COVID-19 has caused significant volatility in financial markets, creating headaches for defined contribution pension schemes seeking to deliver robust outcomes. Overcoming this requires a full map of risks along the savings and retirement journey, argues Francois de Bruin.
As part of their fiduciary duty to members, pension schemes must make decisions in a maelstrom of shifting uncertainties and will naturally look to minimise risk in their portfolios. Modern portfolio theory relies on volatility as the primary measure of risk, but there is a serious question mark over whether it adequately captures the biggest risks to investors.
One limitation is that it doesn’t distinguish between upside and downside returns, whereas investors are chiefly concerned with loss of capital or shortfall risk. In 2014, research showed equity investors are not compensated for volatility on a risk-adjusted basis.1 Left-tail measures, which deal with value-at-risk and loss of capital, are much better predictors of excess returns. In other words, the fact prices fluctuate does not imply much about inherent riskiness. An investment’s ability to deliver sustainable value or productivity, particularly during times of stress, is much more significant and something poorly captured by volatility. But what risks should investors consider to build resilience into their portfolios?
Mapping out risks along the savings and retirement journey
The risks are multiple, overlapping and complex. Drawing on mental imaging techniques, we can map them out along the accumulation and decumulation phases of a scheme member’s journey. This can help inform schemes’ decisions in terms of investment guidelines, risk budgets and risk allocations. It can also help schemes communicate to members on key risks to their retirement plans, allowing them to make more informed decisions in terms of contribution levels and time horizons, and to understand how their adviser can help them navigate to and through retirement.
Figure 1: Potential pitfalls of the retirement journey – a map for scheme members
Volatility in context
Managing these risks is largely in the hands of pension managers, who are well aware of the difficult trade-offs they must make to maximise returns while managing exposures. Volatility risk still must play a part and, alongside inflation risk (5) and investment risk (6), is of course central to investment decisions and risk-budget allocations (see Figure 1).
Investment risk – the risk of default on bond repayments, share price fluctuation, equity dilution and possible bankruptcy when a company runs into fundamental issues due to strategy errors or external factors – can be easy to overlook in bull markets, particularly when using an index as a reference. As we enter a period of recession and considerable economic uncertainty, it is important to remember that, on average, 32 per cent of stocks that disappeared from the S&P 500 index between 2000 and 2016 were due to corporate failures (Figure 2).
Figure 2: Reasons for removal from the S&P 500 Index, 2000-2016
As for bonds, after falling below their historical average in recent years, default rates are now expected to rise – though much will depend on economic conditions, as well as monetary and fiscal support in response to COVID-19 (Figure 3).2
Figure 3: Credit spreads suggest defaults are coming
Troubled times like these, when many investors sell at the same time and almost all asset values start falling, are also a stark reminder of the impact liquidity (11) and correlation risks (8) can have on returns – and of the benefits of being able to hold onto assets until a measure of calm returns (See Figures 4, 5).
Figure 4: 52-week correlations as of January 3, 2020
Figure 5: 52-week correlations as of April 15, 2020
Over the longer term, regulatory risk (12) and sustainability risk (10) have steadily risen in recent years – and both are here to stay.
The latter is also a risk for scheme members, as it can depend on their investment choices as well as those of their pension fund manager. Several other risks are also in their hands, and pension schemes can help members better prepare for their savings and retirement journey through communication and education.
Helping scheme members prepare for retirement
As the savings and retirement map shows, member engagement and an understanding of the risks are crucial. In addition to sustainability risk, depending on where they are on the retirement journey, members can be exposed to risks of shortfall, longevity, volatility, drawdown, behaviour and timing.
Timing risk (9) can affect the total wealth an investor accumulates, depending on where markets are when they start saving and when they retire. If they start saving at the beginning of a market downturn, it can take them much longer to accumulate the same amount as an investor who invested the same amount at the beginning of a rally. It is a key risk in the current environment, and savers should think about investing larger sums where they can, to at least partly make up for lower returns.
Shortfall risk (1) is linked to timing risk, and is the risk total savings will fall short of an investor’s goal and never return to expected levels; either because they have not set aside enough money periodically, because investments have not performed as well as expected, or a combination of the two.
While the prospect for life expectancy has changed, so too has the prospect for total returns. Slower growth and demographic trends have given rise to historically low yields and, in aggregate, equities and bonds are unlikely to deliver the returns of the past.
Over a five-year horizon, current yields are a good proxy for prospective returns. The Bloomberg Global Aggregate Bond Index today yields less than two per cent, suggesting investors need to balance capital preservation against their multi-decade needs (Figure 6).
