Reckless conservatism: Why it blights young people’s DC pots

Other issues such as the cost of annuities and how to derisk into retirement have been the subject of much debate since the 2014 Budget announcement.

Perhaps what we need is more leverage, so funds aim to achieve similar volatility to equities but with higher expected total returns

Here we will consider whether adding more risk into a DC portfolio for young people will produce better retirement benefits.

While contributions are significant in the context of a member’s fund size, higher volatility is less of a risk than when the fund size dwarfs the impact of current and future contributions. 

The merits of reducing volatility as members age are therefore twofold: the fund is closer to being needed and the ability to benefit from volatile asset values – ie buying more units for the same contribution when they are cheaper – and the ability to pay more contributions to compensate for investment losses, is reduced. 

The investment rationale for having higher risk in the earliest years then reducing in stages over the investment period until they are needed for retirement benefits is strong. 

However the question remains as to how much risk makes sense in the earlier years of saving for retirement. Members only really have four levers to pull in their retirement provision: contributions, retiring later, retiring on less, or higher investment returns.

Here we need to consider the behavioural economics of the situation as well as the investment arguments.

Nest is well known for its foundation phase where the balance is tilted towards capital preservation rather than growth. Much of the rationale for this came from asking prospective members about their loss aversion, which proved to be quite high among those surveyed. 

However, in most DC employer-sponsored arrangements the employer contribution is at least as large as that paid by the member, and the members often end up with three or four times their net contributions actually being invested after tax relief.

This means that in the early years, even after any poor investment years, it is unlikely that a member will have a fund size that is not at least the amount it has cost them through net contributions. 

It seems members are unlikely to stop contributing after poor investment periods, even if that performance is just after they have joined the arrangement. 

The typical lifestyle strategy has the inherent flaw that the most risk to the member is at the time that derisking is about to start.  This is too late in the process and if members could take more risk earlier they could reduce risk earlier as well – and still achieve similar average outcomes, with less variability of outcome. 

We are seeing some DC arrangements use risk parity funds as part, or all, of their growth portfolio. The most efficient of these vehicles leverage their allocations to the less risky assets in their diversified portfolio with the aim of producing similar total returns to equities with lower volatility. 

But perhaps what we need is more leverage, so funds aim to achieve similar volatility to equities but with higher expected total returns. 

If we then held these assets for a period before moving to less leveraged products, and then remove leverage totally as members approach middle age, the shape of the risk in the strategy will be better suited to the level of assets invested and future contributions to be paid.

The new world of freedom and choice means the timeframe of DC investing is potentially extended, as all of the pension pot could remain invested post expected retirement. 

This means the growth phase is effectively longer than previously, further increasing the potential risk tolerance in the earlier years, and even the middle years. Derisking can therefore be delayed, possibly not reaching the end point, until after retirement and a longer timeframe allows more volatility to be carried for longer.

The Pensions Regulator is encouraging better DC governance, which is likely to lead to consolidation of fiduciaries – ie bigger mastertrusts and delegated contract-based solutions. 

Between them, these developments should enable investment efficiency to be improved and with it proper oversight.

However, it is by no means certain these will address the reckless conservatism inherent in young people’s pensions savings, even if additional risk is reasonable in the context of their long savings journey.

Chris Smith is a senior consultant at Towers Watson