How to take some of the worry out of market volatility

In our survey, 40 per cent of members indicated they would tolerate a loss of only 10 per cent or less in their savings before feeling the need to make changes to their plan. The figures were higher still for those in the 22-34 age range, at 49 per cent.

Among the changes they indicated they might make were to freeze contributions, reduce saving, seek more conservative investments and even discontinue membership of the plan.

The data is particularly sobering in light of the double figure falls in global equity markets over recent months. How might we have expected members to react amid the market turmoil that ensued during 1987’s ‘Black Monday’, 1998’s Russian debt default, the bursting of the tech bubble in 2000 or the global financial crisis in 2007?

The impact is intensified of course as members approach retirement, when their ability to tolerate losses diminishes because their available recovery horizon is shorter.

A well-diversified portfolio provides a solid foundation for balancing asset class-specific volatility and should narrow the range of outcomes

With default funds the favoured investment option for many DC savers, addressing volatility within the default strategy presents a good starting point.

A well-diversified portfolio provides a solid foundation for balancing asset class-specific volatility and should narrow the range of outcomes.

Asset allocation also needs to be flexible enough to adjust, dynamically, over time to account for potential market downturns that can contribute to the substantial declines in pension savings that concern members.

In addition, systematic volatility management can be introduced using strategies like target volatility triggers. These adjust equity asset allocation in line with market conditions to maintain a desired level of risk within the equity portfolio.

Modelling equity volatility

TVT strategies typically overlay a portfolio’s equity exposure. A level of volatility is set, either within an off-the-shelf product, or tailored according to a plan sponsor’s requirements.

The TVT strategy establishes a daily forecast of future equity volatility – based on the equity market’s realised volatility over the trailing 12 months.

This forecast figure is used to predict the portfolio’s volatility level based on its exposure to equities. When predicted volatility is high, the equity exposure is reduced to bring the portfolio’s risk level back to the desired threshold and vice versa.

One key characteristic of TVTs is that they do not continually hold a ‘risk-off’ position. Only a pick-up in volatility triggers derisking of the portfolio. This can allow improved participation during a market’s upside.

For DC plans, TVT strategies are available as standalone funds that can be incorporated within a scheme’s default glide path. The glide path can then be implemented via a lifestyle strategy or a target date fund.

TVTs come with trade-offs

However, TVTs come with a few trade-offs. They might not offer protection from sudden corrections and bounce-backs not signalled by the market’s trailing realised volatility. Depending on the trading threshold and realised volatility, TVTs also could lead to increased transaction costs.

Furthermore, these shifts in equity weighting can increase tracking error compared with a fund’s benchmark. Explaining a substantial difference between a fund’s return and that of its benchmark — as well as times when a fund’s equity weights are smaller or larger than the portfolio’s strategic equity allocation — may present communication challenges for plan sponsors.

Members in default funds that do not adjust may be more exposed to volatility losses that can have a big impact on confidence in their investments. We need solutions that provide them with the intuitive flexibility they expect.

Alistair Byrne is senior DC investment strategist at State Street Global Advisors