Lifestyling is letting down pension savers because it treats them all the same, says a new report from the Cass Business School and BNY Mellon. Paul Farrow investigates
Lifestyle strategies are not the silver bullet that will protect defined contribution investors and they will be “poorer” in retirement as a consequence of them.
This is the finding of a new report published by the Cass Business School in conjunction with BNY Mellon.
The authors of the report found that lifestyle and target date strategies are too rigid because they bundle together people of the same age with the same number of years before they retire as though they have the same income objectives in retirement. Lifestyle also assumes that all workers will annuitise on retirement, it said.
The Cass report found that a lifestyle approach also fails to consider how close individuals are to achieving their target retirement incomes.
What this means in practice is that in most existing DC arrangements two people of the same age, with entirely different retirement income objectives, one ’on target’ and the other significantly ’under target’, will have identical asset allocation profiles.
David Calfo, head of DC at BNY Mellon says: ” Lifestyle is very mechanistic in its approach and in some conditions its fine - but with uncertainty outcomes are all over the place. Lifestyle is probably not the way to go.”
“Much is made of the fact that DC is different from defined benefit, and rightly so. DB schemes treat members’ assets as a single pool with corresponding liabilities, whereas DC schemes have historically focused solely on scheme members’ assets, with little consideration to their needs in retirement. With this in mind, we wanted to investigate the extent to which aspects of the way in which DB schemes view and treat assets in the context of liabilities could be applied to DC schemes.”
It is not just lifestyle that is failing members. So to is target date says the report, and although Calfo concedes that target date strategies are an improvement, he argues that they still make the same assumption that two 55 year-olds should be treated as one.
“Two workers might be the same age and have the same retirement date, but one might want to retire on two-thirds salary and the other 50 per cent - they also might be on different salaries. Their liabilities are not being recognised. Many people think that DC members don’t have liabilities, but they do.”
Lifestyle is very mechanistic in its approach and in some conditions its fine - but with uncertainty outcomes are all over the place
Calfo’s use of the word liabilities is noteworthy. It is why many pension experts are looking at whether liability driven investing can be used in DC.
Tomorrow’s generations will have to rely solely on DC schemes to fund their retirement, unlike today when many retires have some form of DB to fall back on.
Pension rules have changed and annuity purchase is no longer compulsory. Coupled with low annuity rates many advisers recommend would-be pensioners to adopt a flexible approach that might involve part-annuitisation and some sort of drawdown.
What’s more, the demand for such flexibility will only increases as people retire with bigger DC pension pots - far bigger than the current average DC pot from a private company scheme of around £50,000, according to Aon Consulting.
Mark Jaffray, head of DC investment at Hymans Robertson admits that there needs to be recognition that a one-size can’t fit everyone. “We are talking to a lot of clients. Different members want to different levels of risk and accumulate and different paces. As you get to retirement people have different needs regarding annuities or whether you will use income drawdown.”
“Go forward 10 years people will have significant pot sizes and once you get to that level of size do you want to be locking down into an annuity. Do you want to use flexible drawdown? You might want a base annuity and use the rest to be flexible and draw some dividend income.
The industry needs to get to grips with this because as it stands it is built for buying an annuity.”
As it stands lifestyle is the strategy of choice for many schemes. Essentially it de-risks workers as they approach retirement, switching out of equities and into bonds. But Cass Business School’s report has questioned whether it works - it is a finding that will stir debate with the DC arena.
According to Cass, a DC member beginning the lifestyling, or de-risking process in 1980, required a DC pot of £5,766 to achieve a replacement ratio of two-thirds of his or her final salary; by 2001 this figure had risen to a staggering £152,986.
To put this into a real context Cass said, in 1980 its representative DC member would have needed a DC pot equivalent to just under twice his annual salary at 55 (in 1990); by 2001 the necessary pot size would have needed to be just over nine times his annual salary at 55 (in 2011).
In another example, had DC members begun their lifestyling in 1980, and assuming that they did not take any tax-free lump sum from their fund, they would have been able to purchase a level payment annuity equivalent to 73 per cent of their final salary, or an RPI-linked annuity equivalent to 40 per cent of their final salary.
The problem is that the pensions market focused on DC, on a target
or a potContrast this with the fortunes of the equivalent individuals beginning their lifestyling journey in 2001. These individuals can only afford a level payment annuity equivalent to 21 per cent of their final salary, or an RPI-linked payment equivalent to just 12 per cent of their final salary.
This reflects the poor equity returns of the last 10 years. But it also illustrates how lifestyling has failed to deal with annuity rate risk. Calfo added: “Historically lifestyle strategies were put in place but they have not been looked or modified since.”
There are those that reckon that LDI can be modified for DC workers. We argue that members, trustees, sponsors and consultants need to think further ahead than just accumulating a pot of money that can be used to buy an annuity - they need to start thinking more strategically about their income replacement and even the state of their pension after they have retired.
