Should DC default funds take more risk?

On the other hand, fiduciaries should take less risk because of their duty to protect unlucky members from really bad outcomes. The former argument seems to be winning out, with regular advice being given to fiduciaries to take more risk. 

How to take more risk

There are two understandable reasons. First, many models that sit behind default fund construction predict lower future returns from risk assets than has been the case historically — to deliver similar levels of benefit, you need to take more risk. 

The level of risk taken early in the member journey has a limited impact on expected outcomes. Far more important is how long the ‘risk on’ environment is maintained

This is one reason DC schemes are looking to private equity allocations that traditionally carry higher risk — including ourselves at Cushon, and the likes of Nest.

Second, one of the bastions of the “less risk” argument relied on observations about customer value from the National Audit Office, which argued that value depends on different cohorts having similar experiences. 

Because diversification reduced outcome dispersion between cohorts, diversified growth funds were appropriate for the growth phase. Of course, many diversified growth funds have seen disappointing returns for a significant period.

If the balance of arguments favours taking more risk, the next question is “how?”

One answer on how to increase risk in a DC strategy would be to maximise exposure to risk assets when members are young. 

We could allocate 100 per cent to global-listed equities and choose parts of the listed equity market that have higher risk and higher expected returns and allocating more assets — 100 per cent equity with an emerging market overweight and a small-cap tilt.

Many DC schemes allocate 100 per cent to global equities, but then derisk into a more diversified portfolio many years before members’ expected retirement dates. 

Cushon’s analysis demonstrates that the level of risk taken early in the member journey has a limited impact on expected outcomes. Far more important is how long the “risk on” environment is maintained.

This makes intuitive sense — returns generated when the member’s fund is at its biggest are bound to have the biggest impact. Delaying derisking should have a positive effect on increasing member outcomes. But what about unlucky cohorts for whom early derisking arguably protects from very bad outcomes?

Holding risk assets for longer improves expected outcomes

Source: Cushon

Our analysis shows that holding risk assets for longer improves expected outcomes for all cohorts, down to the fifth centile.

This analysis assumes a relatively high-risk, drawdown-type derisking strategy for both examples, leaving equity exposure at around 45 per cent at the point of benefit vesting. 

This mitigates damage to members by the long derisking approach. For members derisking into cash or annuity assets, longer derisking periods do more damage.

Reduce the derisking period

Key to increasing expected returns is reducing the derisking period. Constructed in the right way, shorter derisking periods can avoid damaging outcomes for members with below-average outcomes. 

Our analysis demonstrates that long derisking periods significantly damage almost all member outcomes without improving outcomes for the unluckiest cohorts.

Why is it that all schemes do not implement short derisking periods? 

Our analysis assumes members take benefits in line with their expected benefit vesting dates. The shorter the derisking period, the greater the risk of damage to member outcomes if members find themselves in the “wrong” derisking strategy — one not aligned to the way they want to take their benefits — at the “wrong” time, either before or after their expected retirement date.

Members are more likely to find themselves in the “wrong” strategy at the “wrong” time when engagement levels are low. Low engagement is the norm for most DC schemes, therefore fiduciaries could conclude that shorter derisking periods are not in members’ interests. 

If engagement levels are high, the risks of member detriment are significantly reduced. Decisions about when to start taking risk off the table need to take engagement into account. High engagement levels allow for shorter derisking periods, which mean higher expected outcomes.

Cushon technology currently achieves engagement levels of around 65 per cent, and consequently our default derisking period is short. 

Expected outcomes for members are therefore higher, not only for members who enjoy the best outcomes, but right down to those experiencing below-average outcomes. It benefits everyone.

Ultimately, it is the job of master trusts and fund managers to use their judgment to decide what risk is worth taking. 

What became clear in our modelling is that maximising risk exposure when members are younger does not compensate for longer derisking periods.

Julius Pursaill is a strategic adviser at Cushon