Why industry critics are wrong about 'reckless conservatism'

Try swapping the word ‘losses’ for ‘gains’. Setting ambitious return targets for younger savers can only ever have a modest impact on their final pot size at retirement.

So why not take a more pragmatic view of risk capacity and also design an investment journey which doesn’t ignore younger savers’ risk appetite? After all, risk capacity should be seen as precisely that – capacity. It’s a limit, not a target.

We have modelled the outcomes of the Nest foundation phase and found that the impact of taking less risk when contributions are small amounts to a difference of a percentage point or two – or a few hundred pounds on overall pot size at the end of a savings career. 

Of course, it’s impossible to predict in advance for any given scenario whether a risk-on or risk-off approach will deliver the higher realised return, but what we can say is that it will only be a small amount either way – and well within the margin of uncertainty.

Risk capacity should be seen as precisely that – capacity. It’s a limit, not a target

The main thing that does make a difference is contributions. A regular and continuous contribution history will have by far the biggest impact on the final outcome.

Leverage can play different roles in portfolio management. On the one hand it can help build a risk parity portfolio and on the other it can help you climb the capital market line. At Nest we have a lot of faith in some of the principles behind risk parity – that risk allocation and not just capital allocation is crucial to building a truly diversified portfolio.

However we don’t believe that leverage is the best way to achieve maximum risk diversification – we take a true portfolio view of our members’ money. We are aware, for example, that they may have significant leverage in their home finances and also through the balance sheets of the companies their pensions are invested in.

As for using leverage to push for ever higher returns, we believe this runs against fiduciary duty and common sense, particularly when we consider the ultimate downside risk DC savers face – losing faith in saving and ceasing contributions.

Tested and proven behavioural science shows that people are far more emotionally opposed to losses than they are attracted to potential gains. This is called prospect theory and is part of the reason why members will ‘catastrophise’ – or see the chance that their money is at risk as the same as the chance of losing everything. While inertia and default effects are strong and will generally overcome people’s natural aversion to risk, they are not absolute.

We analysed 25,000 DC pension savers who mapped very closely the population for auto-enrolment. Looking at their behaviour before and after the financial crisis of 2008 revealed starkly how the experience of significant real losses can prompt people to act in ways that may be against their best interests.

Nearly half – 46 per cent – of the population we studied responded in some way to the interim losses caused by the financial crisis, either by changing their contribution patterns, increasing their fund-switching activity or a combination of both. The most striking and concerning finding was that 15 per cent stopped contributing altogether.

So if the amount of risk taken on small contributions has very little impact on overall pot size, why swim against the tide of behavioural science and empirical evidence that all point to the very big risk that people will respond negatively to losses?

Keeping people saving in those early years is the most important thing that can improve someone’s retirement prospects. If they opt out or stop contributing, the impact on their final pot size will be far greater than a few percent either way.

Mark Fawcett is chief investment officer at Nest