Sequencing risk – the scourge of DC retirees

Defined contribution savers, as the name suggests, can control one key factor in determining their retirement outcome – their contributions into a pot.

There is no guaranteed way of managing a sequence of returns risk from an investment strategy perspective

Gregg McClymont, The People’s Pension

With good governance and low costs, a well-run DC plan should also deliver compound investment returns over the long term. But what neither trustees nor savers can do much about is the state of global markets when a member decides to retire.

That state, as analysis of bull and bear markets by fintech company Finalytiq’s Timeline app shows, varies wildly. A saver with a DC pot invested in equities would have seen their pot grow by 3,514 per cent over a nearly 13-year period, but would face a drop of more than a third in just two months following this.

Of course, few of today’s savers are invested solely in equities, with DC schemes de-risking member pots towards their expected retirement date.

But our analysis, which charts the total return for a simplified version of a well-known master trust’s end asset allocation, shows that even modern target-date funds could not have prevented a significant drop in fund value around the time of the global financial crisis.

A further risk presents itself in the sequencing of these returns. If returns are poor – or not sufficient to cover withdrawals – in the early years of retirement, the pot itself shrinks and its capacity to generate future income is limited.

So can anything be done about this element of randomness? Gregg McClymont, director of policy at The People’s Pension says not: “There is no guaranteed way of managing a sequence of returns risk from an investment strategy perspective. Using derivatives is expensive and certainly not foolproof, nor can options address the way in which the drawing of a regular income crystallises capital losses in a market downturn.”

He adds: “As such spending rules are crucial, adjusting the income drawn from capital is the key. Only later-life annuitisation can combat the longevity risk aspect of drawdown.”

From a trustee perspective, in as far as most workplace DC schemes only look after members up to the point of retirement, there is little trustees can do. With preferences between cash, annuities and drawdown differing from member to member, complete immunisation against market risk in a default glide path becomes impossible.

“Now, glide paths can’t just target an annuity, they almost have to target keeping your options open,” says Darren Philp, head of policy and communications at master trust Smart Pension.

“If [in drawdown] you take your money out at the wrong time and the markets move against you, then ultimately you will never be able to get that money back.”

Of course, the added market and longevity risk involved in drawdown is precisely what enables it to generate a more attractive level of retirement income. But for the less wealthy and non-advised future generations of retirees brought into saving by auto-enrolment, providers are beginning to think about how to steer their clients towards solutions that moderate these risks while still affording the benefits of freedom and choice.

Better comms could guide members through retirement

Products under development at a select few master trusts look set to include a combination of annuities, drawdown and pure cash, delivered by a structure bearing some resemblance to an accumulation default.

Smart’s, for example, aims to match products in the background with consumers’ desires – savers will be asked to choose what proportion of income they need guaranteed, what proportion of their spending they are happy to take flexibly, and what proportion they would like to use for other aims such as leaving an inheritance, rather than being confronted with industry jargon and the complexities of sequencing risk. 

Mr Philp says that with the right information needed to make assumptions, a default mix of products could be suggested for savers to then tweak.

While better communication strategies can guide savers through retirement choices, providers exploring to-and-through retirement offerings still face an engagement problem. Getting the necessary information to guess at a default is tricky, and if savers only engage in the run-up to retirement, trustees will not be able to optimise their glide path, either over or under-immunising their portfolio against market moves.

The use of collective DC has been mooted as a partial solution to this problem. Lifetime income could be paid out, theoretically without the need to de-risk entirely into bonds, and members would be able to change their preferences even after retirement, not being locked into annuities.

“I do think over time, as the scale within master trusts grows and also people start having bigger pots, that more collective forms of at-retirement provision will start to emerge,” says Mr Philp, but he cautions that CDC provision must similarly be cut back if returns are poor.

The answer, he says, will depend on getting the right balance between flexibility and certainty, the latter being something “that you can never get in the CDC world”.