Figure 6: Bond return expectations
Agency issues might also arise if retirees, who clearly have a long-time horizon, default to balanced funds with large bond allocations, where managers are reviewed on significantly shorter timespans and can manage near-term outcomes at the potential cost of long-term ones.
These investors may need to add credit risk for additional yield or increase their allocation to equities. It represents a conundrum though, as the long-term historical returns for equities are unlikely to be repeated.
Robert Shiller’s cyclically adjusted price-to-earnings ratio looks at average inflation-adjusted earnings over a ten-year period, and finds the price paid for these earnings to be a reliable predictor of long-term returns. Based on a cyclically adjusted earnings yield of less than four per cent today, equity returns have never delivered double-digit annualised returns over a ten-year holding period (Figure 7).
Figure 7: Equity return expectations are lower
Longevity risk (2) is the risk the retirement pot runs out before the end of the investor’s life. While defined benefit schemes are familiar with it, in defined contribution schemes this risk is borne by the end investor, who needs sufficient savings to last several decades in retirement.
To give an example, according to the Office for National Statistics, a British male who turns 65 today (who was only expected to live to 67 years when born) is expected to live for another 20 years on average, while the percentage of people expected to live to over 100 is increasing (Figures 8, 9).
Figure 8: Life expectancy at birth
Figure 9: Life expectancy at 65
While this is cause for celebration, investors need to consider any near-term adjustments against the long-term prospective returns of different asset classes. Asset allocations should therefore reflect appropriate time horizons. Longer life expectancy also means savers must be careful to not draw their capital down too quickly, particularly when market conditions are affecting returns.
The difficulty of keeping emotions at bay
Drawdown risk (4) – the risk retirees will shrink their savings pot too quickly – tends to be poorly captured by traditional risk measures. This is because it is only prevalent for a certain cohort of investors – those in decumulation – and doesn’t feature on factsheets. Those forced to sell shares or units to meet their near-term needs run the risk of not having enough assets remaining to recover over the long term.
To illustrate drawdown risk, we can take the example of savers retiring anywhere between 1970 and 2000. Figures 10 and 11 show a wide range of global equity returns over the 20-year periods, from 16 per cent per annum for the 1980 retiree to 6.7 per cent per annum for someone retiring in 2000.
Figure 10: The accumulation journey: Long-term investor returns have been strong although outcomes vary greatly
Assuming these investors decided to draw down over 20 years, at an annual rate equal to the market’s average annual return; starting with $100,000, the average expected end value is $10,000. Significantly, in 11 of the scenarios the retirees run out of money. That is a 35 per cent chance of ruin over a 20-year period, knowing an increasing number of savers will live longer than 20 years in retirement.
Figure 11: The decumulation journey: Investor outcomes in drawdown are highly path-dependent despite strong returns
Going back to our initial thoughts, volatility (3), although not the only risk, can exacerbate drawdown risk by causing widely divergent outcomes for investors in the same plan but who enter drawdown only months apart. Most investors aim to reduce volatility by increasing their allocation to bonds, but this creates a difficulty because, as we have seen with longevity and shortfall risks, this type of reallocation can come at the cost of long-term outcomes.
This can be compounded by behavioural risk (7), when emotionally charged decisions lead savers to draw down just as volatility pushes asset prices down, forcing them to sell even more assets.
Some of this is down to luck, but investors who are aware of the risks will be better prepared – for instance, they might discuss their options with an adviser, increase their contributions or change the timings of their drawdowns.
As the map of the savings and retirement journey shows, each risk may affect scheme members’ paths to varying degrees at different points in time and combine with others to multiply or offset the impacts.
The outcome is that market returns do not equate to investor returns. All investors look at long-term time series to decide how and where to allocate, but this often masks the reality of savers’ experience, which is magnified once they start drawing down income.
Pension schemes and advisors can help scheme members understand where they are on the map, keep the different risks in mind and consider how they can best manage them to reach their desired retirement destination.
Ultimately, we can make better decisions if we identify as many risks as possible, even if they are difficult to quantify. As Annie Duke, World Series of Poker champion and author of Thinking in Bets: Making Smarter Decisions When You Don’t Have All the Facts, puts it: “Ignoring the risk and uncertainty might make us feel better in the short run, but the cost to the quality of our decision-making can be immense. If we can find ways to become more comfortable with uncertainty, we can see the world more accurately and be better for it”.