Jaffray suggests that and DC members do have ’liabilities’ in they just don’t know about it. “Essentially workers have a massive deficit and they will have a funding plan and you try to recoup that deficit.
“DC prefers having targets and targeting an income. If you think of DB managing assets allocation over time to better match those liabilities then you can translate some of those principles to DC.”
If LDI, as a concept, is going to work, experts believe that DC members will need to think about their pension in greater detail. They should not view it as simply saving a pot of money. A pension statement landing on their doorstep means very little in reality because it is impossible to estimate what the replacement income ratios will be years down the line.
Jaffray says: “The problem is that the pensions market focused on DC on a target or a pot. You have to remember that lifestyle does have some benefits - it does slowly de-risk people towards retirement and although people have different targets they will come a point that people want some certainty regardless of how well off they will be in retirement. Even if that certainty is that I will retire on 20 per cent of salary, rather than 40 per cent.”
Malcolm Delahaye, director at SuperTrust agrees with Jaffray, although he is sceptical on how it could work if members are not fully engaged and do not have access to online tools. He is also not against lifestyle either because it does constrain volatility and ensure that extremes of volatility of pension outcomes do not arise.
But he said that those DC members are mistakenly led to believe that the investment strategy is all about betting on getting upside from a risky asset. Because there is no balance sheet concept, the impact of future contributions and what might happen is ignored.
“Future pension prospects are portrayed plotting from current market values as if they would only ever have moved up from yesterday’s values.
This is the result of savers not knowing where they were heading for when they set out, and only getting information on the left side of their balance sheet as if it had no future contributions. Imagine if DB trustees made decisions based on this information.”
It is early days but a few fund groups are investigating the LDI approach for DC. Schroders is one.
Steve Bowles at Schroder says that it is possible to transfer the investment methodologies used in LDI for DB pension schemes into DC and create new investment solutions that can be implemented as part of a lifestyle type solution.
“Rather than switching into gilts as you approach retirement it is now possible to use interest rate and inflation swaps. The characteristics of these investment tools mean that annuity rate hedging can be implemented much earlier, with a significantly reduced impact on the overall portfolio’s ability to deliver growth.
“It is possible to dial down the compromise and offer member a better hedge,” he concludes.
Bowles said that lifestyle hedges out annuity risk using solid asset such as bonds, but also
sing synthetic investments could potentially deliver better outcomes. “We can better match out that risk using swaps - if you use leveraged debt you can implement your price protection earlier. You are not buying £1 of protection by selling £1 of growth, you can sell £1 of growth for £8 of protection.”
But Schroders is not just battling to convince trustees and consultants. It also has regulatory issue to face. “Leverage is where the value comes from and this is where problems arise as most use life funds and this is not permissible,” adds Bowles.
The Cass Report will stir debate within DC circles and whether lifestyle is the best route for the masses - the move by Nest to use target-date suggest that many believed it to be too rigid.
But Calfo is adamant that the industry needs to find a solution if workers expectations in retirement are going to be met. “No one has cracked LDI in DC yet,” he said. “But the quicker they do, the better.”
John Lawson, head of pensions policy, Standard Life
I think we have room for improvement is bringing this planning forward to people who are still in the DC savings phase, particularly those in their mid-40s upwards.
We should encourage individuals to start considering what retirement looks like. Will their mortgage be paid off? Will their kids or parents still need financial support? What sort of lifestyle do they aspire to? That would enable a sensible conversation to develop about setting a realistic retirement age. Once that bridge has been crossed, the conversation can then develop to what the income requirement looks like and how best to deliver that.”
Daniel Smith, director business development, Fidelity
The trend towards de-risking is indeed moving to DC. The levels of volatility have shocked plan members over recent years; they want a less bumpy investment journey. As such there has been a shift in focus away from the objective of maximising returns to looking more at controlling risk.
This has lead to an increased demand for multi-asset funds but also for those funds with dynamic asset allocation, which adapt according to an individuals investment time horizon. This has encouraged development of more sophisticated lifestyle strategies which seek to identify the level of risk an individual is able to tolerate in order to establish a “risk budget”.
Billy Burrows, director, Better Retirement Group
The basic rule of investment, that you do not put all your eggs in one basket, also applies to annuities.
The dilemma for individuals is they are facing a number of different risks at retirement. They do not know whether inflation is going to be low or high and they do not know whether the stock market is good or bad.
A combination of annuities is looking at spreading their individual risk and it also recognises that conventional annuities are increasingly offering poorer value to the Middle Britain cohort as things like postcode annuities and Solvency II have an impact.
lifestyling, annuity rates and pensionsPanel A: Historic annuity rates Panel B: Annual pension for typical DC member