Three key levers to help manage DC longevity risk

Within the UK there is a perceived retirement shortfall of 10 years, according to our research. 

This is perhaps unsurprising since the average UK life expectancy continues to grow, with a typical pension scheme member predicted to spend 25 years or more in retirement.

Adequately maintaining living standards for individuals over this lengthening time horizon requires higher retirement funding levels, but the Pensions Regulator reveals that the average defined contribution pension pot is £25,000, which falls well short of any meaningful definition of ‘adequate’. 

There are three courses of possible action:

• Work longer. People are, where they can, deferring retirement. According to the latest figures, 11.9 per cent of UK citizens aged over 65 are still in work. There are several reasons for this, but a significant number of savers need to work longer to expand their retirement pot.

• Save more. Saving levels, especially in DC, are still far too low and people will need to save a lot more to get anywhere near defined benefit replacement levels.

• Increase appetite for risk. This means gaining exposure to higher risk/reward assets in the hope of securing greater investment gains that grow assets more aggressively. However, investing more aggressively to compensate for a savings shortfall is rarely a good idea given the considerable risks of depleting an already small pot.

If DC members continue to remain unengaged, option three – increasing investment risk – appears to be the most likely means of bridging the UK’s savings gap.

However, the complexity lies in deciding how much extra risk is appropriate.

More choice for the undecided

Auto-enrolment has been a huge success. However, there is now a substantial pool of workplace pension members that did not previously exist. This group has, to a very large degree, been auto-enrolled into a default plan with the accompanying inertia and disengagement.

Yet there is now more pension choice available than ever before for this disengaged majority, presenting something of a challenge in ensuring they meet their retirement goals.

In the short term, pension freedom is unlikely to be an issue since most DC retirees will have small pots and will likely take cash, but for the next generation there is an opportunity for advisers to become embedded within the workplace to help members prepare for retirement.

Advisers will need to ask how much risk is appropriate to get DC members through retirement successfully, not just to a point at which they can retire.

The obvious investment answer is to maintain a high level of risk assets – predominantly equities – in the portfolio, but prioritising longevity risk can lead to greater market and event risk when participants may be least able to afford portfolio losses.

Managing multiple risks

Optimal pension fund design must be properly structured to manage not just longevity risk, both in the accumulation and decumulation phases, but the many dynamic and changing risks inherent over a lifetime.

The Holy Grail is a glide path design that better balances longevity risk with multiple risks, including market and event risk, inflation risk, interest rate risk – not to mention member-controlled risks such as user risk, accumulation risk and withdrawal risk – in an effort to deliver a more consistent performance through all market environments.

However, while it is clear that disengaged individuals will need guidance to ensure their choices incorporate these factors, there is a reluctance to pay for advice.

This presents a role for the employer to finance additional support. Paying for independent advice can help corporates get their employees to a point where they are able to retire and allow the investment industry to deliver effective solutions.

Ultimately, however, if people are not saving enough, there is only so much any pension can provide.

Simon Chinnery is head of UK DC at JPMorgan Asset Management