leverage the portfolio. These instruments can be more volatile than investment in equities or bonds. The use of leverage can increase gains as well as losses and expose the strategy to increased risk. The use of derivatives and leverage involves a higher degree of risk and may lead to a higher volatility in the unit prices of the funds. Issued by Schroder

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