How to tackle risk in a diversified default strategy

Given that a typical DC plan’s default strategy is home to three-quarters of its members, it is essential that it is designed as ‘best in breed’ and fit for regulatory and replacement income purposes.

Before looking at design, it is important to frame this through the lens of the member and the various risks they face.

Identifying risk

The risks over which members have control include failing to save enough to retire and misusing investment options – creating an overly conservative, aggressive or under-diversified portfolio.

These are usually the largest determinants of whether participants will secure safe retirement funding, since even the most innovative DC programmes still require members to save enough and invest appropriately.

While plan sponsors cannot completely control participant decisions around how much to contribute, how to invest those assets and when to make withdrawals, smart plan design can help facilitate constructive behaviours through strategies such as auto-enrolment and contribution matching.

In contrast, there are a number of risks caused by factors largely out of the participants’ control, such as outliving retirement savings (longevity risk), being exposed to a market drawdown as one approaches retirement (market risk), being exposed to potential severe loss due to a single extreme market event (event risk), losing the value of savings due to inflation (inflation risk), and losing value in fixed income securities if rates rise (interest rate risk).

These risks are usually best addressed through participants’ asset allocation choices.

Dynamic risk management

However, one issue currently facing the majority of UK DC schemes is their ability – or lack thereof – to quickly adapt their investment choices.

More than 85 per cent of plan members are enrolled in a default strategy, the most common of which is lifecycle, which mechanistically changes asset allocations over time based on age.

When first introduced, there was a prevailing expectation for equity investments to deliver an impressive 8 per cent to 10 per cent or more annually, with little attention paid to downside exposure.

But times have certainly changed, and multi-asset management is employed more broadly.

It is essential to have a dynamically managed, well-diversified fund that manages these risks over time and has the inherent ability to adapt quickly to changes of whatever nature.

In the US, target date funds are well established and in 2014 held more than $650bn (£428bn) of US pension assets, according to figures from Morningstar. 

TDFs employ dynamic asset allocation that changes gradually. Compared with lifecycle structures they may also be more focused on member outcomes, rather than simply on beating a benchmark.

In addition, because of their single fund structure, TDFs are intuitive to use and easy to monitor, keeping member experience simple and allowing plan sponsors to focus on encouraging better saving behaviours.

As a result, TDFs will likely be the next phase in evolution of the default.

And given that DC pensions have typically glided members to an annuity purchase, unlike TDFs, a lifecycle structure is less readily capable of adapting its glide path in preparation for such a dramatic change in investor behaviour.

Over the course of any individual participant’s working years, all of the risks described above may be experienced to some degree.

Simon Chinnery is head of UK DC at JPMorgan Asset Management