A blueprint for designing the DC growth phase

While traditional solutions have the ability to offer returns that outstrip inflation, they cannot do so without a significant risk of poor member outcomes.

The returns from equity solutions have proven to be unacceptably volatile for most members, causing many to have to work longer or retire on smaller incomes.

Auto-enrolment has given schemes the opportunity to review their default design, and their aim should be to adopt an investment strategy that offers members a smoother ride.

To achieve this, the default needs to explicitly limit risks while still delivering returns that will outstrip inflation. The growth vehicle could deliver a typical return of inflation plus 4 per cent a year, exhibit volatility no greater than two-thirds that of equities and seek to limit potential losses in absolute terms over any one-year period to a maximum of 12 per cent.

To best deliver these objectives a solution should be made up of a three-fold investment strategy: a core equity strategy, to deliver the total return objective; a dynamic asset allocation strategy, to control portfolio volatility; and a downside risk management strategy, to minimise potential losses.

The core of the portfolio should be directly invested in actively managed global stocks. This equity portfolio should be managed with a patient tilt towards value and quality stocks, but with the ability to perform well in all types of market environment, including those favouring growth or small-cap stocks.

This should be supplemented with diversifying investments including regional, single country and small cap equity investments, commodity-related investments, high-yield bonds and cash.

In addition, the solution needs to allocate actively across all asset classes, with a view to reducing overall volatility and mitigating the effects of extreme market environments.

To meet the specific volatility and downside risk objectives, the portfolio needs to consider tactical risk management in the form of an overlay.

An effective risk management overlay should have the following characteristics:

• Independent: The investment team responsible for the overlay should operate independently of the multi-asset team that manages the underlying portfolio;

• Complementary: A systematic risk management overlay is required and should be designed to complement the asset allocation process;

• Integrated: The multi-asset and risk management teams should work closely together. The risk management team should be continuously updated on all the positions held in a portfolio as they change.

Asset managers have traditionally attempted to deliver equity-like returns with limited downside in two ways, either market-timing or low exposure to growth assets, with a large allocation to volatility-dampening bonds. Neither seems suitable in the current market environment.

The first option has proved notoriously difficult to deliver and in a higher-volatility environment, is arguably even more challenging. The second simply would not deliver the required objectives in a low bond yield and high equity market volatility environment, unless leverage is used in the bond component, which is unlikely to be permitted.

The approach we would advocate in the design of a growth default combines active allocation across multiple asset classes with a systematic risk management override that automatically ‘switches on’ during turbulent markets, and allows delivery of the required real return target – with a maximum downside risk – without resorting to either leverage or market timing.

David Heathcock is a DC product manager at asset manager Schroders